-- 

-- 

THE SECRETARY OF THE TREASURY 

WASHINGTON 20220 

FOREWORD 
 

In December 1975, in a speech to the Tax Foundation, I 

called for a fundamental overhaul of the U.S. tax system.

1 felt that I was speaking for millions of Americans who 

were fed up with the current tax system and wanted it 

replaced with one they could understand and trust. I noted 

that we need to return to the basic principles upon which 

our income tax system was founded and the three cornerstones 

of its structure equity, efficiency and simplicity. I 

said we need to wipe the slate clean of personal tax preferences,

special deductions and credits, exclusions from income and 

the like, and impose a single, simple progressive tax on all 

individuals. In the months that have passed since that 

speech, I have received overwhelming evidence that thin is 

indeed the way the American people feel. 

It is time to start over from scratch and develop a new 
 tax system in the United States. It must be a system that 
 is designed on purpose, based on a clear and consistent set 
 of principles, which everyone in the United States can 
 understand. 
 

During the past year, at the same time my staff and I 

were working with the Congress on the Tax Reform Act of 

1976, we were also engaged in a major study, which we called 

the "Basic Tax Reform" study. We began by examining irhe 

concept of "income" and what it can and should mean as the 

base for Federal taxation. We looked at all the transactions 

and circumstances that produce what we commonly think of as I, .

income," and we also considexed "income" from the standpoint

of its uses its value to those receiving it. 

We then tried to develop an ideal income base that took 

into account all possible forms of income but that equally

considered practical realities and the overriding importance 
of a simple tax system, Our “real-world‘‘implementation
 reflects many compromises and modifications that we have 
 discussed explicitly in the study so that everyone can 
 evaluate our judgments and our conclusions. 
 

Our report -- Blueprints for Basic Tax Reform -- presents the results of this year-long study. It gets down 

to the fundamentals. 

This report presents two specific model tax systems.
 The first is a plan for broadening the base of the income 
 tax. It calls for integration of the corporate and personal
 income taxes, taxation of capital gains at full rates after 
 allowing an adjustment for inflation, and taxing many other 
 items that presently are not taxed. In place of the existing
 complex rate structure, with rates ranging from 14 to 70 
 percent, the model plan has only three rate brackets,
 ranging from 8 percent to 38 percent. 
 

The second model is based on consumption and is called 

a cash flow tax. It differs from an income tax in excluding

savings, although the withdrawal of savings for consumption

of goods and services would be taxed. This model also has 

three tax brackets with rates from 10 to 40 percent.

Because the present income tax system has many important

similarities to the cash flow tax, the change to this model 

would not be as great as it might seem. 

After years of seeking to reform the tax system, I am 

convinced that tinkering is no longer the answer. We must 

design an entirely new tax system , adopt it as an integrated whole, with a much broader tax base but with much 

lower and simpler rates so that it will be widely accepted

and so that all can share its advantages. This report is a 

start toward this objective. It demonstrates clearly that 

we can construct a fair, efficient progressive tax system in 

the United States. 

Responsibility for preparation of this study was taken 

by Assistant Secretary for Tax Policy Charles M. Walker. 

Deputy Assistant Secretary William M. Goldsteln provlded

important counsel. Primary work on this project was undertaken 
--- 

by Deputy Assistant Secretary David F. gradford. Mr. Bradford 

and the staff of the Office of Tax. Analvsis z--- are due snecial -z- -­

recognition for their professional expertise and special 

thanks for their devotion to this task. 

Washington, D.C. 
 January 1971 
 

DEPARTMENT OF THE TREASURY 

WASHINGTON, D.C. 20220 

SaSTANT SECRRARV 

ACKNOWLEDGMENTS 
 

It is hard to imagine a project more appealing to a 

public finance economist than directing the professional
 staff of the United States Department of the Treasury in a 
 study of income tax reform. A yeas ago Secretary William E. 
 Simon asked Assistant Secretary Charles M. Walker to prepare 
 a plan to simplify the tax system. As Deputy Assistant 
 Secretary and Director of the Office of Tax Analysis, I was 
 asked to lead this effort. With the publication of "3lueprints
 for Basic Tax Reform," the main objective of the project is 

accomplished, and it is my pleasure now to acknowledge the 
 superb efforts of those who did so much of the work. The 

pages of the report are the product of a tremendous cooperative

effort, much of it applied during evenings and weekends, 
 by many dedicated people. 
 

An especially important role was played by Harvey

Galper, Associate Director of the Office of Tax Analysis.

His experience and acumen as a tax analyst contributed 

directly to the prolect and his sense of humor and enormous 

capacity for work contributed indirectly by ensuring the 

smooth functioning of the Office. It was a delight to work 

with him. 

Other principal associates in drafting the report were 
 Larry L. Dildine and Eric J. Toder of the Office of Tax 
 Analysis and Charles M. Whedbee, on loan from the Internal 
 Revenue Service. Their analytical skills are reflected 
 throughout the report. 
 

Nelson McClung took principal responsibility for 

assembling the data base for the study, supported by J. 

Scott Turner, with Roy Wyscarver manning the computer

simulations. Gary Robbins kept the project moving toward a 

sequence of unmeetable deadlines. Ron Garbin and the Office 

of Computer Science, Office of the Secretary, provided

programming support. 

The early groundwork for the study was developed with 
 the assistance of Seymour Fiekowsky, Nelson McClung, Hudson 
 Milner, and Ralph kist01 of the Office of Tax Analysis, and 
 Richard Koffey, now Deputy Tax Legislative Counsel. 
 
Many others, inside and outside the Department of the 

Treasury, contributed to the work. These include Peter 

Cook, John Copeland, Daniel Feenberg, David fly^, Geraldine 

Gerardi, Gary Hufbauer, Michael Kaufman, Thomas King, Allen 

Lerman, Howard Nester, Gabriel Rudney, Jay Scheck, Eugene

Steuerle, Walter Stromquist, and John Wilman, all members of 

the Office of Tax Policy Staff. Joseph Foote of Washington,

D.C., Peter Mieszkowski of the University of Houston, Harvey

Rosen of Princeton University, Richard Barr of Southern 

Methodist University, and Ann Bergsman of Hendrickson 

Corporation brought their special knowledge to bear on the 

problems we confronted. Others outside the Treasury who 

assisted in various ways include William Andrews, Martin 

Bailey, Edwin Cohen, Martin Feldstein, Frederic Hickman,

Daniel Halperin, Bernard saffran, mil Sunley, Nicholas 

Tideman, and Alvin Warren. 

Finally, for their unsurpassed skill, never enaing

patience and cheerfulness, deepest thanks to Rosalind Carter 

and Xathi Cambell who typed and typed and typed and .._. 

for Tax Policy (Tax Analysis) 

Washington, D.C. 
 January 1977 
 
TABLE OF CONTENTS 
 

Chapter 1: INTRODUCTION AND SUMMARY OF TEE REPORT 

OVERVIEW............................................ COMPREHENSIVE INCOME TAX ............................ 
 Integration of the Corporation and Individual 
 Income Taxes...................................... 4 
 

Treatment of Capital Gains and Losses............. 5 
 

Depreciation .ules ................................ 6 
 

State and Local Bond Interest..................... 6 
 

Imputed Income from Consumer Durables............. 7 
 

Itemized Deductions............................... 7 
 

Retirement Income and Unemployment Compensation... 7 
 

Choice of a Filing Unit and Exemptions for 
 

Family Size ....................................... 8 
 

CASH FLOW. CONSUMPTION BASE TAX..................... 9 
 

Advantages of a Consumption Base.................. 9 
 

How a Consumption Base Could Be Taxed............. 10 
 

Similarities to the Present Tax Base.............. 10 
 

Treatment of Investments in the Model Plan........ 11
 

Other Features of the Cash Flow Tax............... 11
 

The Filing Unit and Tax Rates..................... 12 
 

TRANSITION PROBLEMS................................. 13 
 

HOW AN INDIVIDUAL WOULD CALCULATE TAX LIABILITY 
 UNDER THE REFORM PLANS.............................. 13 
 

Elements Common to Both Plans..................... 13 
 

The Comprehensive income Tax...................... 14 
 

The Cash Flow Tax................................. 14 
 

CHAPTER-BY-CHAPTER OUTLINE OF THE REMAINDER OF THE 
 PORT...... ........................................ 15 
 

Chapter 2: WHAT IS TO BE THE TAX BASE? 

INTRODUCTION........................................ 21 
 

TWO PRELIMINARY MATTERS OF EQUITY................... 24 
 

Equity Over what Time Period?..................... 24 
 

Is the Family or the Individual the Appropriate
 unit? ............................................. 25 
 

INCOME AND CONSUMPTION.............................. 26 
 

Definitions of Income and Conswnption............. 27 
 

THE PRESENT TAX BASE................................ 33 
 

Is the Present Base Consumption or Income?........ 33 
 

1s the Tax system Presently on an "Ability-
 to-Pay" or a "Standard-of-Living" Basis? .......... 36 
 
ALTERNATIVE: BASES: EQUITY CONSIDERATIONS........... 
 Consumption or Income: Which is the Better 
 Base?............................................. 
 " Standard-of-Living" or "Ability-to-Pay": 
 

Which Criterion?.................................. 
 Summing Up: The Equity Comparison of Consumption
 and Income Bases.................................. 
 ALTERNATIVE TAX BASES: SIMPLICITY CONSIDEMTXONS... 
 Consumption or Income Preferable on Grounds of 
 Simplicity?....................................... 
 Measurement Problems.............................. 
 "Standard-of-Living" or "Ability-to-Pay"
 Preferable on Simplicity Grounds?................. 
 EFFICIENCY ISSUES IN A CHOICE BETWEEN AN INCOME 
 AND A CONSUMPTION BASE.............................. 
 SUMMZNG UP.......................................... 
 

Chapter 3: A MODEL COMPREHENSIVE INCOME TAX 

O..RVIEw ............................................ 
 Purpose of the Model Tax.......................... 
 Base-Broadening Objective......................... 
 Organization of Chapter 3......................... 
 EMPLOYEE COMPENSATION............................... 
 Expenses of Employment............................ 
 Employer-Provided Pensions........................ 
 Social Security................................... 
 Employer-Paid Health and Casualty Insurance....... 
 Disability Insurance.............................. 
 Life Insurance.................................... 
 Unemployment Compensation......................... 
 PUBLIC TRANSFER PAYMENTS............................ 
 Model Tax Treatment............................... 
 Rationale for Taxing Transfer Payments............ 
 Valuing In-Kind Subsidies......................... 
 BUSINESS INCOME ACCOUNTING.......................... 
 Basic Accounting for Capital Income............... 
 Capital Consumption Allowances.................... 
 Self-constructed Assets........................... 
 Other Business Income Accounting Problems......... 
 INTEGRATION OF THE INDIVIDUAL AND CORPORATION 
 INCOME TAXES........................................ 
 The Corporation Income Tax........................ 
 Inefficiency of the Corporation Income Tax........ 
 A Model Integration Plan.......................... 
 Administrative Problems of Model Tax 
 Integration....................................... 
 

38 
 

38 

41 
 

41 
 42 

43 

44 

48 

49 

51 
 

53 

53 

53 

54 

54 

55 

56 

58 

59 

59 

60 

60 

61 

61 

62 

63 

63 

63 

64 

66 

67 

68 

68 

68 

69 

73 
The 1975 Administration Proposal for Integration.. 75 
 CAPITAL GAINS AND LOSSES............................ 75 
 

Accrual Versus Realization........................ 75 
 

Present Treatment of Capital Gains................ 76 
 

Model Tax Treatment of Capital Gains.............. 77 
 Capital Losses.................................... 79 
 

Taxation of Accrual in the Model Tax.............. 79 
 Accrual Taxation ALternative...................... 81 
 

Realization-With-Interest Alternative............. 81 
 

The Income Averaging Problem...................... 82 
 

Inflation Adjustment.............................. 83 
 

STATE AND LOCAL BOND INTEREST....................... 84 
 

Inefficiency of Interest Exclusion................ 84 
 

Inequity of the Exclusion......................... 84 
 

Alternatives to Tax-Exempt Bonds.................. 85 
 

OWNER-OCCUPIED HOUSING.............................. 85 
 

Imputed Rental Income............................. 85 
 

Deductibility of Homeowners' Property Tax......... 86 
 

Deauctibility of Mortgage Interest................ 88 
 

Consumer Durables.................................. 89 
 MEDICAL EXPENSES .................................... 89 
 Model Tax Treatment............................... 90 
 "Tax Insurance" Under Present Law................. go
 

Optional Catastrophe Insurance Provision.......... 91 
 STATE AND LOCAL TAXES............................... 92 
 Income Tax Deductibility.......................... 93 
 Property Tax Deductibility........................ 93 
 Sales Tax Deductibility........................... 93 
 

Alternative Treatment of Sales and Income Taxes ... 94 
 

3enefit Taxes ..................................... 94 
 

CONTRIBUTIONS TO CHARITIES.......................... 95 
 

Charity as Income to Beneficiaries................ 95 
 Charities as Public Goods......................... 96 
 

A Practical Alternative to Taxing Charitable 
 Organizations..................................... 96 
 

Alternative Tax Incentives for Philanthropy....... 97 
 

CASUALTY LOSSES..................................... 97 
 Model Tax Treatment............................... 97 
 

Present Law Trea~ent............................. 98 
 

INTERNATIONAL CONSIDERATIONS........................ 98 
 

The Residence Principle........................... 98 
 

Establishing the Residence Principle.............. 99 
 Interim Rules..................................... 100 
 THE FILING UNIT..................................... 101 
 Model Tax Treatment............................... 102 
 Problems of Taxation of the Filing Unit........... 102 
 Choice of the Filing Unit......................... 103 
 
The Problem of Secondary Workers .................. 104 
 Tax Adjustments for Differences in Family Status.. 105 
 ADJUSTING FOR FAMILY SIZE ........................... 106 
 Exemptions Versus Credits ......................... 106 
 SAMPLE COMPREHENSIVE INCOME TAX FORM ................ 107 
 

Chapter 4: A MODEL CASH FLOW TAX 
 

INTRODUCTION ........................................ 113 
 

Cash Flow Accounting .............................. 113 
 ELEMENTS IN COMMON WITH THE COMPREHENSIVE INCOME 
 

TAX ................................................. 116 
 

Family Size and Family Status ..................... 116 
 Deductions for Charitable Contributions, Medical 
 Expenses. and Taxes ............................... 116 
 Health. Disability. and Unemployment Insurance .... 118 
 Casualty Losses ................................... 118 
 DIFFERENCES BETWEEN THE CASH FLOW TAX AND THE 

COMPRERENSIVE INCOME TAX ............................ 119 
 The Treatment of Assets Under.a Cash Flow Tax ..... 119 
 

Equivalence of Qualified Account Treatment and 
 

Tax Prepayment. Approach ........................... 123 
 Treatment of Borrowing and Lending ................ 124 
 Advantages of Taxpayer Option Treatment of Asset 
 

Purchases and Borrowing ........................... 125 
 Lifetime Perspective of the Cash Flow Tax ......... 127 
 Uncertain Outcomes: A Problem with the Tax-
 Prepayment Approach ............................... 128 
 

No Optimal Treatment for Nonfinancial Business 
 

Assets ............................................ 130 
 

DIFFERENCES BETWEEN CASH FLOW AND COMPFSHENSIVE 

INCOME TAXES: SPECIFIC PROVISIONS .................. 131 
 

Pension Plans and Social Security ................. 131 
 Life Insurance .................................... 131 
 

State and Local Bond Interest..................... 133 
 

Interest Paid ..................................... 133 
 

Corporate Income .................................. 133 
 Capital Gains and Losses .......................... 134 
 

Business Income Accounting ........................ 135 
 

SPECIAL PROBLEMS: PROGRESSIVITY. WEALTH 

DISTRIBUTION. AND WEALTH TAXES ...................... 136 
 

Progressivity of the Tax .......................... 136 
 INFORMATION ON SAMPLE TAX FOX? FOR CASH FLOW TAX .... 140 
 

Chapter 5: QUANTITATIVE ANALYSIS 

THE DATA BASE ....................................... 145 
 
ESTIMATION OF THE INCOME CONCEPTS................... 147 
 Economic and Comprehensive Zncome................. 154 
 Present Law Tax................................... 156 
 A Proportional Comprehensive Income Tax........... 159 
 THE MODEL COMPREHENSIVE INCOME TAX.................. 159 
 

THE CASH FLOW TAX................................... 167 
 

COMPARISONS OF TAX LIABILITIES UNDER THE DIFFERENT 
 PLANS............................................... 172 
 The Marriage Penalty.............................. 172 
 Lifetime Comparisons.............................. 176 
 

Chapter 6: TRANSITION CONSIDERATIONS 
 

INTRODUCTION........................................ 181 
 WEALTH CHANGES AND THEIR EQUITY ASPECTS............. 181 
 Carryover Problems................................ 182 
 

. Price Changes..................................... 183 
 The Equity Issues................................. 185 
 INSTRUMENTS FOR AMELIORATING TRZLVSITION PROBLEYS.... 188 
 Objectives........................................ 188 
 Alternatives...................................... 189 
 PROPOSED SOLUTIONS TO SELECTED PROBLEMS IN THE 
 TRANSITION TO THE COMPREHENSIVE INCO-ME TAX.......... 191 
 Capital Gains..................................... 192 
 Corporate Integration............................. 194 
 

Business and Investment Income. Individual and 
 Corporate......................................... 200 
 Other Individual Income........................... 201 
 TRANSITION TO A CASH FLOW TAX SYSTEM................ 204 
 

Goals of Transition............................... 205 
 

Distribution Issues............................... 206 
 A Preliminary Transition Proposal................. 209 
 Alternative Transition Plans ...................... 211 
 

BIBLIOGRAPHY.......................................... 217 
 

BLUEPRINTS FOR BASIC TAX REFORM 

Chapter 1 
 

INTRODUCTION AND SUMMARY 
 

OVERVIEW 
 

There has been increasingly widespread dissatisfaction 

in the United States with the Federal tax system. Numerous 

special features of the current law, adopted over the years,

have led to extreme complexity and have raised questions

about the law's basic fairness. Many provisions of the code 

are, in effect, subsidies to certain types of taxpayers, or 

to particular interests, for some forms of investment and 

consumption. These subsidies are rarely justified explicitly

and, in some cases, may even, be unintentional. In many

instances, they alter the pattern of economic activity in 
 ways that lower the value of total economic output. Further, 
 although the Federal tax system by and large relates tax 
 burdens to individual ability to pay, the tax code does not 
 reflect any consistent philosophy about the objectives of 
 the system. 
 

Previous efforts at tax reform have not attempted a 

thorough rethinking of the entire tax structure. As a 

result, reform legislation aver the past 25 years has 

consisted of a series of patchwork palliatives, leading to a 

tax system increasingly difficult to understand. Indeed, 

the Tax Reform Act of 1969 has been referred to as the 

"Lawyers and Accountants Relief Act," and the Tax Reform Act 

of 1976 deserves this sobriquet no less. The confusion and 

complexity in the tax code have led Secretary of the Treasury

William E. Simon to suggest that the Nation should "have a 

tax system which looks like someone designed it on purpose." 

The first part of this report is devoted to clarifying

the goals of the tax system, attempting to give specific 

content to the universally recognized objectives of equity,

efficiency, and simplicity. Based on this analysis, two 

alternative conceptions of an ideal tax system axe adopted 

to form the basis for practical reform plans. The report 

presents two model plans, comprehending both the individual 

and corporate income taxes, which demonstrate that the tax 

system Ican be made more equitable, easier to understand and 
 justify, and more conducive to the efficient operation of 
 the private economy. 
 
-2-

Both plans have the genexal effect of broadening the 

tax base -- the measure of income to which personal exemptions

and tax rates are applied. This, is the result of including

in the base items excluded from tax under current law. This 

permits a simpler code in that elaborate rules are no longer

required �or defining items of tax preference or for protecting

against the abuse of such preferences. Under either plan,

the revenues currently collected from individual and corporate

taxpayers could be raised with a substantially lower rate 
 

structure. Pn turn a lower rate structure would mitigate the 
 distorting effects of taxes on economic decisions. 
 

The alternative proposals for tax reform are: (1)a 

comprehensive income tax, and (2) a consumption base tax, 

called a cash flow tax. Both proposals seek to treat 

individual items in the tax code in ways that would achieve 

consistency with an ideal base, departing from the ideal 

only when necessary for administrative feasibility, simplicity, or compelling economic or other policy reasons. 

When concessions are suggested, they are identified as such 

and justification is provided. 

The differences between the proposals derive from their 

underlying concepts of the tax base. The Comprehensive

income tax proposal is based on a broad concept of income 

that is defined in terms of the uses of an individual's 

receipts. According to this definition, an individual's 

income can be allocated either to consumption or to increasing

his wealth (net worth). Because all increments to wealth 

constitute income, this approach is sometimes called an 

accretion concept. The cash flow tax assesses tax burdens 

on the basis of consumption, excluding from the tax base all 

positive and negalrive changes in net worth. 

Both proposals deal with the major areas in which 

changes from the current tax code merit consideration. In 

all cases where there are ambiguities about defining consumption or change in net worth as components of income, or 

where the benefits achieved by exclusions or deductions from 

income under the current law appear to merit continued 

consideration, specific policy judgments are made for the 

purpose of presenting complete proposals. The report 

identifies the features of each proposal that are essential 

to the definition of the ideal tax base, distinguishing them 

from elements that can be handled differently and still remain 

consistent with a reasonable definition of either the 

comprehensive income or consumption tax base. The table at 

the end of this chapter compares the major features of the 

model tax refoxm plans with the current tax system. 
-3- 
 

This study shows that it is feasible to have a broadly

based tax that departs in major ways from the current tax 

law. In providing specific alternative plans, the report 

sets out a guide for future legislation aimed at sweeping 

tax reform. It also points out some of the major policy

issues that remain to be resolved. In presenting a plan for 

a tax system based on the consumption concept, the report

points toward a promising alternative approach to tax reform 

that is not as different from our present system as it might 

seem and that, if consistently implemented, should provide

major advantages in fairness, simplicity, and economic 

efficiency. 

COMPREHENSIVE INCOME TAX 
 

Proposals to adopt a more comprehensive definition of 
 income in the tax base have received the most attention from 
 tax reform advocates. 
 

AS previously stated, income may be viewed as the sum 

of consumption and change in net worth in a given time 

period. Although income is thus defined conceptually in 

terms of uses of resources, it is not practical to measure 

an individual's annual income by adding up all of his individual purchases of consumer goods and the change in value 

of all the items on his balance sheet. Rather, the measurement of income is accomplished by using the accounting

notion that the sum of receipts from all sources within a 

given time period must equal the sum of all uses. To 

compute income, it is necessary simply to subtract from 

sources expenditures that represent neither consumption nor 

additions to net worth. These expenditures include the cost 

of operating a business (payment of salaries, rent, interest,

etc.1, or the direct cost of earning labor income (union

dues, work clothing, etc.). They may include other specified

expenditures, such as interest, charitable contributions, 

State and local income and sales taxes, and large nondiscretionary medical expenditures. 

Because of exclusions, deductions, and shortcomings in 

income measurement rules, the tax base under current law 

departs from this comprehensive concept of income. For 

example, State and local bond interest and one-half of 

realized capital gains are not included in the tax base. On 

the other hand, corporate dividends are included in the tax 
-4- 
 

base twice, once at the corporate level and once at the 

individual level. In some cases, rules for tax depreciation

allow deductions in excess of actual changes in asset 

values. When this occurs, business income is understated,

and the taxpayer has increase in net wofth that goes untaxed. 

In setting out a practical plan to achieve equity,
 simplicity, and efficiency in the tax system, the model 
 comprehensive income tax follows a broad concept of accretion 
 income as a guide. The major features of the model compre­
 hensive income tax are summarized below. 
 

Integration of the Corporation and Individual Income Taxes 

A separate tax on corporations is not consistent with 

an ideal comprehensive income tax base. Corporations do not 

“consume” or have a standard of living in the sense that 

individuals do: all corpoxate income ultimately can be 

accounted for either as consumption by individuals or as an 

increase in the value of claims of individuals who own 

corporate shases. Thus, corporations do not pay taxes in the 

sense of bearing the burden of taxation. People pay taxes, 

and corporate tax payments are drawn from resources belonging 

to people that would otherwise be available to them for 

present or future consumption. 

It is difficult, however, to determine which people

bear the burden of corporate tax payments. In a free 

enterprise system goods are not produced unless their prices

will cover the costs of rewarding those who supply the 

services of labor and capital required in their output as 

well as any taxes imposed. The corporation income tax thus 

results in some combination of higher relative prices of the 

products of corporations and lower rewards to the providers

of productive services, and it is in this way that the 

burden of the tax is determined. It spite of many attempts,

economists have not succeeded in making reliable estimates 

of these effects, although a substantial body of opinion

hold5 that the corporation income tax is born by all capital 

owners in the form of lower prices �or the services of 

capital. 

The two major advantages of integrating the corporate

and personal taxes are that (1) it would eliminate the 

incentive to accumulate income within corporations by ending

the double taxation of dividends, (2) it would enable the 

effective tax rate on income earned within corporations to 

be related to the circumstances of individual taxpayers. 
-5- 
 

Under the model comprehensive income tax, the integration of corporate income with the other income of shareholders 

is accomplished by providing rules to allocate all corporate

income, whether distributed or not, to individual shareholders 

Corporate distributions to shareholders are regarded simply 

as a change in the composition of investment portfolios -- that is, a portion of each shareholder's equity claims is 

converted to cash -- and have no tax consequences. Under 

this "full integration" plan, corporation income is fully

taxed at the rates appropriate to each shareholder. 

For this reason, the model plan eliminates the corporation

income tax. The possibility of having corporations withhold 

taxes on behalf of shareholders, in order to alleviate 

problems arising when tax liabilities exceeded corporate

cash distributions, is examined. It is emphasized that 

full integration is proposed in the context of a plan that 

attempts to tax equally income from all sources. "Dividend" 

integration such as that proposed by the Ford Administration 

in 1975, which represents, in itself, a desirable change in 

the absence of comprehensive reform, may also be considered 

as a transition to the model treatment of corporate income. 

Treatment of Capital Gains and Losses 
 

Under the broadest concept of a comprehensive tax base, 

capital gains that represent an increase in real wealth 

would be taxed even though not realized by sale or exchange

of the asset. Similarly, capital losses, whether realized 

or not, would be subtracted in full from all sources of 

income in computing the tax base. The proposal moves in 

that direction by adopting the integration concept. Full 

integration provides a practical method �or taxing increases 

in asset values arising from corporate retained earnings, a 

major source of capital gains in the current system. Capital

gains realized upon sale or exchange of assets are taxed 

fully under the model plan -after allowing a step-up in basis

for inflation. Because maximum tax rates would be considerably

lower if a comprehensive tax base were adopted, there is far 

less reason for special treatment of capital gains to 

achieve rough averaging effects in a progressive rate structure. 

Realized capital losses are fully deductible against ordinary

income in the model system. 
-6- 
 

Thus, the proposal, while ending the current provision
 for exclusion of one-half of capital gains from the base,
 will also end the taxation of purely inflationary gains and 
 eliminate current limits on deductibility of realized 
 capital losses. Compared with present law, taxation of 
 capital gains would be lower during periods of rapid infla­
 tion and possibly somewhat higher during periods of relative 
 price stability. The proposal does not recommend taxation 
 of gains as accrued (that is, prior to realization) because 
 the administrative cost of annual asset valuations is prohibitive
 and because otherwise taxpayers might face problems in 
 making cash tax payments when no cash had been realized. 
 The corporate integration proposal would enable the largest 
 part of individual income previously reflected in realized 
 capital gains to be taxed as accrued by eliminating the 
 corporate tax and taxing corporate income directly to the 
 shareholders, whether or not it was distributed. This is a 
 fair and workable solution. 
 

Depreciation Rules 
 

The proposal defines some general principles for 

measuring depreciation of assets for tax purposes. It is 

recornended that a systematic approach to tax depreciation,

perhaps one modeled after the present Asset Depreciation

Range System, be made mandatory for machinery and equipment

and structures. A set of accounting procedures would be 

prescribed that would provide certainty to.the taxpayer that 

his depreciation allowances would be accepted by the tax 

collector and woulc3 reasonably approximate actual declines 

in the value of these depreciable assets. Cost depletion is 

recommended in place of percentage depletion for mineral 

deposits, as a better measure of the income arising from 

these properties. 

State and Local Bond hterest 
 

The proposal suggests that interest from state and 

local bonds be treated like all other interest receipts in 

the computation of the tax base, on the grounds that those 

receipts can be used for consumption or increases in net 

worth. Transition problems relating to existing bond 

holdings are recognized. The implicit tax burden in ownership of state and local bonds resulting from their lower 

interest yield is identified and evaluated. The report

mentions alternative, less-costly ways of providing the same 

subsidy to state and local governments as is presently

provided by the interest exemption. 
-7- 
 

Imputed Income from Consumer Durables 
 

Under the broadest fon of comprehensive income base, 

the imputed return in the form of the rental value of 

consumption services from ownership of consumer durables 

would be taxed. The exclusion of this form of income from 
 tax provides an important benefit to home owners. They have 
 invested part of their net worth in their home, rather than 
 investment assets, but the value of the use of their home 
 (the income it produces) is not taxed. This is particularly 
 true when, as under our present system, interest on home 
 mortgages is deductible from other income. This proposal
 does not I

recommend taxation of the imputed value of the use 
 of homes and consumer durables because of difficulties of 

measurement. However, it is recommended that the deductibility

of Local taxes on noncommercial property, including owneroccupied homes, be reconsidered, on the grounds that this 

amounts to exclusion of more than the income that would be 
 imputed to such assets. 
 

Itemized Deductions 
 

The report considers options for the treatment of major

deductions, including deductions for medical expenses

(which could be replaced with a catastrophic insurance 

program), charitable contributions (which could be eliminated 

or retained in the same form, without compromising the basic 

integrity of either the comprehensive income or cash flow 

tax), state and local income taxes (which would remain 

deductible) and sales taxes (not deductible) and casualty

losses (not deductible). Decisions as to whether, and in 

what form, major personal deductions should be maintained 

depend on whether or not these expenditures should be viewed 

as consumption and on whether or not particular types of 

activities ought to continue to be encousaged through the 

tax system. The report presents specific proposals for 

treatment of major deductions but it is noted that other 

rules are also consistent with the concept of a compxehensive income base. The deduction of interest is maintained, 

as is, in modified form, the deduction of child care expenses.

The report recommends elimination of the standard deduction, 

which will be replaced in part by more generous personal

exemptions. 

Under a Comprehensive income tax, both contributions to 
 retirement pensions and the interest earned on such contri-
 
-- 

-- 

-8-

butions would be included in the base. However, a roughly

equivalent result is achieved by taxing earnings on pension

funds as they accrue and retirement benefits as received and 

allowing employer -and employee contributions to pensions to 
 be deducted from the tax base. This procedure is preferable
 because it minimizes problems of income averaging. Rules 
 for making different types of pension accounts conform to 
 this principle are outlined in the report. It is proposed 
 

that deduction of both employee and employer contributions 

to Social Security be allowed and that all social security

retirement benefits be included in the tax base. The report
 also recommends that unemployment compensation payments 
 

be included in the tax base. 
 

Liberal personal exemptions recommended will insure 
 that persons with very low incomes are not taxed on social 
 security benefits or unemployment compensation. 
 

Choice of a Filing Unit and Exemptions �or Family Size 
 

The decision on the appropriate filing unit represents 
 a compromise between objectives that are mutually exclusive 
 under a progressive tax: a system in which families of 
 equal size and income pay equal taxes and a system in which 
 the total tax liability of two individuals is not altered 
 when they marry. The report recommends continuation of 
 family filing, with separate structures of exemptions and 
 rates for married couples, single individuals, and unmarried 
 heads of household. To reduce the work disincentive caused 
 by taxation of secondary earners at marginal rates determined 

by the income of a spouse, the plan proposes that only 75 

percent of the first $10,000 of earnings of secondary
 workers be included in the tax base. Alternative treatments 
 of the filing unit consistent with the general principles of 

a comprehensive income base are presented. 

The report discusses the issues in the choice between 

exemptions and tax credits as adjustments for family size, 

and recommends a per-member exemption instead of a credit. 

However, it is noted that various methods of adjusting for 

family size, including use of credits, are fully consistent 

with the comprehensive income base. 

The report shows how adoption of the recommended 

changes in the tax base would change tax rates. With an 

exemption of $1,000 per taxpayer and an additional $1,600 

per tax return, _ - it is possible under -the comprehensive 

income tax to raise thee= with roughly --the same 

distributionofthe 7tax burden by- income class as under the 

-income -tax, using only three rate brackets, ranging 
 
-9- 
 

from 8 percent in the lowest bracket, to 25 percent for 

middle income taxpayers, to 38 percent for upper income 

taxpayers. The generous $1,000 personal exemption (instead

of $750 under present law) plus an additional $1,600 exemption 

per return helps provide the same ability-to-pay distribution 

of the tax burden as present law. Alternatively, it is 

possible to raise the same revenue under the comprehensive

income tax with a flat rate of slightly over 14 percent on 

all income if there are no exemptions and with a flat rate 

of slightly under 20 percent with exemptions of $1,500 per 

taxpayer. 

In smary, the comprehensive income tax proposal is a 
 complete plan for a major rebuilding of the tax system that 
 eliminates many of the inconsistencies in the present tax 
 code. The plan clearly demonstrates the feasibility of 
 major improvements in the simplicity, efficiency, and fair­
 ness in the income tax. 
 

CASH FLOW, CONSUMPTION BASE TAX 
 

Consumption is less widely advocated than income in 

discussions of tax reform but it deserves serious consideration as an alternative ideal. for the tax base. A consumption 

tax differs from an income tax in excluding savings from the 

tax base. In practical terms, this means that net saving, 

as well as gifts made, are subtracted from gross receipts to 

compute the tax base. Withdrawals from savings, and gifts

and bequests received but not added to net savings, are 

included in gross receipts to compute the tax base. 

Advantages of a Consumption Base 
 

The report shows that a version of a consumption base 

tax, called the "cash flow tax," has a number of advantages 

over a comprehensive income tax on simplicity grounds. The 

cash flow tax avoids the most difficult problems of measurement under a comprehensive income tax -- such as depreciation

rules, inflation adjustments, and allocation of undistributed 

corporate income -- because all forms of saving would be 

excluded from the tax base. 

In addition, the report demonstrates that the cash flow 

tax is more equitable because it treats alike all individuals 

who begin their working years with equal wealth and the same 

present value of future labor earnings. They are treated 

differently under an income tax, depending on the time 

pattern of their earnings and the way they choose to allocate 

consumption expenditure8 among time periods. 
-- 

- 10 -
 

By eliminating disincentives to saving, the cash flow 
 tax would encourage capital formation, leading to higher
 growth rates and more capital per worker and higher before-
 tax wages. 
 

How a Consumption Base Could be Taxed 
 

According to one method of designing a consumption tax 

the taxpayer would include in his tax base all monetary

receipts in a given time period, including withdrawals from 

past savings and gifts and bequests received, and exclude 

from his tax base current savings, gifts made, and certain 

itemized expenditures also allowed as deductions under the 

comprehensive income tax. Thus, the full proceeds of asset 

sales would be taxed if used for consumption rather than for 

purchase of other assets (including such "purchases" as 

deposits in savings accounts). Inclusion of asset sales and 

deduction of asset purchases from the tax base, make it 

possible for the tax base to measure an individual's annual 

consumption without actually tallying up his purchases of 

consumption goods and services. 

A second method of computing the base for a tax based 

on consumption is to exempt all capital income from tax. 

Dividends, interest, capital gains, and profit from a personal

business would be excluded from an individual's tax base. 

Interest receipts would be excluded from the base, and 

interest payments on loans would not be deducted. Purchases 

of productive assets would not be deductible, because the 

returns from them would not be included in the base. 

These alternative treatments of assets lead to a tax 
 base with the same present value. Deferral of tax in the 
 present leads to payment of the same tax plus interest when 
 the asset is sold for consumption. However, the payment of 
 taxes occurs later under the method which allows a savings
 deduction than under the method which allows an interest 
 exemption. 
 

Similarities to the Present Tax Base 
 

The report points out that the current tax system is 

closer to a cash flow tax than to a comprehensive income tax 

in its treatment of many forms of income from capital. In 

particular, two important sources of saving for many Amercans homeownership and employer contributions to retirement annuities (or contributions of individuals to Keogh

Plans and IRA'S) -- are treated under the current law almost 
-- 

- 11 -

exactly the same way they would be treated under a consumption 

tax which allows a deduction for savings. Similarly, many

of the present system's uncoordinated exclusions of capital

income from tax approximate the second approach to a consumption

base tax. Thus, the model cash flow tax is not as complete 

a change from the present tax system as it might seem. 

Treatment of Investments in the Model Plan 

In the model cash flow tax individuals nay choose 

between the two essentially equivalent ways of treating

investments. Purchases of assets are eligible for deduction 

only if made through "qualified accounts." The qualified 

accounts would keep records of an individual's net investnent balance so that annual saving and dissaving can be 

measured. Each year, net contributions to qualified accounts 

would be computed and subtracted from the tax base. If 

withdrawals exceed contributions in any year, the difference 

would be added to the tax base. Thus, the proceeds from an 

investment made through a qualified account are subject to 

tax only when withdrawn. 

Savings not deposited in a qualified account are not 

eligible for deduction, but the interest and capital gains

from investments financed by such saving are not included in 

the tax base. There is no need to monitor the flow of 

investments or the investment income earned outside of 

qualified accounts because they have no place in the calculation 

of tax. 

The report Spells out the consequences of allowing a 

taxpayer to choose between alternative ways of being taxed 

on income from assets, providing specific examples of how 

the tax would work. It is shown how allowing two alternative 

treatments for both assets and loans provides a simple

averaging device that would enable taxpayers to avoid the 

inequities associated with applying a progressive rate 

system to individuals with different annual variation in the 

level of consumption. The report also shows how allowing

alternative treatment of assets and loans simplifies the 

measurement of the tax base. 

Other Features of the Cash Flow Tax 
 

Under the proposal, all consumer durables (such as 
 automobiles and homes) are treated as assets purchased
 outside of a qualified account. NO deductions are allowed 
 for the purchase of a consumer durable, and receipts from 
 the sale of a consumer durable are not included in the tax 
 base. 
 
- 12 -

Gifts are treated differently under the cash flow tax 

than under both the comprehensive income tax and the current 

tax system. In the cash flow tax proposal, gifts and inheritances received are included in the tax base, while gifts

given are deducted. Under present income tax law and under 

the model comprehensive income tax the treatment is reversed,

with gifts received excluded from the donee’s tax base but 

no deduction allowed for an individual who makes a gift. It 

is assumed that in both systems there would continue to be a 

separate tax on transfers of assets by gift or bequest, such 

as the present estate and gift tax. 

The proposal describes in detail how specific items of 

capital income -- dividends, interest, capital gains, income 

from personal business, and accumulation of retirement 

pensions -- are treated. The corporate income tax is 

eliminated because there is no longer a need to tax undistributed corporate income. Purchases of corporate stocks 

through qualified accounts are tax deductible, while all 

withdrawals from qualified accounts are included in the tax 

base. Sale proceeds of corporate stock, dividends, and 

interest, if remaining in the qualified account, are not taxed. 

The cash flow tax, like the comprehensive income tax,
 would move towards neutrality in the tax treatment of 
 different kinds of investments. In doing so, both proposals
 would have the effect of encouraging the best use of available 
 capital. In addition the cash flow tax would eliminate the 
 discouragement to capital formation inherent in the concept
 of a tax on income. 
 

The Filing Unit and Tax Rates 

The cash flow tax proposal treats definition of the 

filing unit, exemptions for family size, and deductions of 

personal consumption items the same way as the comprehensive

income tax praposal. The differences between the two 

proposals are in the treatment of items which represent a 

change in net worth, or income from capital, and in the 

treatment of gifts and inheritances. 

Under the cash flow tax, an exemption of $800 per 

person and $1,500 per return together with the three rate 

brackets -- 10 percent, 28 percent, and 40 percent -- would 

allaw present tax revenues to be raised while maintaining

the same vertical distribution of tax burdens. 
- 13 -

TRANSITION PROBLEMS 

Reforming the existing tax system poses a different set 
 of problems than designing a new tax system from scratch. 
 Although the report concentrates on the design of approxi­
 mations to ideal tax systems, the problems of transition 
 have also been examined and possible solutions embodied in 
 specific proposals. 
 

Transition to a new set of tax rules poses two separate,

but related problems. First, changes in rules for taxing

income from capital will lead to changes in the relative 

value of assets. Problems of fairness would exist if investors 

who had purchased a particular type of asset in light of the 

present tax system were subjected to losses by sudden major

changes in tax policy. Similarly, changes in tax policy may

provide some investors with windfall gains. Second, changes

in the tax Saw raise questions of what to do about income 

earned before the effective date, but not yet subject to 

tax. For example, the comprehensive income tax, which 

proposes full inclusion of capital gains in the base (subject to an inflation adjustment), requires a transition rule 

for taxing capital gains accumulated before, but realized 

after, the effective date. 

The report describes two methods for moderating the 

wealth effects of tax reform--"grandfathering," or exempting

existing assets from the new tax provisions, and phasing-in

of the new rules. Specific proposals for use of these 

instruments for projected changes in the tax code are 

presented. The report also outlines specific transition 

proposals for handling income earned before the effective 

date, but not yet taxed. 

HOW AN INDIVIDUAL WOULD CALCULATE TAX LIABILITY UNDER 

THE REFORM PLANS 

Elements Common to Both Plans 
 

The method of calculating tax liabilities under the 

model tax systems would be similar to the method in use 

today. Taxpayers would fill out a form like the Form 1040,

indicating family status and number of exemptions. There 

would not be a standard deduction under either plan. Taxpayers

who had eligible deductions would choose to itemize; to 

reduce the number of itemizers, deductions would be subject 

to floor amounts. 
- 14 -

The tax base would be calculated on the form, and the 

tax rate schedule appropriate to the filing unit (i.e.,

single, married, head of household) would be applied to 

compute tax liability. Taxes owed and refunds due, would 

depend on the difference between tax liability and taxes 

withheld as reported on W-2 statements or estimated tax 

paid. 

The wages and salaries of the primary wage earner would 

remain the biggest item in the tax base of most households 

and would be entered into the calculation of income the same 

way as under the current system. The first $10,000 of 

wages and salaries of secondary wage earners would be multiplied

by .75 before being added to the tax base. The rules for 

calculating some deductions (e.g., child care) would be 

changed, and other deductions (e.g., property and gasoline

taxes) would be eliminated. 

The Comprehensive Income Tax 
 

Under the comprehensive income tax, some additional 

items would be added to the computation of tax. Corporations

would supply to all stockholders a statement of the amount 

of profit attributed to that stockholder in the previous 

year, and an adjustment to basis that would rise with earnings

and fall with distributions. Similar statements of attributed 

earnings would be supplied to taxpayers by pension funds and 

insurance companies. In addition to the income reported in 

these statements, taxpayers would report income from interest 

on State and local bonds, unemployment compensation, and 

social security retirement benefits. 

All capital gains (or losses) would be entered in full 

in the computation of taxable income. The basis for corporate

shares would be increased by coxpoxate income taxed but not 
 distributed to them. In computing gains from sale or exchange,
 the taxpayer would be allowed to adjust the basis of assets 
 sold for inflation. A table of allowable percentage basis 
 adjustments would be provided in the tax form. The taxpayer

would USE statements received from corporations to adjust

the basis of corporate shares upward for any past attributed 

corporate profits and downward for dividends or other distributions 

received. 

The Cash Flow Tax 
 

The major change under the cash flow tax is that the 

taxpayer would receive yearly statements of net withdrawals 
-- 

- 15 -

or deposits from all qualified accounts. If deposits exceeded 

withdrawals, the difference between deposits and withdrawals 

would be subtracted from the tax base. If withdrawals 

exceeded deposits, the difference would be added to the tax 
 base. 
 

Interest, dividends, and capital gains realized on 

investments made outside of qualified accounts would not be 

reported on the tax form and would not be included in 

taxable income. The rationale for this is that the tax 

would have been pre-paid, because no deduction was allowed 

at the time of purchase. 

Gifts and inheritances received would be included in 

the tax base (but if deposited in a qualified account would 

have an offsetting deduction). A deduction would be allowed 

for gifts and bequests given. The identity of the recipient

of deductible gifts would be reported on the donor's return. 

CHAPTER-BY-CHAPTER OUTLINE OF THE REMAINDER OF THE REPORT 

Chapter 2 -- What is to be the Tax Base? 

Chapter 2 reviews the main issues in choosing an 

appropriate tax base (the sum to which the structure of 

exemptions and rates is applied} and presents the case for 

considering a cash flow tax based on consumption as an 

alternative to a reformed comprehensive income tax. General 

issues of equity in design of a tax system are discussed,

and the concepts of consumption and income are explained in 

detail. It is shown that the current tax system contains 

elements of both a consumption base and a comprehensive

income base. Thus, it is shown how the adoption of a consumption or cash flow tax would not be as great a change

from the present system as it might seem. The alternative 

tax bases are compased on grounds of equity, simplicity, and 

effects on economic efficiency. 
 

Chapter 3 A Model Comprehensive Income Tax 

A model comprehensive income tax is presented in chapter

3. The major innovations in the plan relate to integration

of the corporation and individual income taxes, and to tax 

treatment of capital gains, State and local bond interest, 

income accumulated in pensions and life insurance funds,

retirement income, and unemployment compensation. Changes

in many personal deductions are suggested. Impostant recommendations for changes in the filing unit, adjustment for 
-- 

- 16 -

family size, and taxation of secondary wage earners are set 
 forth. International considerations in income taxation are 
 discussed briefly. The chapter concludes with a description
 of a sample form �or tax calculation under the comprehensive
 income proposal. 
 

Chapter 4 -- A Model Cash Flow Tax 

In chapter 4, a model cash flow tax based on consumption

is presented. The major innovation in the cash flow tax is 

that savings may be deducted from the tax base. The use of 

qualified accounts to measure the flow of saving and consumption is proposed. The equivalence between deductibility

of saving and exclusion of capital earnings from tax is 

explained, and alternative treatments of assets reflecting

this equivalence are presented. Treatment of specific items 

under the model cash flow tax is proposed in detail and 

compared with treatment of corresponding items under the 

Comprehensive income tax. Arguments against the cash flow 

tax on grounds of progressivity and effects on wealth distribution 

are evaluated. The use of a supplementary wealth transfer 

tax to provide greater progressivity is explored. The 

chapter concludes with a description of a sample tax form 

under the cash flow proposal. 

Chapter 5 Quantitative Analyses 

Chapter 5 presents simulations of the effects of the 

proposed reforms on the tax liabilities of different groups

of taxpayers. The chapter demonstrates that the vertical 

structure of tax burdens undes the present income tax system 

may be broadly duplicated with a more generous set of exemptions

and a rate schedule which is more moderate and much simpler 

so long as the tax base is greatly broadened as proposed

under either the comprehensive income tax (chapter 3) or the 

cash flow consumption type tax (chapter 4). 

Chapter 6 -- Transition Considerations 

Chapter 6 proposes transition rules to accompany adoption

of the model tax plans. Problems which may arise in changing 

tax laws are explained, and instruments to ameliorate 

adjustment problems, including exempting existing assets 

from changes and phasing in new rules, are described and 

evaluated. specific proposals are presented for transition 

to both a comprehensive income base and a cash flow base 

that cover the timing of the application of new rules to 

specific proposed changes in the tax code. 
Item 

Corporate income 

a. 	 Retained earnings Separately taxed to 

Corporations 

b. 	 Dividends Separately taxed to 

corporations, included 

in individual tax base 

with $100 exemption 

Capital gains 	 SO% of long-term gains 

included when realized; 

alternative tax available 

Capital losses 	 50%oE long-term losses 

deductible against 

included pottion of 

long-term gains and 

$1,000 of ordinary 

income; carryover of 

losses allowed 

Depreciation 	 Complex set of depreciation rules for 

different types of 

equipment and structures 

Table 1 

Summary Comparison of Model Tax Plans 

Current tax : Model comprehensive : 

income tax 

Attribured to individuals 

as income and included in 

tax base 
 

Not taxed separately 

Fully included in tax 

base on realization: 

no partial exclusion 

Fully deductible from 

tax base on realization 

Reforn d rul for 

depreciation; depreciation to approximate 

actual decline in 

economic value on a 

systematic baeis by 

industry classes 

Model cash flow tax 

No tax until consumed 

No tax until consumed 

I 

No tax until consumed 	 k-

-2 

I 

No tax offset unless 

consumption is reduced 

Permits expensing of all 

business outlays, capital 

or current 
Table 1 

Summary Comparison of Model Tax Plans 

(continued) 

Item Current tax : Model comprehensive 

income tax 

: Model cash flow tax 

State and local bond interest Excluded from tax base 	 Included in tax Excluded from tax base 

base until consumed 

Other interest received Included in tax base Included in tax base 	 Excluded from tax base 

until consumed 

Proceeds of loans Excluded from tax base Excluded from tax base 	 Inclusion in tax base 

optional 

I

Interest paid on loans Deducted from tax base Deducted from tax base Deducted from tax base if 

F-’ proceeds of loan fncluded m 

in base I 

Principal repayments on loans Not deducted from tax Not deducted from tax Deducted from tax base if 

base base proceeds of loan included 

in base 

Rental value of owner-occupied Excluded from tax base Excluded from tax base Implicitly included in tax 

homes base because purchase treated 

a6 consumption 

State or local property, sales Deducted from tax base Not deducted from tax Not deducted from tax 

and gasoline taxes (non- base base 

business) 

Medical expenses A/ Expenses over 3% of 

adjusted gross income 

No deduction: possible 

credit for expenses 

No deduction; possible credit 

for expenses over 10% of 

deducted from tax base over 10%of income* consumption* 

Charitable contributions 2/ Deducted from tax Not deducted from base* Not deducted from tax 

base* 
Table 1 

Sunnary Comparison of Model Tax Plans 

(continued) 

Current tax 

: Model comprehensive :

Item 
 

Casualty losses 
 

State and local income taxes 
 

Child care expenses 21 

Contributions to retirement 
 

pensions 
 

Intetest earnings on 
 

pension funds 
 

income tax 
 

Uninsured losses deducted Not deducted from tax 
 

Model cash flow tax 

Not deducted from tax 
 

base 
 

Deducted from tax base* 

Revised tax deduction* 
 

All contributions excluded 
 

from tax 
 I 

P 

Excluded from tax ILI 
 

I 

Included in tax base 

unless saved 

All contributions 

excluded from tax 

Included in tax base 
 

unless saved 
 

Included in tax base for 

primary earner; for secondary 

earners, 75% of wages under 

$10,000 and all wages over 

$10,000 included*; savings 

out of wages deductible 

from tax base* 

Deducted from tax base 

Limited tax deduction 
 

Employer conttibutions 

untaxed; employee 

contributions taxed 

Excluded from tax 
 

base* 
 

Deducted from tax base* 
 

Revised tax deduction* 
 

All contributions 

excl.uded from tax 

Attributed to employer 

or to individuals and 

taxed in full as accrued 

Included in tax base 

All contributions 

excluded from tax 

Included in tax base 
 

Included in tax base 

for primary earner; 

for secondary earners, 

75% of wages under 

$10,000and all wages 

Over $10,000 included" 
 

Retirement benefits from pension Included in tax base 

funds 
 

Social security contributions 
 

Social security retirement 
 

income and unemployment 
 

compensation 
 

Wage and salary income &/ 

except �or return of 

employee contribution 

Employer contributions 
 

untaxed; employee 
 

contributions taxed 
 

Excluded from tax base 

Included in tax base 
 
Table 1 
 

Summary Comparison of Model Tax Plans 
 (continued) 
 

: Model comprehensive : m ash tax 

Item 
 

Deposits in qualiEied invest­
 

ment accounts 
 

Withdrawals from qualified 
 

investment accounts 
 

Standard deduction 
 

Personal exemptions 
 

Current tax 
 

No tax consequences 

No tax consequences 
 

Available to nonitemizers only; $1,600 

OK 16% of adjusted gross 

income up to $2,400for 

single taxpayer,

$1,900 of 16% of adjusted 

income tax 

No tax consequences 

No tax consequences 
 

No arandard deduction; 
 $1,600 per return 
 

exemption 
 

Deducted from tax base 
 

Included in tar base 

No standard deduction; 

$1,500 per return 

exemption 

I 

N 

D 

1 

$800 per individual 

gross income up to $2,800 

for married couple filing 

jointly 
 

$750 per individual; extra 

exemptions for aged and 

blind 
 

$1,000 per individual 

Office of the Secretary of the Treasury 

Office oE Tax Analysis 

* Indicates alternative treatments possible. 

-

1/ Medical deduction optional under model tax plans. Alternative ways of structuring deduction or 

credit possible. 

2f Charitable deduction optional under model tax plans. Other alternatives possible, including - limited credit. 
 

-31 Child care deduction and it8 form and limits optional under model tax plans, 

-4/ Treatment of secondary earners optional undsr model tax plans. 
- 21 -

Chapter 2 
 

WHAT IS TO BE THE TAX BASE? 

INTRODUCTION 

The dominant complaint made about the present tax 
 system is that it does not tax all income alike. This 
 complaint reflects concern about equity: taxpayers with 
 the sane level of income bear different tax burdens. It 
 reflects concern about efficiency: taxation at rates that 
 differ by industry or by type of financial arrangement leads 
 to misallocation of resources. Finally, it reflects concern 
 about simplicity: the enormously complex tangle of pro-
 visions the taxpayer confronts in ordering his affairs and 
 calculating his tax leads to differential rates of taxation. 
 

The usual approach to the complaint that all income is 
 not taxed alike is to attempt to make income as defined by 
 tax law correspond more closely to the "real thing."
 The problem with this approach is the difficulty of identifying
 the "real thing." As with other abstractions, these are 
 numerous ways to look at the concept of "income," some of 
 which may be better or worse according to context. 
 

Laymen find it hard to believe that there are major

problems in defining income. They are used to thinking in 

terms of cash wages and salaries, which are easily identified and clearly income. In fact, wages and salaries 

account for the great bulk of income -- however defined -- in the U.S. economy; other items like interest and dividends 

are also easily identified. So it may be fairly said that 

most of the dollars identified as income in the total 

economy will be the same under any definition of income. 

But as one approaches the edges of the concept of 

income, there is a substantial grey area. It is small 

compared with the bulk of income,but this grey area (capital

gains, for example) is the focus of much controversy. There 

is an extensive literature on the subject, beginning before 

the turn of the century and continuing to the present, with 

no consensus except that particular definitions may be more 

practical in certain circumstances than in others. 
- 22 -

Many of the major problems in defining income concern 

expectations or rights with respect to the receipt of 

payments in the future -- does an individual have income 

when the expectation or right arises, or only when the money 

comes in? Is the promise to pay a pension to be counted as 

income when made, although the amounts will be paid 20 years

hence? Is a contract to earn $60,000 a year for the next 5 

years to be discounted and counted as income in the year the 

contract is made? Is the appreciation in the market value 

of an outstanding bond resulting from a decline in the 

general market rate of interest to be counted as income now, 

even though that appreciation will disappear if interest 

rates rise in the future? Is the increase in the present

value of a share in a business attributable to favorable 

prospects o� the business earning more in future years to be 

counted as income now or in the future years when the 

earnings actually materialize? 

Differences in view with respect to the definition of 
 income cut across political philosophies. Although many
 "liberal" economists argue for an expansive definition of 
 income, the extreme view that incame cannot be defined 
 adequately to constitute a satisfactory tax base has been 
 advanced by the eminent British Socialist economist, Nicholas 
 Kaldor, who argues for a consumption tax. At another 
 extreme, one of the most all-inclusive definitions of income 
 was formulated by Professor Henry Simons, a conservative 
 economist long affiliated with the University of Chicago. 
 

Professor Simons' definition -- usually referred to as 

the "Haig-Simons definition" or the "accretion" concept of 

income -- is perhaps most commonly used in discussions about 

income taxes. Professor Simons himself was careful to say

that the definition was not suitable for all purposes and 

would not, without modification, describe a satisfactory 

tax base. Most analysts would agree. However, the definition is useful for analytical purposes. It represents a 

kind of "outer limit" that helps identify items that are 

potential candidates for inclusion or exclusion in any

income tax base. In the discussions that follow, it should 

be understood that the Haig-Simons or "accretion" definition 

is used and discussed in that way, and that no blanket 

endorsement of that definition of income is intended. 

Indeed, the accretion concept of income has many

shortcomings as a tax base. Several of them are serious, 

and attempts to deal with them account fox much complexity 
-- 

-- --- 

- 23 -

in the present tax code. Among these shortcomings are 

severe measurement problems. Many items that are required

for the calculation of net income must be imputed -- either 

guessed at or determined by applying relatively arbitrary

rules (as in the case of depreciation). Because such rules 

are never perfect, they are the subject of continual controversy. A particular problem with certain current rules 

is their inability to measure income correctly in periods of 

inflation. 

An especially serious drawback of an accretion income 

base is that it leads to what is sometimes called the 

"double taxation" of savings: savings are accumulated after 

payment of taxes and the yield earned on those savings is 

then taxed again. This has been recognized as a problem in 

the existing tax law, and many techniques have been introduced to make the tax system more neutral with respect to 

savings. The investment tax credit, accelerated depreciation,

special tax rates for capital gains, and other provisions 

are examples. Also, tax deferral on income from certain 

investments for retirement purposes is an example of how 

current law attempts to offset the adverse effects on savings of 

using an accretion income base. Significantly, this last 

example is also viewed as desirable for reasons of equity. 

All these techniques have the same practical effect as 

exempting from tax the income from the investment. To this 

extent, this is equivalent to converting the base from 

accretion income -to consumpTTon. 
 

The present tax system thus may be regarded as having a 

mixture of consumption and accretion income bases. Jn view 

of this, a question that arises is whether the proper objective

of tax reform should be to move more explicitly toward 

a consumption base rather than toward a purer accretion 

base. The issue is considered in this chapter. 

The analysis suggests that the consumption tax has many

important advantages as compared with an income tax and 

accordingly should be seriously considered in designing a 

reformed tax system. In some respects, a broad-based 

consumption tax is more equitable than a broad-based income 

tax. It is also easier to design and implement and has 

fewer harmful disincentive effects on private economic 

activity. In many important ways, a broad-based consumption 

tax more closely approximates the current tax system than 

does a broad-based income tax and would constitute less of a 

changeI 
-- 

- 24 -

The remainder of this chapter compares consumption and 

income taxes with respect to various criteria. The chapter

includes: 

A discussion of some general issues relating to 

equity: 

An explanation of the concepts of consumption and 

income, including a discussion of some definitional 

problems; 

A comparison of the treatment of pessonal savings under 
 the current tax system with the treatment of savings
 under a consumption tax and a broad-based income tax; 
 

A discussion of the merits of the alternative tax bases 
 on criteria of equity; 
 

A comparison of the alternative tax bases for simplicity;

and 

A discussion of the economic efficiency effects of tax 

policies and a comparison of the efficiency losses 

under a cqnsumption tax and an income tax. 

TWO PRELIMINARY MATTERS OF EQUITY 

As has already been suggested, the specification of a 

tax code has the effect of defining the conditions under 

which two taxpayers are regarded as having the same circumstances, so that they should properly bear the same tax 

burden. This section considers two aspects of such a 

comparison that have important implications fox tax design:

first, over what period of time are the circumstances of two 

taxpayers to be compared: and, second, what are the units -- individuals or families between which comparisonsareto

be drawn. 

Equity Over What Time Period? 
 

Most tax systems make liabilities to remit payments

depend upon events during a relatively short accounting

period. In many cases, this is a matter of practical

necessity rather than principle. That is, tax liabilities 

must be calculated periodically on the basis of current 

information. Generally, there is nothing sacred about the 
- 25 -

accounting period -- be it a week, a month, or a year -- as far as defining the period over which taxpayer circumstances are to be compared. Indeed, it is usually regarded 

as regrettable that practical procedures do not allow the 

calculation of liabilities to take a much longer view. 

Averaging and carryover provisions represent (inadequate) 

attempts to resolve inequities that arise in this respect. 

An example from another program will illustrate. Under 

many welfare programs the accounting period is 1 month. A 

family earning just at the eligibility level at an even rate 

for the year will receive nothing. A family earning the 

same amount during the year, but earning it all during

the first 3 months will appear to have no earnings during

the remaining 9 months. That family win then be eligible

for full benefits for 9 months, in spite of being no worse 

off than the first family in the perspective of a year's

experience. 

it is assumed in this study that the period over which 

such comparisons are made should be as long as possible.

Ideally, two taxpayers should be compared on the basis of a 

whole lifetime of circumstances, and this is taken here to 

be a general goal of tax system design: lifetime tax burden 

should depend upon lifetime circumstances. 

It is important to note that lifetime tax burden 

depends not only on the sum of all tax liabilities over a 

taxpaying unit's lifetime, but also on their timing.

Deferral of a portion of tax liability is a form of reduction 

in tax burden in an income tax framework because interest 

can be earned on the deferred tax payments. For example, if 

investors can expect a 10-percent annual rate of return on 

riskless assets, a tax liability of $110 a year from now is 

equivalent to a tax liability of $100 today because SlDO, if 

untaxed and invested, will grow to $110 in value in one 

year's time. A common way of expressing this is to say that 

the present value of a tax liability of $110 one year in the 

future is $100. When comparing the lifetime tax burdens of 

two taxpayers, we are, in fact, comparing the present value 

of the sum of current and future tax liabilities viewed from 

the vantage of some point early in the life of the two 
 taxpayers (e.g., at birth, or at the beginning of working 
 years, or at age 18). 
 

Is the Family or the Individual the Appropriate Unit? 

What taxpaying unit is the subject of this comparison

of situations? When it is asked whether one taxpayer is in 
-- 

the same situation as another, is the taxpayer an individual 
 or a family? The sharing of both consumption and wealth 
 within families supports continuation of present law in 
 regarding the family as the unit of comparison. 
 

On the other hand, a family is not a simple Institution, with a predictable lifetime, and a constant identity. Quite apart from the problem of distinguishing

varying degrees of formality in family structure (e.g., is 

the second cousin living in the guest room part of the 

family?), the family necessarily is a changing unit, with 

births, 'deaths,marriages, and divorces continually altering

family composition. 

In this study, differences in family association have 

been regarded as relevant to that comparison of lifetime 

situation by which relative tax burdens are to be assigned 

to different individuals. The practical consequence of this 

will be that the tax liability of a father, for example,

will depend in part upon consideration of the situation of 

the whole family. 

INCOME AND CONSUMPTION 

A tax base is not a quantity like water in a closed 

hydraulic system, wherein the total remains constant regardless of how it is directed by valves and pumps. Rather,

it is an aggregation of transactions sometimes implicit

but usually voluntary. The transactions that take place

will depend in part upon how they are treated by the tax 

system. The choice of a tax base is a choice about how to 

tax certain transactions. 

A tax base is necessarily defined by a set of accounting

rules that classifies actual and implicit transactions as 

falling within or outside the "tax base," that is the total 

to which a tax schedule is applied to determine the taxpayer's

liability. The Internal Revenue Code prescribes an "income" 

tax, with "income" defined by the elaborate body of statutory

and administrative tax law that has evolved. But this 

definition is criticized by many observers, who believe that 

tax burdens should be related to a broader tax base, i.e., to 

a wider set of transactions. 

As was pointed out above, the concept of income generally
 used in discussion of tax reform has been called an "accretion" 
 concept. It is supposed to measure the command over resources 
 
- 27 -

acquired by the taxpayer during the accounting period, that 

command having been either exercised in the form of consumption or held as potential for future consumption in the 

form of an addition to the taxpayer's wealth. Hence, the 

apparently paradoxical practice of defining "income" by an 

"outlay" or "uses" concept -- consumption plus change in net 

worth. 

Everyday usage on the other hand tends to associate 

income with the sources side of the accounts. Thus, one 

speaks of income "from labor," such as wages, or income 

"from capital," or "from proprietorships," such as interest 

and profits. Because sources and uses must be equal in a 

double entry accounting system, the result should be the 

same whichever side is taken for purposes of measurement,

provided that -all uses are regarded as appropriate for 

inclusion in the tax base. 

Definitions of Income and Consumption 
 

In thk section, a rudimentary classification of 

transactions is developed to define income and consumption.

The accounts considered first are those of a wage earner 

whose only sources of funds are his wages and his accumulated 

balance in a savings account. 

In the simplest case, the possible applications he can 

make of these funds may be divided into the purchase of 

goods and services for his immediate use and additions to or 

subtractions from his accumulation of savings. Thus, an 

account of his situation for the year might be the following: 

SOURCES 

Wages
 Interest 
 Balance in 
 savings 
 account at 
 beginning of 
 period 
 

USES 

Rent 
 Clothing
 Food 
 

Recreatiqn
 Balance in 
 savings account 
 at end of 
 period 
 

The two sides of this account are, of course, required to 

balance. Of the uses, the first four are generally lumped 
-- 

- 28 -
 

under the concept of consumption, the last constituting the 
 net worth of the household. Thus, the accounts may be 
 schematically written as: 
 

SOURCES 

Wages
 Interest 
 Net worth at 
 beginning of 
 period 
 

USES 
 

Consumption 
 

Net worth at end 
 of period 
 

The concept of income concerns the additions or v

ac­
 cretions to source and the application of that accretion 
 auring the accounting period. This can be found simply by
 subtracting the accumulated savings (net worth) at the 
 beginning of the period from both sides, to give: 
 

ADDITION TO 

SOURCES 

Wages
 Interest 
 

USES OF ADDITION 
 

TO SOURCES 
 

Consumption
 Savings (equals
 increase in net 
 worth over the 
 period) 
 

Income is defined -here as be the sum of consumption

-

and increase in net worth. Note carefully that a uses

definition is adopteca measure of differences nndividual circumstances. This approach to the concept of 

income has substantial advantages as a device for organizing

thinking on particular policy issues, even though it will no 

doubt be unfamiliar to many readers, who natusally think of 

income as something that "flows in" rather than as something

that is used. With this uses definition of income, the 

situation of the illustrative individual may be represented

by: 
- 29 -
 

ADDITION TO USES OF ADDITION 

SOURCES TO SOURCES 

wages Income 
 Interest 
 

The last version of the accounts makes clear the way in 

which information about sources is used to determine the 

individual's income. To calculate his income fox the year,

this individual obviously would not add up his outlays for 

rent, clothing, food, recreation, and increase in savings 

account balance. Rather, he would simply add together his 

wages and interest and take advantage of the accounting

identity between this sum and income. 

This classification of uses into consumption and 

increase in net worth is not sufficient, however, to accommodate distinctions commonly made by tax policy. It will 

be helpful, therefore, to refine the accounts to the following: 

ADDITION TO 
 SOURCES 
 

Wages
 Interest 
 

USE OF ADDITION 
 TO SOURCES 
 

Consumption
 Cost of earnings
 Certain other 
 out1ays 

Increase in net 

worth 

&I individual's outlay for special work clothes needed 

for his profession requires the category "cost of earnings."

These are netted out in defining income. Note that the 

decision about which outlays to include in this category is 

a social or political one. Thus, in present law, outlays

for specialized work clothes are deductible, but commuting 

expenses are not. There is no independent standard to which 

one can appeal to determine whether such outlays are consumption, and hence a part of income, or work expenses, and 

hence out of income. 
ADDITION TO USES OF ADDITION 

SOURCES TO SOURCES 

- 

- 30 -

Similarly, a judgment may be made that some outlays,

while not costs of earning a living, are also not properly

classified as consumption. The category of "other outlays"

is introduced for want of a better label for such transactions 

For example, in everyday usage, State income taxes would not 

be an application of funds appropriately labeled "personal

consumption," much less "increase in net worth." (They might

be allocated to the "cost of earnings" category.) Thus, 

using the definition of income as the sum of consumption and 

the increase in net worth, we now have: 

ADDITION TO 
 SOURCES 

Earnings

(wages -k 

Interest) 

USES OF ADDITION 
 TO SOURCES 

Income (Consumption + Increase 

in net worth)

Cost of earnings
 Certain other 
 outlays 
 

Again, to calculate income it is generally convenient 

to work from the left-hand, sources side of the accounting

relationship described above. In this case, 

Income - Earnings

minus 
 Cost of earnings
 minus 
 Certain other outlays. 
 

Similarly, and of great importance in understanding this 
 study, consumption may be calculated by startinq with 
 sources data: 
 

Consumption - Earnings

minus 

Cost of earnings

minus 

Certain other outlays

minus 

Increase in net worth. 
- 

- 31 -

One further addition to the accounting scheme is needed 

at this point: the item "gi�ts and bequests given." This is 

a use o� funds that same would regard as consumption, but in 

this report the term consumption, without modifierr is 

reserved for the narrower notion of goods and services CJ� 

direct benefit to the ihdivldual in question. The accounts 

now have the following structure: 

ADDITION TO 
 SOURCES 

Wages
 

Interest 

WSES OF ADDITION 

TO SOURCES 

Consumption 
 Gifts and bequests
 given

Cost of earnings

Certain other 

outlays
 Increase in net 
 worth 

It must be decided whether gifts and bequests given are 

to be regarded as income, that is, as a component of the 

total by which taxpayers are to be compared for assigning

burdens, The term "ability-to-payTr is used to describe the 

income concept that considers income to be the- sun of 

consumption plus gifts and bequests given plus increase in 

net worth, becacse it is within the taxpayer's ability to 

choose among these u5e5 and, hence, all three measure 

taxpaying potential equally. It should be emphasized that 

the label "ability-to-pay" is intended to be suggestive

only, There is hc~agreed upon measure of the idea of a 

taxpayer's ability to pay. Because of this, quotation marks 

will be used when the term "ability-to-pay" is used in its 

role as a label for an income or consumption concept. 

hAbility-to-pay" income or consumption would also 

generally be calculated by starting OA the sources side; 

"Abi1ity-to-pay " incone - Earnings

rninns 

Cost of earnings
 minus 

Certain other outlays. 
- 

- 32 -

"Ability-to-pay" consumption = Earnings

minus 

Cost of earnings

minus 

Certain other outlays

minus 

Increase in net worth. 

The difference between consumption and income is the 

savings or increase in net worth over the period. Thus, 

equivalently: 

'IAbi1ity -to-pay" consumption = "Ability-to-pay" income 

minus 

Increase in net worth. 

Finally, there is the pair of income and consumption 

concepts that excludes gifts and bequests given from the 

category of uses by which tax burdens are to be apportioned.

These are given the label "standard-of-living" because they 

are confined to outlays for the taxpayer's direct benefit. 

As with the term "ability-to-pay," this label is intended to 

be suggestive only. The "ability-to-pay" and "standard-ofliving" concepts are related as follows: 

"Standard-of-living" income - "Ability-to-pay" income 

minus 

Gifts and bequests given, 
 

"Standard-of-Living" consumption = "Standard-of-living" income 

minus 

Increase in net worth. 

This discussion leads to a four-way classification of 
 tax bases: 
 
- 33 -
 

Included 

Increase 
 in 
 net 
 worth EXcluded 

THE PRGSENT TAX BASE 

Included 

Ability-to-pay

income 

Ability-to-pay

consumption 

Excluded 
 

Standard-of-living
 income 
 

Standard-of-living
 consumption 
 

Is the Present Base Consumption or Income? 

While the present income tax system does not reflect 
 any consistent definition of the tax base, it has surpris­
 ingly many features of a "standard-of-living" consumption
 base. 
 

The idea of consumption as a tax base sounds strange

and even radical to many people. Nonetheless there are many

similarities between a consumption base tax and the current 

tax system. Adoption of a broad-based consumption tax might

actually result in less of a departure from current tax 

treatment of savings than adoption of a broad-based income 

tax. 

The current tax system exempts many forms of savings

from tax. In particular, the two items that account for the 

bulk of savings for most Americans, pensions and home 

ownership, are treated by the present tax code in a way that 

is more similar to the consumption model than to the comprehensive income model. 

Retirement savings financed by employer contributions 

to pension plans (or made via a "Keogh" or "Individual 

Retirement Account" (IRA)) are currently treated as they

would be under a consumption tax. Under the current system,

savings in employer-funded pension plans are not included in 

the tax base, but retisement benefits from those plans, 
- 34 -

which are available for consumption in retirement years, are 

included. Employee contributions to pension plans are 

treated somewhat less liberally. The original contribution 

is included in the tax base when made, but the portion of 

retirement income representing interest earnings on the 

original contributions is not taxed until these earnings are 

received a6 retirement payments. If the tax on those 

interest earnings were paid as the earnings accrued, treatment of employee contributions to pension plans would be the 

same as that under a comprehensive income tax. However, the 

tax on interest earnings in pension funds is lower than 

under a comprehensive income base because the tax is deferred. 

If na tax were paid on the interest earnings portion of 

retirement pay, then the present value of tax liability

would be exactly the same as the present value of tax 

liability under a consumption tax. Thus, the current 

treatment of employee contributions incorporates elements of 

both the Comprehensive income model and the consumption

model but, because of the quantitative importance of tax 

deferral on pension fund earnings, the treatment is closer 

to the consumption model. 

The current tax treatment of home ownership is very

similar to the tax treatment of home ownership under a 

consumption tax. Under present law, a home is purchased out 

of tax-paid income (is not deductible), and the value of the 

use of the home is not taxed as current income. Under a 

consumption tax, two alternative treatments are possible.

Either the initial purchase price of the house would be 

included in the tax base (i.e., not deductible in calculating the tax base) and the flow of returns in the form of 

housing services would be ignored for tax purposes, or the 

initial purchase price would be deductible and an imputation

would be made for the value of the flow of returns, which 

would be included in the tax base. 

In equilibrium, the market value of any asset is equal 

to the net present value of the flow of future returns,

either in the form of monetary profits or value of consumption services. For example, the market value of a 

house should equal the present value of all future rental 

services (the gross rent that would have to be paid to a 

landlord for equivalent housing) minus the present value of 

future operating costs (including depreciation, operating

costs, property taxes, sepairs, etc.). Thus, in both cases,

the present value of the tax base would be the same. For 

example, if an individual purchased a $40,000 house, the 
- 35 -

present value of his future tax base for that item of 
 consumption would be $40,000 regardless of how he chose to 
 be taxed, Because the initial purchase price is easier to 
 observe than the imputed service flow, it would be most 
 practical, under a consumption tax, to include the purchase
 of a house in the tax base and exclude net imputed returns. 
 In that case, capital gains from sale of a house would not 
 be taxable. 
 

In the current tax system, as in the consumption tax 
 system, the down payment and principal payments for an 
 owner-occupied residence are included in the tax base, and 
 the imputed net rental income in the form of housing services 
 is excluded from tax. Capital gains from housing sales are 
 taxable at preferential capital gains rates upon realization 
 (which allows considerable tax deferral if the house is held 
 for a long period), and no capital gains tax is levied if the 
 seller is over 65 or if the gain is used to purchase another 
 house. 
 

In contrast, under a comprehensive income base, the 
 entire return on the investment in housing, received in the 
 form of net value of housing services, would be subject to 
 tax and, in addition, the purchase price would not be 
 deductible from the tax base. 
 

Many special provisions of the tax law approximate a 

consumption tax in the lifetime tax treatment of savings.

For example, allowing immediate deduction for tax purposes

of the purchase price of an item that will be used up over a 

period of years (i.e., immediate expensing of capital investments) is equivalent to consumption tax treatment of investment income because it allows the full deduction of savings;

thus, accelerated depreciation approxhates the consumption 

tax approach. While depreciation provisions under the 

present law are haphazard, a consumption base tax would 

allow the immediate deduction of saving to -all savers. 
 

In conclusion, taxation of a significant portion of 
 savings under the current system more closely resembles the 
 consumption model than the comprehensive income model. For 
 owner-occupied housing, a large fraction of pension plans,
 and some other investments, the tax base closely approximates
 either the present value of imputed consumption benefits or 
 the present value of consumption financed by proceeds of the 
 investment. 
 
- 36 -
 

IS the Tax System Presently on an "Rbility-to-Pay" or a 
 -Standard-of-Livinq" Basis? 
 

Three possibilities may be considered for the income 
 tax treatment of a gift from one taxpaying unit to another: 

(1) the gift might be deducted from uses in calculating the 

tax base of the donor and included in sources in calculating

the base of the donee: (2) it might be left in the base of 

the donor and also included in the base of the donee; or (3)

it might beeftn the base of the donor but excluded from 

the base of the donee. 

The first of these treatments is that implied by a 
 "standard-of-living" basis for determining relative tax 
 burdens. The second treatment expresses an "ability-to-pay''
 view. The third treatment is that of the present income tax 
 (excluding the estate and gift tax) law, at least with 
 respect to property, with no unrealized appreciation at the 
 time the gift is made. 
 

The first and third treatments are similar in that there 
 is no separate tax dne transfer of wealth from one 
 taxpaying unit to another. The tax burdens under those two 
 options may differ with a progressive tax structure, however. 
 Under the third treatment, aggregate tax liability is 
 unaffected by the gift, but under the first, it will rise 
 or fall depending on whether or not the marginal tax bracket 
 of the donee is higher than the marginal tax bracket of the 
 donor. Under the second treatment, with the gift or bequest
 in the tax base of both the donor and the donee, the con­
 sumption or change in net worth financed by the gift is, in 
 effect, taxed twice. It is taxed as consumption by the 
 donor, and then taxed again as consumption or an increase in 
 net worth of the donee. 
 

To illustrate the alternative treatments of wealth 

transfers, consider the case of taxpayers A and 3, who start 

life with no wealth and who are alike except that A decides 

to accumulate an estate. Their sons, A' and B', respectively, consume their available resources and die with zero 

wealth. Thus, A has lower consumption than B; A' (who

consumed what his father saved) has higher consumption than 

B'. Under a "standard-of-living" approach, the pair A-A' 

should bear roughly the same tax burden as the pair B-B'. 

This is so because the higher consumption of A' is simply

that which his father, A, did not consume. Under an 

"ability-to-pay'' approach, the combination A-A' should bear 

more tax than B-B' . A and B have the same ability to pay, 
-- 

- 37 -

but because A chooses to exercise his ability to pay by

making a gift to his son, A' has a greater ability to pay

than B', by virtue of the gift received. 

Neglecting the effect of progressivity, present income 

tax law taxes the combination A-A' the same as it does the 

combination B-B' (whether or not A and A' are related). In 

this respect, present income tax law incorporates a "standardof-living" basis. The way this is accomplished, however, is 

"backward." That is, instead of taxing A on his "standardof-living" income and then taxing A' on his "standard-ofliving" income, present law taxes A on his consumption plus

increase in net worth plus the gift given (i.e., the gift is 

not deductible in calculating the income tax due from A),

while A' is taxed on the value of his consumption plus

increase in net worth minus the value of the gift received 

(i.e., the receipt of =gift is not included in calcu­
 lating the tax due from A'). 
 

This procedure clearly mismeasures the income of A. It 

mismeasures the income of A', as well, if a "standard-ofliving" concept of income is used. The income of A' is 

understated (gift received is not included) and that of A is 

overstated (gift given is not excluded). However (continuing to neglect the effect of progressivity), the impact

of the tax system on A and A' is the same as if the treatment were the other way around, at least as far as intentional 

gifts are concerned. Suppose, for example, that A wants to 

enable A' to have an extra $750 worth of consumption. Under 

present law, A simply gives A' $750 cash and A' consumes it. 

Under a "standard-of-living"concept of income (assuming A 

and A' are both in the 25-percent rate bracket), A would 

give A' $1,000. After paying taxes of $250, A' would have 

$750 to consume. At the same time, A would deduct $1,000

from his tax base, saving $250 and making the net cost of 

his gift $750, 

Although the effects of progressivity would alter this 

somewhat, it is not clear that the differences in rates 

between giver and receiver would be likely to be large if a 

lifetime view were taken. Naturally, under present law, an 

adult donor will tend to have a higher marginal rate of 

income tax than a child donee. It is for this reason that 

present income tax law treatment of gift and bequest transactions may come closer than the more intuitively obvious 

one excluding to donor, including to donee -- to measuring 
- 38 ­

l'standard-of-livhg" income correctly. Certain administrative 

aspects also favor the present treatment of gifts and 

bequests for income tax purposes. 

In summaryt whether by accident or design, present

income tax law incorporates a rough sort of "standard-ofliving" view of the concept of income because it does not 

include an extra tax on wealth transfers as an integral part

of the income tax. Such treatment approximates a provision

where a gift given is included in the income of the donee 

and excluded from the i~c;omeof the donor, even though the 

mechanics of calculating the tax are on the opposite basis. 

~t is, then, mainly the estate and gift tax that 

introduces the "ability-to-pay" element into the tax system, 

because it results in a gift or bequest being taxed twice to 

the donor, once under the income tax and again under the 

transfer tax. The value implicitly expressed is that taxes 

should generally be assessed on a "standard-of-living"

basisI except in the case of individuals whose ability to 

pay is very larger and -whose standard of living is low 

relative to ability to pay [iseaJthose who refrain from 

consuming in order to make gifts and bequests), 

ALTERNATIVE BASES: BQUTTV CONSIDERATIONS 
 

The prevfous section considered what tax base is 

implicit in present law, In a sense, the answer itself is 

an equity judgment, because equity traditionally has played 

an important role in the tax legislation process, This 

section considers the relative equity claims of a "consumption" as compared with an "income'' basist ofIeither 

"ability-to-pay" or "s~andard-~f-living"typec and the 

"ability-to-pay" or "standaud-~f-living"version of either 

consumption or income, 

Consllmzrtion or Income: which is the Better Base? 

Involved in the choice between consumption and income 

as the basis for assessing tax burdens is more than a simple

subjective judgment as to whether, of two individuals having

different incomes in a given period but who are identical. in 

all respects in all other periods, the one with the higher

income should pay the higher tax. Examples of tax burdens 

considered within a life-cycle framework suggest that a 

consumption base deserves careful attention if the primary

consideration is fairness, whether one takes an ability-topay or a standard-of-living view. 
- 39 -

Many observers consider income and consumption to be 

simply alternative reasonable ways to measure well-being;

often, income is regarded as somewhat superior because it is 

a better measure of ability to pay. However, in a lifecycle context, income and consumption are -not independent of 

each other. Of two individuals with equal earning abilities 

at the beginning of their lives, the one with higher consumption early in life is the one who will have a lower 

lifetime income. This is true because saving is notonly a 

way of using wealth, but also a way of producing income. 

Thus, the person who saves early in life will have a higher

lifetime income in present-value terms. Although his initial 

endowment of financial wealth and of future earning power -is 
 independent of the way he chooses to use it, his lifetime 
 income is not independent of his consumption/savings decisions. 
 

The examples presented below show that a consumption

base would be more likely to maintain the same relative 

rankings of individuals ranked by endowment than an income 

base, if "endowment" is defined as an individual's wealth,

in marketable and nonmarketable forms, at the beginning of 

his working years. Wealth so defined consists of the total 

monetary value of financial and physical assets on hand, the 

present value of future labor earnings and transfers, less 

the cost of earning income and less the present value of the 

"certain other outlays" discussed in the accounting framework 

above. If endowment is regarded as a good measure of 

If individuals consume all of their initial endowment 
 during their lifetime (that is, leave no bequest), a consump­
 tion tax is exactly equivalent to an initial endowment tax. 
 However, an income tax treats individuals with the same 
 endowment differently, if they have either a different 
 pattern of consumption over their lifetime or a different 
 pattern of earnings. 
 

Consider first two individuals with no initial financial 
 or physical wealth, no bequest, the same pattern of labor 

earnings, and different patterns of consumption. Intuition 

suggests that, unless these individuals differ in some 

respect other than how they choose to use their available 

resources (e.g., with respect to medical expenses or family

status), they should bear the same tax burden, measured by

the present value of lifetime taxes. The tax system should 
- 40 -
 

not bear more heavily on the individual who chooses to 

purchase better food than on the one who chooses to buy

higher quality clothing. Nor should it bear more heavily on 

the individual who chooses to apply his endowment of labor 

abilities to purchase of consumption late in life (by saving

early in life) than it does on the one who consumes early in 

life. 

While an income tax does not discriminate between the 

two taxpayers in the case where the two taxpayers consume 

different commodities, it does in the case where they choose 

to consume in different time periods in their lives. An 

income tax imposes a heavier burden on the individual who 

prefers to save �or later consumption than on the one who 

consumes early, and the amount of difference may be significant. The reason is the double taxation of savings under 

an income tax. The “use” of funds for savings is taxed, and 

then the yield from savings is taxed again. The result is 

that the individual who chooses to save early for Later 

consumption is taxed more heavily than one who consumes 

early. 

The tax burden may be reduced most by borrowing for 
 early consumption, since the interest cost is deducted in 
 calculating income. 
 

NOW, suppose that the two individuals have different 

time paths of labor earnings but that the two paths have the 

same present discounted value. For example, individual A 

may earn $10,000 per year in a given 2-yeas period, while 

individual B works �or twice as many hours and earns $19,524

in the first of the 2 years, but earns nothing in the 

second. (The figure of $19,524 is the total of $10,000 plus

the amount that would have to be invested at a 5-percent 

rate of return to make $10,000 available one year laber.)

Each individual prefers to consume the same amount in both 

periods, and in the absence of tax, each would consume the 

same amount, $10,000 per year. Intuition suggests these two 

individuals should hear the same tax burden. However, under 

an income tax (even at a flat rate, i.e., not progressive),

they would pay different taxes, with B paying more than A. 

The reason, again, is the double taxation of B’s savings.

The differences may be very large if a long time period is 

involved. An income tax imposes a higher burden on the 

individual who receives labor income earlier even though

both have the same initial endowments in present-value terms 

and the same consumption paths. 
- 41 ­

"Standard-of-Liv'ing"or "Ability-to-Pay": Which Criterion? 
 

Although for the vast majority of individuals bequests

and gifts of cash and valuable property constitute a negligible portion of sources and an equally negligible portion

of uses of funds, the tax treatment of these transactions 

will have significant consequences for a minority of wealthy

individuals and, therefore, for the perceived Tairness of 

the tax system. 

The equity judgment embodied in present law is that 
 large transfers should be subject to a substantial progres­
 sive tax under the estate and gift tax laws and that rela­
 tively small transfers need not be taxed. Fox income tax 
 purposes, amounts given are taxed to the donor and are not 
 taxed to the donee. This has general appeal. The usual 
 reaction to the idea that gifts given should also be in­
 cluded in the tax base of the donee is that this would be an 
 unfair double taxation. 
 

As has been pointed out, the circumstances under which 

large transfers occur are relatively large wealth and low 

consumption of donor. The imposition of a substantial 

transfer tax (estate and gift tax) is consistent with a 

common argument for this tax; namely, that it is desirable 

to prevent extreme accumulations of wealth. If this is,

indeed, the equity objective, it suggests that the code's 

present allowance of relatively large exemptions and imposition

of high rates on very large transfers is sensible. 

Summing Up: The Equity Comparison of Consumption and Income

Bases 

As a general matter, the important conclusions to be 
 drawn from the foregoing discussion are: 
 

Either an income or a consumption tax may be designed 

to fulfill "ability-to-pay'' or "standard-of-living"

objectives. The difference is not between these two 

types of tax, but rather between a tax in which gifts

given are considered part of the tax base of either 

donor or donee or, instead, part of the tax bases of 

both donor and donee. In the latter case, the tax 

embodies an "ability-to-pay" approach; in the former,

the tax follows from a "standard-of-living" approach.

The present income tax system expresses a "standard-ofliving" basis of comparison, while the psesent estate 

and gift tax system combines with income tax to give an 

"ability-to-pay" approach in certain cases. 
-- 

-- 

- 42 -
 

The difference between a consumption base and an income 

base of either the "standard-of-living" or the "abilityto-pay" type is between one that depends upon the 

timing of consumption and earnings (and gifts, in the 

case of an "ability-to-pay"tax) during an individual's 

lifetime and one that does not. The income tax discriminates against people who earn early in life or 

prefer to consume late in life. That is, if a tax must 

raise a given amount of revenue, the income tax makes 

early earners and late consumers worse off than late 

earners and early consumers. A consumption tax is 

neutral between these two patterns. 

A consumption tax amounts to a tax on lifetime endow­
 ment. It may be viewed as an ideal wealth tax, that 
 is, a tax that makes an assessment on lifetime wealth. 
 An income tax will tend to assess tax burdens in a way
 presumably correlated with lifetime wealth, but because 
 it depends upon matters of timing, the correspondence
 is nowhere near as close as would be the case under a 
 consumption base tax. 
 

As previously noted, present law introduces an "abilityto-pay'' element into the tax system through the estate 

and gift provisions. The same device is equally

compatible with either an income base or a consumption

base tax. As will be discussed in chapter 4, in some 

respects an estate and gift tax system fits more 

logically with a consumption base system, which allows 

deduction of gifts by the donor and requires inclusion 

by the donee. 

ALTERNATIVE TAX BASES: SIMPLICITY CONSIDEFATIONS 

Of central importance in determining the complexity of 

a tax system to the taxpayer in complying and to the tax 

collector in auditing compliance -- is the ease with which 

the required transaction information can be assembled and 

the objective nature of the data. Three desirable characteristics are readily identifiable: 

Transactions should be objectively observable -- as in the case of the transaction of a wage payment.

Such transactions are called "cash" transactions in 

this report. "Imputed" transactions, i.e., values 

arrived at by guesses or rules of thumb -- as in the 

case of depreciation should be kept to a minimum. 
- 43 -

The period over which records need to be kept should be 
 as short as practicable. 
 

The code should he understandable. 
 

Consumption or Income Preferable on Grounds of Simplicitx? 
 

With respect to simplicity criteria, the consumption
 base has many advantages, as can be seen on examination of 
 the accounting relationships. At this stage, both the 
 concept of consumption and the concept of increase in net 
 worth must be complicated by adding imputed elements to the 
 simple example. 
 

The portion of consumption calculable from cash transactions includes cash outlays for goods and services and 

transfers to others (optional, depending upon the choice 

between "standard-of-living" and "ability-to-pay" versions).

In addition, an individual usually obtains directly the 

equivalent of certain consumption services that he could 

purchase in the marketplace. The most important of these 

are the services from durable goods, such as owner-occupied

houses, and household-produced services, such as child care, 

recreation, etc, 

The change in net worth over a given time period, the 

other component of income, is calculable in part by cash 

transactions. These include such items as net deposits in 

savings accounts. Imputed elements,however, are extensive 

and lead to some of the most irksome aspects of income tax 

law. Among these are the change in value of assets held 

over the period, including the reduction in value due to 

wear and tear, obsolescence, etc. (depreciation); increases 

in value of assets due to retained earnings in corporate

shares held, changed expectations about the future, or 

changed valuation of the future (accruing capital gains);

and accruing values of claims to the future (such as pension

rights, and life insurance). 

Thus, both consumption and the change in net worth can 

be expressed as the sum of items calculable from cash 

transactions within the accounting period and items that 

must be imputed. The cash items are easy to measure, but 

imputed items are a source of difficulty. Because the 

imputed consumption elements are needed for a comprehensive

income or consumption base, consider first some of the more 

signifisnt imputed elements of the change in net worth,

representing necessary additions to complexity if an income 

base is used. 
- 44 -
 

Four problems commonly encountered in measuring change

in net worth are depreciation, inflation adjustment, treatment of corporate retained earnings, and treatment of 

unrealized capital gains on nonmarketed assets. 

Measurement Problems 
 

Depreciation. Depreciation rules are necessary under 

an income base to account for the change in value of productive assets due to wear and tear, obsolescence, and 

increases in maintenance and repair costs with age. Because 

productive assets often are not exchanged fox long periods

of time, imputations of their annual change in market value 

must be made. 

Inevitably, depreciation rules for tax accounting, as 

in the present code, can only approximate the actual rate of 

decline in the value of capital assets. Because changes in 

depreciation rules can benefit identifiable taxpayers, such 

rules become the object of political pressure groups and 

are sometimes used as instruments of economic policy,

causing the tax base to depart even further from a true 

accretion concept. Thus, accelerated depreciation, at rates 

much faster than economic depreciation, has been allowed in 

some industries as a deliberate subsidy (e.g., mineral 

industries, real estate, and some farming). To the extent 

that the relationship between tax depreciation and economic 

depreciation varies among industries and types of capital, 

returns to capital investment in different industries and on 

different types of equipment are taxed at different effective 

rates. Differences in the tax treatment of capital income 

among industries create distortions in the allocation of 

resources across products and services and in the use of 

different types of capital in production. 

Unrealized depreciation of an asset is neither added to 

nor subtracted from the consumption base. Thus, the time 

path of depreciation imputed to assets does not affect the 

tax base of asset owners. Adoption of a consumption base 

tax would automatically eliminate current tax shelters that 

operate by allowing depreciation in excess of economic 

depreciation in some industries. Alternative tax subsidies 

to the same industries, if adopted, would have to be much 

mre explicit and would be easier to measure. The accidental 

taxation of returns to capital in different industries at 

different rates that arises under the current system because 

of imperfect knowledge of true economic depreciation rates 

would not occur. 
- 45 -
 

Inflation Adjustment. During a period of rapid inflation, the current income tax includes inflationary gains

along with real gains in the tax base. For example, an 

individual who buys an asset for $100 at the beginning of a 

year and sells it for $110 one year later has not had any

increase in the purchasing power of his assets if the 

inflation rate is also 10 percent. Yet, under the current 

system he would include at least part of any gain on the 

sale of the asset in the sources side of his tax calculation. 

An ideal income base would have to adjust for losses on 

existing assets, including deposits in savings banks and 

checking accounts, resulting from inflation. Such adjustments would pose challenging administrative problems for 

assets held for long periods of time. The current tax 

system effects a rough compromise in its treatment of "longterm capital gains" by requiring that only half of such 

gains be included in taxable income and by allowing no 

inflation deduction. (However, this treatment has been 

substantially modified by the minimum tax and by denial of 

maximum tax benefits for "earned income" if the taxpayer

also has capital gains.) Dividends and interest income are 

taxed at the same rate as labor income even though the 

underlying assets may be losing real value. 

A second type of inflationary problem under the current 

tax system is that rising nominal incomes move taxpayers

into higher marginal tax brackets, and thus increase the 

average tax rate even when real income is not growing.

Inflation will automatically raise the average tax rate in 

any tax system with a graduated rate structure, whether 

based on income, consumption, or the current partial-income

base. A possible solution is some type of indexing plan,

such as automatic upward adjustment of exemption levels. 

Because this problem does not affect the relative distribution 

of the tax base among individuals, it 1s not an issue in 

choosing between a consumption and an income base. 

Under a consumption tax, inflation would not lead to 
 diLficulties in measuring the relative tax base among indi­
 viduals because consumption in any year would be measured 
 automatically in current dollars. A decline in the value of 
 assets in any year because of inflation would be neither a 
 positive nor a negative entry in the consumption base. 
 
- 46 -

Treatment o'f Corporate Income, Given the difficulty of 

taxing gains in asset values as they accrue, the present 

corporate income tax serves the practical function of 

preventing individuals from reducing their taxes by awumulatinq income within corporations. Naturally, this is hat 

a rough approximation o� the appropriate taxation of this 

income and the difficulty of ident5fying incidence and 

allocation ef�ects of this tax is well known. Under a fully

consistent income tax concept, as outlined below in chapter 

3, "corporation income" would be attributed to individual 

stockholders, This integration of the corporation and 

personal income taxes is desirable fur a progressive income 

tax system because the variation among individuals in 

marginal tax rates makes it impossible for a uniform tax on 

corporate income, combhed with exclusion pf dividends and 

capital gains, to assess all individual owners at the 

appropriate rate. Although feasible and desirable in an 

income tax system, full corporate integration is sometimes 

regarded as posing tou many challenging administrative 

problems. A partial integration plan that allowed mrporations to deduct dividend payments and/or allowed shareholders to "gross up" dividends by an amount reflecting the 

corporation income tax, taking a credit for the same mount 

in their individual income tax calculation, would eliminate 

the problem of ''double taxation'' of corporate dividends. 

This could be done without introducing significant complexity

into the tax code, but the problem of how to treat corporate

retained earnings would remain mresoLved. 

Treatment o� corporate income under a consistent 

consumption tax is simpler than under a comprehensive

hxmrne tax. The corporation profits tax as such would be 

eliminated, Individuals would normally include in their tax 

base all dividends received and the value of all sales of 

corporate shares, and they would deduct the value of all 

shares purchased, There would be no need to treat receipts 

frmt sales of shares differently than other sources OL to 

attribute undistributed corporate profits to individual 

shareholders. 

Treatment of Unrealized Asset Value Changes. The 

increase in net worth due to any chanqes in value of assets, 

whether realized or not, would 6e inciuded in the accretionconcept of income. An individual who sells a stock at the 

and of the year �or $100 more than the purchase price at the 

beginning of the year and an individual who holds a parcel

of land that increases in value by $100 during the same time 

interval both experience the same increase in net worth. 
- 47 -

However, unrealized asset value changes are often difficult 

to determine, especially if an asset has unique characteristics 

and has not been exchanged recently on an open market. 

Further, there is a question as to what is meant by the 

value of an asset for which the market is very thin and 

whether changes in the value of such assets should be viewed 

in the same way as an equal dollar flow of labor, interest, 

or dividend income. For example, if the value of an individual's house rises, he is unlikely to find it convenient 

to realize the gain by selling it immediately. Any tax 

obligation, however, must ordinarily be paid in cash. 

Similar questions arise with respect to the treatment 

of increases in the present value of a person's potential

income from selling his human services in the labor market. 

It is not practical to measure either the increase in an 

individual's wealth from a rise in the demand for his labor 

or the depreciation of the present value of future labor 

earnings with age. Present law makes no attempt to recognize

such value changes nor would they be captured in the comprehensive income tax proposal presented in chapter 3. 

Under a consumption tax, unrealized changes in asset 
 value would not need to be measured because consumption from 
 such assets does not occur unless either cash flow is 
 generated by the asset or the asset is converted into a 
 monetary value by sale. 
 

Finally, the problem of income averaging can be minimized with techniques of cash flow management. Averaging

is desirable under an income tax because, with a progressive

rate structure, an individual with an uneven income stream 

will have a higher tax base than an individual with the same 

average income in equal annual installments. Equity requires

that two individuals pay the same tax when they have the 

same lifetime endowment, regardless of the regularity of the 

pattern in which earnings are received (or expended). 

The consumption tax may be viewed as a tax in the 
 initial time period on the present value of an individual's 
 lifetime consumption expenditures. Deferral of consumption
 by saving at positive interest rates raises total lifetime 
 consumption but leaves unchanged the present value of both 
 lifetime consumption and the tax base. 
 

Although the annual cash flow measure of the consumption 

tax correctly measures the present value of lifetime oonsumption, averaging problems may arise if annual cash flow 
-- 

- 48 -
 

varies from year to year. The major averaging problem

results from large irxegular expenditures, such as the 

purchase of consumer durables. As described in chapter 4,

there are two alternative ways of dealing with loans and 

investment assets in measuring the tax base. Both methods 

yield the same expected present value of the tax base over 

time but enable an individual to alter the timing of his 

recorded consumption expenditures. The availability of an 

alternative treatment of loans and assets enables individuals to even out their recorded pattern of consumption

for tax purposes and represents a simple and effective 

averaging device under a consumption tax. 

The same type of automatic averaging cannot be intro­
 duced under an income tax because an income tax is not -a tax

on the present value of lifetime consumption. Under an 
 accretion income tax, the present value of the tax base 
 rises when consumption is deferred, if interest earnings are 
 positive, because the income used for saving is taxed in 
 -the year it is earned and then the interest is taxed aEin. 

Thus, allowing deferral of tax liability under an income tax 

permits a departure from the accretion concept, lowering the 

present value of tax liability. 

The discussion above suggests that, contrary to popular
 belief, a consumption-based tax might be easier to imple­
 ment, using annual accounting data in an appropriate and 
 consistent fashion, than an income-based tax. 
 

"Standard-of-Living" or "Ability-to-Pay" Preferable on 
 Simplicity Grounds? 
 

The choice between an "ability-to-pay" and a "standardof-living" approach under the consumption or income tax has 

significant implications for simplicity of administration. 

It is relatively easy to insure that the amount of a gift is 

counted in the tax base of either the donor or the donee. 

Under present law, gifts (other than charitable gifts) are 

not deductible from the tax base of the donor. If gifts 

were deductible, the donor could be required to identify

the donee. A requirement that both donor and donee be 

taxed, as would be implied by an "ability-to-pay" approach,

would introduce a great temptation to evade. Taxing both 

sides would require that the gift not be deductible by the 

donor and that it be included in the tax base of the donee. 

Particularly for relatively small gifts and gifts in-kind, 
- 49 -
 

auditing compliance with this rule, where no evidence is 
 provided in another person's return of having made the gift,
 could be a formidable problem. For much the same reason,
 compliance with the existing gift tax law is believed to be 
 somewhat haphazard. 
 

The issue of gifts in-kind is important. It is difficult 
 to establish whether a gift has been given in these cases 
 (e.g., loan of a car or a vacation home). Again, if the 
 gift need only be taxed to one of the parties to the trans-
 action, failing to report a gift simply means it is taxed to 
 the giver and not the recipient. 
 

Gifts in-kind are significant in another sense. Gifts 

and bequests can be considered a minor matter to most 

people only if the terms are taken to refer to transfers of 

cash and valuable property. If account were taken of the 

transfers within families that take the form of supporting

children until their adulthood, often including large

educational outlays, inheritance would certainly be seen to 

constitute a large fraction of the true wealth of many

individuals. Any discussion of gifts and bequests should 

take into account that the parent who pays for his child's 

college education makes a gift no less than the parent who 

makes a gift of the family farm or of cash, even though this 

equivalence is not recognized in present tax law. 

Where large gifts of cash and property are involved, it 

seems likely that enforcement of a double tax on transfers 

will be less costly than when gifts are small. This has 

proved to be the case under current law. 

EFFICIENCY ISSUES IN A CHOICE BETWEEN AN INCOME AND A 

CONSUMPTION BASE 

In public discussions, the efficiency of a tax system

is often viewed as depending on its cost of administration 

and the degree of taxpayer compliance. While these features 

are important, one other important characteristic defines 

the efficiency of a tax system: As a general principle,

the tax system should minimize -. - the extent to which indi3uals alter their economic behavror so asto avoid payinq 

tax. InTEFZrYEXs, it is usually unGsEaEefortaxes to 

influence individuals' economic decisions in the private 

sector. There may, of course, be exceptions where tax 

policies are used deliberately to either encourage or 

discourage certain types of activities (for example, tax 

incentives for installation of pollution equipment or high

excise taxes on consumption of liquor and tobacco). 
- 50 -
 

Both an ideal. consmption tax and an ideal incame tax, 

though neutral among commodities purchased and produced, do 

have important incentive effects that are unintended byproducts of the need to raise revenue. Specifically, individuals can reduce their tax liability under either tax to 

the extent it is possible to conduct economic activities 

outside of the marketplace. Fur example, if an individual 

pays a mechanic to repair his automobile, the labor charge

will entered into the measurement o� consumption or income 

and will be taxed under either type of tax. On the other 

hand, if the individual repairs his own automobiler the 

labor cost will not be accompanied by a measurable transaction and will not be subject to tax. Phrased more generally,

both an income and a consumption tax distort the choice 

between labor and leisure,.where leisure is defined to 

include all activities, both recreational and productive,

that are conducted outside the praceEs of market exchange. 

While both consumption and income taxes distort the 

Choice betweeh market and mnmarket activities, only an 

income tax distorts the choice between present and future 

consumption. 

Under an income tax, the beforetax rate of return un 

investments exceeds the after-tax interest rate received by 

those who save to finahce them. The existence of a posftiva

market interest rate reflects the fact that society, by

sacrificing a dollar's worth of consumption today and 

allocating the dollar's worth of resources to the production 

of capital goods, can increase output and consumption by 

more than one dollar next year. Under an income taxl the 

potential increase in output tomorrow to be gained by

sacrificing a dollar's worth of output today exceeds the 

percentage return to an individual, in increased future 

consumption, to be derived from saving. In effect, the 

resources available tq an individual for future consumption 

are double-taxed; first, when they are earned as current 

incame and secondl when interest is earned an savings. The 

present value of an individual's tax burden may be reduced 

by shifting consumption from future periods to the present. 

A consumption tax, on the other hand, is neutral. with 

respect to the choice to consume in different periods 

because current saving is exempted from the base. The 

expected present value o� taxes paid is not affected by the 

time pattern of consumption. A switch from an income tax to 

an equal-yield consumption tax would thus tend t~ increase 

the fraction of national output saved and invested, and 

thereby raise luture output and consumption. 
- 51 -
 

The fact that a tax is neutral with respect to the 

savings-consumption decision is not, of course, decisive in 

its favor even on efficiency grounds. NO taxes are neutral 

with respect to all choices. Thus, for example, it has 

already been pointed out that neither the income nor the 

consumption tax is neutral in the labor/leisure choice; that 

is, both reduce the incentive to work in the marketplace.

Economic theorists have developed measures of the amount of 

damage done by nonneutrality in various forms. Although

it is not possible on the basis of such research to make a 

definite case for one tax base over the other based on 

efficiency, when reasonable guesses are made about the way

people react to various taxes it appears that the efficiency

loss resulting from a consumption tax would be considerably

smaller than that from an equal yield income tax. 

The possible efficiency gains that would result from 

adopting a consumption base tax system relate closely to the 

frequently expressed concern about a deficient rate of 

capital formation in the United States. Switching from an 

income to a consumption base tax would remove a distortion 

that discourages capital formation by U.S. citizens, leading 

to a higher U.S. growth rate in the short run, and a permanently higher capital/output ratio in the long run. 

SUMMING UP 

The previous discussions have attempted to provide a 
 systematic approach to the concept of income as composed of 
 

certain uses -of resources by individuals. The current

income tax law lacks such a unifying concept. Indeed, as 

has been suggested here, income as implicitly defined in 

current law deviates from a consistent definition of accretion 

income especially in that it excludes a major part of income 

used for savings [often in the form of accruing rights to 

future benefits). Eliminating savings from the tax base 

changes an income tax to a tax on consumption. 

This chapter has considered whether there is any sound 

reason for considering substitution of a consumption base 

for the present makeshift and incomplete income base. It 

has been suggested that there is much to be said for this on 

grounds of equity; such a base would not have the drawback, 

characteristic of an income tax, of favoring those who 

consume early rather than late in life, and of taxing more 

heavily those whose earnings occur easly rather than late in 

life. The argument has been made that the choice is -

not
-- 

-- 

- 52 -

between a tax favoring the rich (who save) and the poor (who

do not), as some misconceive the consumption tax, and a tax 

favoring the poor over the former rich by the use of proqressive rates, as some view the income tax. The choice is 

between an income tax that, at each level of endowment,

favors early consumers and late earnsvz late consumers 

and early eirners and a consumption tax that is neutral 

between these two types of individuals. The relative 

burdens of rich and poor are detesmined by the degree of 

progressivity of the tax. Either tax is amenable Ito % 

degree -of progressivity --of rates. 

A distinction has been drawn between a tax based on the 
 uses of resources for the taxpayer’s own benefit and one 

based on these uses plus the resources he gives away to 

others. The shorthand term adopted for the former is the 

“standard-of-living“approach to assigning tax burdens; for 

the latter, it is the “ability-to-pay‘‘approach. It has 

been suggested that either a consumption or an income tax 

could be designed to fit either concept. Examination of 

current practice suggests that the basic tax -- the present

income tax -- is, broadly speaking, of the “standard-ofliving“ type. An “ability-to-pay“ element is introduced by

special taxes on gifts and estates. 

The next two chapters consider two different approaches

to reform of the tax system. Chapter 3 contains a plan for 

a comprehensive income tax, and chapter 4 contains a plan

for a very different tax, called a cash flow tax, which is 

essentially equivalent to a consumption tax. In both cases, 

a “standard-of-living” approach is adopted, under the 

assumption that a transfer tax of some sort, perhaps the 

existing estate and gift tax, would continue to be desirable 

as a complement. 
- 53 -

Chapter 3 

A MODEL COMPREHENSIVE INCOME TAX 

OVERVIEW 

This chapter presents a model income tax system based, 

as nearly as practicable, on a consistent de.finiticm of 

"standard-of-living" income as set forth in the previous

chapter. The exceptions to strict conformity with the 

conceptual income definition are noted. These exceptions 

occur when rival considerations of efficiency or shplicity 

have seemed to overrule the underlying principle that all 

income should be taxed alike, In addition, those cases 

where the concept of income is not readily translated into 

explicit rules are noted and discussed. In every case, 

a specific model tax treatment, sometimes together with 

optional treatments is defined and highlighted. 

Purmse of the Model Tax 

The purpose of the model tax is to provide a concrete 

basis for the discussion of fundamental tax reform and also 

to de�ine a standard �or the quantitative analysis presented

in chapter 5. For each major issue of income tax policy, the 

model tax reflects a judgment of the preferred treatment. 

It is. not claimedt howeverf that the model tax provides

the unequivocally right answer to all the difficult issues 

o� measurement, definition, and behavioral effects raised. 

The chapter does not, therefore, only advocate a particular 

set o� provisions; it also presents discussions of alternative treatments. 

Base-Broadenins Ubiective 

Alternative treatments are suggested when a change from 

the model tax provision clearly would not violate the basic 

principle that an income tax should be based on a practical 

measure of income, consistently defined, ~n some cases, 

alternative accounting methods or alternative mean5 of 

applying tax rates may be used; and there may also be some 

uncertainties in the interpretation of the income concept 

itself. &cause a low-rate, broad-based tax promises a 

general imrpavement in incenkives, and because there are 

cmts associated with recordkeeping and administration, 

there is a presumption against deductions, exemptions, and 

credits throughout the model tax. In particular instances, 

this presumption may be reversed in favor of an alternative 
-- 

- 54 -

treatment without offending the basic principle of income 

rneasur anent. 

Organization of Chapter 3 

The first issues taken up in the chapter concern rules 

for a definition of income suitable as a tax base. Such 

rules are derived for three broad SOUFCCS of household 

income-employee compensation, government transfer payments, 

and business income. The first of these ig treated in the 

next section. The third section considers the tax treatment 

of government transfer payments, and the fourth section 

deals with problems of accounting for income �ram businesses, 

The next four sections of the chapter discuss some specific

issues in the taxation of income derived from the ownership

of capital. In each af these sections, the model tax is 

compared with the existing Federal inmme taxes. Next are 

three sections that treat issues in the definition of 

taxable income from all sources. These are the major

"personal deductions" under the existing tax. Here, each of 

these items -- medical expenses, State and local taxes, 

charitable contributions, and casualty losses is considered as an issue of income measurement and economic 

efficiency, Fallowing these is a brief discussion of the 

problems and principles of international income tax coordination. Finally, the questions of the proper unit for reporting 

taxable income and of appropriate adjustments for family

size and other circumstances are considered. The chapter

concludes with a sample model income tax form that serves a5 

a summary of the model tax provisions. 

EMPLOYEE COMPENSATION 

--.> The customary starting point for systems of income 

accounting is to observe the terms under which individuals 

agree to provide labor services to employers. In the 

simplest case, described in the previous chapter, the 

employee is paid an annual wage that is equal to his consumption plus change in net worth, However, in practice, 

complications usually will arise, On the one hand, the 

employee may have expenses associated with employment that 

should not be regarded as consumption, On the other hand, 

he may receive benefits that have an objective market valuer 

which, in affect, represent an addition to his stated wage. 

The model comprehensive income tax attempts to measure 

the value to the employee of all the financial terms o� his 

employment. In general, the accounting for employee cornpensation is 11) wage and salary receipts, less (2) necessary 
-- -- 

-- 

- 55 -

employment expenses, plus (3) the value of fringe benefits. 

The remainder of this section discusses the measurement 

problems presented by items (2) and (3). 

Expenses of Employment 
 

Model Tax Treatment. The model comprehensive income 

-

tax 	 would allow deduction from wae I

and salary -s

-for expenses reguma condltlon of a particular job,

such as the purchase of uniforms and tools, union dues, 

unreimbursed travel, and the like. NO deduction would -be 

allowed for expenditures associated zth ___ the choice of Ian occupation, place of employment, or place of residence, 

even though each of these is related70 employment. The 

latter rule would continue the present treatment of education and commuting expenses,.but would disallow moving 

expenses. 

Inevitably, such rules are somewhat arbitrary. For 
 example, whether commuting expenses are deemed costs of 
 employment or consumption expenditures will depend upon
 whether the work trip is regarded principally as a part of 
 

one's choice of residence, i.e., the consumption of housing
 services, or as a part of the job choice. The guidelines
 followed here are that expenses should be deductible only if 
 they vary little among individuals with the same job and are 
 specific to the current performance of that job. As at 
 present, regulations would be required to set reasonable 
 limits for those expenses that may be subject to excessive 
 variation, e.g., travel. 
 

A Simplification Option. An option that would simplify

individual recordkeeping and tax administration would be to 

allow deduction for employee business expenses only in 

excess of a specified amount. If this floor were substantially

higher than expenses for the typical taxpayer, most employees

would no longer need tq keep detailed expense records for 

tax purposes. The principal disadvantage of this limitation 

of deductions is that it would tend to discourage somewhat 

the relative supply of labor to those occupations or activities 

that have relatively large expenses. Over time, such supply

adjustments could be expected to provide compensating increases 

in wages to those whose taxes are increased by this provision, but the inefficiency of tax-induced occupation changes

would remain. 
- 56 -

Employer-Provided Pensions 

A substantial share of the compensation of employees is 

in the form of the annual increase in the value of rights to 

future compensation upon retirement. This increase adds to 

the net worth of the employee, so that an annual estimate of 

the accretion of these rights is income under the comprehensive

definition. The model tax treatment is intended as a 

uniform, practical means to estimate the income for tax 

purposes for different types a� private pension plans. 

in the years paid. However, -the earnings of pension plans

Euldbe taxeG they accrued. Liabilifyfor tax OR 

pensioTplan earni-w- either upon the employer, if 

no assignment a� rights were made to employees as the earnings 

accrue, or upon the employee to whom these earnings are 

allocated by the plan. 

Types of Pension Plans. Employer-provided pension

plans come in 'two ' forms -- def bed-contribution and def insdbenefit. The.first form is essentially a mutual fund to 

which the employer deposits contributions on behalf of his 

employees. Each employee owns a percentage of the assetsf 

and each employee's account increases by investment earnings 

on his share of the assets. Upon retirement, his account 

balance may be distributed to him as a Imp sum payment or 

may be used to purchase an annuity. The income of any 

individual from such a plan is simply the contribution made 

by the employer on his behalf plus his share of the total 

earnings a5 they accrueMost pensions are of the second typer defined-Benefit 

pensions. This is something of a misnomer because the 

benefit is not fully defined until retirement. It usually

depends on the employee's average wage over the years of 

employment, the outcome of contract negotiations, etc, The 

employee's benefits may not vest for a number o� years, 

so that the value to him, and the cost to his employer

of his participation are an expectation that depend on the 

chance of his continued employment. By a strict definition 

of income, the annual change in the present value of expected

future benefits constitutes income from the plan, since this 

is conceptually an annual increase in the net worth of the 
-- 

-- 

- 57 -
 

employee. In general, it is not possible to determine the 
 accrued value of future benefits in such a plan without many
 arbitrary assumptions about the employee's future employment 
 prospects, marital status at retirement, and similar issues. 
 

A Practical Measurement Syste-. As an alternative to 
 estimatinq pension income as an accrual of value to the 
 employee,-the model plan would approximate such treatment 
 through the current taxation of plan earnings and full 
 taxation of actual benefits. If done correctly, this would 
 be equivalent to the taxation of the increase in present
 value of expected future benefit as such increases accrue. 
 

The following example illustrates the equivalence
 between taxation of accrued pension earnings and taxation of 
 both pension plan earnings and benefits received. 
 

Mr. Jones' employer contributes $160 to his pension

plan at the beginning of this year. Over the year,

the contribution will earn 10 percent. Mr. Jones 

retires at the beginning of next year, taking his 

pension -- the Contribution plus earnings in one 

payment. Mr. Jones' tax rate in both periods is 25 

percent. 

Method 1. Under a system of taxation of pensions as 

accrued, Mr. Jones would include the contribution in his 

taxable income and owe a tax of $40. The earnings of $12 on 

the remaining $120 would incur an additional tax liability

of $3, leaving net earnings of $9. (Note that Mr. Jones 

could restore the pension fund to $160 only by drawing down 

his other savings, with a presumably equal rate of return, 

by the amount of the tax.) Upon retirement, Mr. Jones would 

receive a tax-prepaid pension distribution of $120 plus $9, 

or $129. 

Method 2. The model tax treatment would subject only

the earnings of the fund -- 10 percent of $160 to tax in 

the first year. This tax of $4 would leave net earnings of 

$12. Mr. Jones would then receive $172 upon retirement, but 

would owe tax on this full amount. The tax in this case 

would be $43, so that the remainder [$172 - $43 = $1291 

would be identical to that resultinu from use of method 

1, and Mx. Jones should be indifferent between the two 

treatments. 
- 58 -

The method of including actual benefits has the advantage

uf avoiding the necessity to allocate prospective benefits 

among nunvested participants. Investment earnings wouldr 

however, have anibiguous ownership for the reasons mentioned 

above. Consequently, it would be necessary to assess a tax 

on the employer for that share of earnings not assigned to 

particular employees. 

Present Law. Under present law, if an employer-provided

pension plan i's legally "qualified," retirement benefits are 

taxable to the employee only when received, ~otas accrued, 

even though contributions are deductible to the employer a5 

they are made. The plan's investment income is tax exempt.

certain individuals are also allowed tax benefits similar to 

qualified pension plans under separate laws, These laws 

allow a limited amount a� retirement saving to be deducted 

from income, its yield to be tax free, and its withdrawals 

taxable as personal income. This treatment allows an 

interest-free postponement of tax liability that would not 

exist under the model tax. Postponement introduces nonneutral. 

tax treatment among forms of saving and investment, encourages 

a concentration of wealth in pension funds, and reduces 

the available tax base, 

Social security 

Social security retirement benefits (OASI) present 

other problems. They are financed by a payroll tax on the 

first $15,300 {in 1976) of annual earnings, half of which is 

paid by the employer and half by the employee. The half 

paid by the employee is included in his tax base under the 

current intome tax; the tax paid by the employer is not, 

although it is a deductible expense to the employer. Social 

security benefits are tax free when paid. 

For an individual employee, the mount of annual 

accrual, Qf prospective social security benefits is ambiguous.

Actual benefits, by cohtrastr are readily measurable and 

certain- Furthermore, because participation in Social 

Security is mandatary, failure to tax accruals does not 

present the same tax neutrality problem encuuntered with 

private pensions; that is, there is no incentive to convert 

savings to tax-deferred forms. Consequently, -tho model tax -base would allow deduction of employee c,ontributip- ­ -the 	 ind'ividual -and continuexo allow &duction of employer

contributions -

the employer, -but 10x1 benef itTayments

would be subject to tax, Very low-income retired persons I_­ would bc shielded from taxation by provision a� a personal

exemption and an additional �artily allowance. 
-- 

-- 

-- 

-- 

- 59 -

Employer-Paid Health and Casualty Insurance 
 

Issues in the tax treatment of.health and casualty

insurance are discussed separately below in the sections on 

medical expenses and casualty losses. In the case of 

employer-paid premiums for insurance unrelated to occupational hazards, the model tax adopts the same treatment 

that is recornended for individual purchase. -The taxpayer

would include as taxable employee compensation -the value 

of the ymiynrpafd on his behalf. Proceeds wouldxbe 

include in income The same model -tax treatment would

apply to -the health insurance (Medicare) component of Social 
 Security. 
 

Disability Insurance 
 

Private Plans. Under present law, employees are not 

required to include employer-paid disability insurance 

premiums in income, and, subject to a number of conditions,

disability grants do not have to be included in the individual's income tax base.. Under the proposed system,

remiums paid into such disability plans by employers

Eould --not be taxable to employers, and emsoyees would 
 -belowed to deduct aeir own contributions, but the 

benefits wozd -be tax-
 

Conceptually, the premiums paid by the employer do 

increase the net worth of the employee by the expected value 

of benefits. Whether benefits are actually paid or not, 

this increase in net worth is income by a comprehensive

definition. However, when benefits are taxable, as they

would be under the model plan, the expected value of tax is 

approximately equal to the tax liability under a current 

accrual taxation system. The model tax treatment is preferred

because valuing the worth of the future interests would pose

insurmountable administrative difficulties. 

Social Security Disability Insurance. The model tax 
 would provide exactly 7-

the same treatment for the disability
 insurance portion of Social Security -(DI), that is given for 

private plans. AcGumation is impractical because the 

annual value of accruing DI benefits is even less certain 

than for private plans. 
wouEtbe 

- 60 -

Life Insurance 
 

Term Life Insurance. There is no similar difficulty of 

valuation in employer provision of term life insurance. The 

annual value to the employee is equal to the premium paid on 

his behalf. Therefore, under the model tax, term life 

insurance -premium P7--- ayments made by the employer would be

included % income -

to t e employee: benefits -__ included in income. This parallels the present treatment of 
 an individual's own purchase of term insurance, and that 
 treatment would be continued. 
 

Whole Life Insurance. Whole life insurance involves 

some additional considerations. A whole life policy represents 

a combination of insurance plus an option to buy further 

insurance. When one buys a whole life policy, or when it is 

purchased on his behalf, that policy may be viewed as 1 

year's insurance plus an option to buy insurance for the 

next and subsequent years at a certain prescribed annual 

premium. That option value is recognized in the form of the 

"cash surrender value" of the policy. It represents the 

value, as determined by the company's actuaries, of buying

back from the insured his option to continue to purchase on 

attractive terms. Naturally, the value of this option tends 

to increase over time, and it is this growth in value that 

represents the income associated with the policy. Dividends 

paid on life insurance are, in effect, only an adjustment in 

the premium paid -- a price reduction. 

The total annual income associated with a whole life 
 insurance policy is equal to the increase in its cash 
 surrender value plus the value of the term insurance for 
 that year (the term insurance premium) less the whole life 
 

Unemployment Compensation 
 

Under present law, both the Federal Unemployment Tax 

Act (FUTA) taxes to finance the public unemployment compensation system and the unemployment compensation benefits 

are excluded from the income of covered employees. Following 
-- 

-- 

- 61 -

the recommended treatment of disability insurance, which has 
 similar characteristics, the model comprehensive income tax 
 would exc'ludepayroll taxes from income as at present, -

but,

unlike 7the present law, unemployment compensation benefits 
 would be included -

in taxable income.

This treatment has two basic justifications. First, it 

conforms with the basic equity principle of subjecting all 

income to the same tax. Employed individuals would not be 

subject to differentially higher tax than those of equal

income who derive their income from unemployment benefits. 

Second, by taxing earnings and unemployment benefits alike,

this treatment would reduce the disincentive to seek alternative or interim employment during the period of eligibility

for unemployment benefits. Anain, the personal exemption

and family allowance would prevent the tax from reaching 

very low-income persons who are receiving such benefits. 

PUBLIC TKANSFER PAYMENTS 

A large element of the income of many households is 

provided by payments or subsidies from government that axe 

not related to contributions by, or on behalf of, the 

recipients. These transfer payments are presently excluded 

from the calculation of income for Federal taxes, despite

their clear inclusion in a comprehensive definition of 

income, 

Model ?ax Treatment 
 

The logic of including transfers in a tax base varies 

among transfer programs. A distinction may be made between 

those grants that are unrelated to the current financial 

circumstances of recipients, e-a., veterans' education 

benefits, and those that depend upon a stringent test of 

means, such as aid to families with dependent children. A 

second useful distinction is between cash grants that are 

readi13measurable in value and publicly provided or suhsidize services. The amount of income provided by these 
 "in-kind" benefits, such as public housing, is not readily
 measurable. 
 

The -model income -tax would include in income Iall

cash transfer payments from government, =ether determined 

by a test of means or not. Such payments include veterans' 

disability and survivor benefits,-veterans' pensions, aid 

to families with dependent children, supplemental security 
- 62 -

income, general assistance, workmen's compensation, black 

lunq benefits, and the subsidy element of food stamps.l/ 

-The-+ -tax would -not require reporting -the value' -ofgovernment-provided or subsidized services. �I= there 

would be no extra tarassociated with the benefits of such 

programs as Medicaid, veterans' health care, and public

housing. 

Rationale for Taxing Transfer Payments 

Horizontal Equity. The principal argument for taxing

transfer payments is horizontal equity. Under present law, 

families that are subject to tax from earnings or from 

taxable pensions may face the same financial circumstances 

before tax as others that receive transfer income. If an 

adequate level of exemption is provided in the design of a 

tax rate structure, these families would have no tax in 

either case. But for those whose incomes exceed the exemption level, the present treatment discriminates against the 

earning family. This is both an inequity and an element of 

work disincentive. 

Those transfer payments that are not contingent on a 
 strict means test are especially likely to supplement family
 incomes that are above the level of present or proposed
 exemptions. These programs are the various veterans' 
 benefits, workmen's compensation, and black lung benefits. 
 

The taxation of benefits from any government transfer 
 

program would effectively reduce benefits below the level 
 that Congress originally intended, and restoration of these 
 levels may require readjustment of the rates of taxation. 

However, with a progressive rate tax, the benefits to individuals 

would be scaled somewhat to family circumstances and, in 

addition, the tax consequences of earnings and grants would 

be equalized. 

Vertical Equity. The means-tested programs -- Aid to 

Families with Dependent Children, Supplemental Security

Income, general assistance, Food Stamps, Medicaid, and 

public housing -- have rules to determine eligibility and to 

scale the value of benefits according to income and wealth 

of the recipient family. Bowever, these rules may be based 

on measures of well-being that are different from those 

appropriate for an income tax. The rules also vary by

region, and certain grants may supplement each other or be 

supplemented by other forms of assistance. Consequently, it 
- 63 -
 

is possible that families with similar financial circum­
 stances before transfers will diverge widely after transfer 
 payments are added. To the extent that some recipient
 households have total incomes that exceed the tax exemption
 level, inclusion of these grants in the tax base would 
 reduce this divergence. Taxation of grants is no substitute 
 for thorough welfare reform, but it may be regarded as a 
 step toward reducing overlap of the various programs and of 
 reducing regional differences in payment levels. 
 

Valuing In-Kind Subsidies 
 

Those programs of assistance to families that provide

particular commodities or services, such as housing and 

medical care, present difficult administrative problems of 

income evaluation. One objective approximation of the 

income to households'from these services is the cost of 

providing them. This is the principle employed to value 

pension contributions, for example. But in the case of inkind transfers, costs are not readily allocable to particular

beneficiaries. Consider how difficult it would be to allocate 

costs among patients in veterans' hospitals, for example.

Furthermore, because a recipient's choices regarding these 

services are restricted, the cost of the services may be 

substantially larger than the consumption (i.e., income)

value to the beneficiary. The recipient family would almost 

certainly prefer an amount in cash equal to the cost of 

provision. Because of these uncertainties and because of 

the attendant costs of tax administration and reporting, the 

in-kind programs might reasonably be excluded from the tax 

base. 

BUSINESS INCOME ACCOUNTING 
 

Basic Accounting for Capital Income 
 

What is meant here by "business income" is that part of 

the annual consumption or change in net worth of the taxpayer that derives from the ownership of property employed

in private sector production. In the ordinary language of 

income sources, this income includes those elements called 

interest, rent, dividends, corporate retained earnings,

proprietorship and partnership profits, and capital gains,

each appropriately reduced by costs. Unfortunately, there 

is no generally accepted set of accounting definitions for 

all of these ordinary terms. An important objective of the 

model income tax is to outline an accounting system for 

property income that is at once administrable and in close 

conformance with a comprehensive definition of income. 
- 64 -

It is apparent from the definition that income is an 
 attribute of families and individuals, not of business 
 organizations. Furthermore, it is useful analytically to 
 think of income in terms of uses of resousces, rather than 
 receipts of claims. Nonetheless, accounting for income is 
 most easily approached by beginning with receipts of individual 
 business activities (or firms), then specifying adjustments
 for costs, and, finally, allocating income earned in each 
 business among its claimants. The sum of such claims for 
 all activities in which a taxpaying unit has an interest is 
 that taxpayer's business income for purposes of the model 
 tax. 
 

In broad outline, accounting for business income 

proceeds as follows. Begin with gross receipts from the 

sale of goods and services during the accounting year and 

subtract purchases of goods and services from other firms. 

Next, subtract the share of income from the activity that is 

compensation to suppliers of labor services, generically

called wages. Next, subtract a capital consumption allowance,

which estlmates the loss in value during the year of capital 

assets employed in production. The.remainder-is net capital

income, or, simply, business income. Finally, subtract 

interest paid or accruing to suppliers of debt finance. The 

remainder is income to suppliers'ofequity finance, or 

profit. A business activity thus generates all three sources 

of income to households -- wages, interest, and profit. 

Major problems in defining rules of income measurement 

for tax purposes include (1) issues of timing associated 

with a fixed accounting period, such as inventory valuation; 

(2) estimation of capital consumption, i.e., depreciation

and depletion rules; and (3) imputations for nonmarket 

transactions, e.g., self-constructed capital assets. In 

each of these cases, there are no explicit market transactions within the accounting period to provide the appro- ' 

priate valuations. Rules for constructing such valuations 

are necessarily somewhat arbitrary, but the rules described 

here are intended to be as faithful as possible to the 

concept of income. 

Capital Consumption Allowances 
 

Rules for capital consumption allowances should not be 

regarded as arbitrary allowances for the "recovery of 

capital costs." Rather, they are a measure of one aspect of 

annual capital cost; namely, the reduction in value of 

productive capital occasioned by use, deterioration, or 
-- -- 

- 65 -

obsolescence. Rules for estimating this cost should be 
 subject to continuous revision to reflect new evidence on 
 actual experience and changing technology. For machinery 
 

-

.cation of all assets by type of activity, 

(2) mandatory vintaqe accounting, (3) a guideline annual 

repair allowance, (4) a specified annual depreciation -rate 
 (or permissible range) to be applied to the undepreciated

balance (together with a date on which any remaining basis 

may be deducted) and (5) annual adjustment of basis in each 

account by a measure of the change in price levels. The 

inflation adjustment would be a factor equal to the ratio of 

the price level in the previous year to the current price

level, each measured by a ueneral price index. Notice that 

the recommended depreciation rules would establish a constant 

relative rate of depreciation as the "normal" depreciation

method instead of straight-line depreciation, and it would 

disallow all other methods. 

Depreciation of Structures. Depreciation of structures 

would be treated in a 9 similar to that for eGipment 

except that prescribed depreciation rates may be made to 

vary over the life of a structure. For example, depreciation of x percent per year may be allowed for the first 5 

years ofan apartment building, y percent for the next 5 

years, and so on. However, in no case would total depreciation deductions be allowed to exceed the original basis, 

after annual adjustment for inflation. Gains and losses 

would be recognized when exchanges or demolitions occur. 

Depreciation and repair allowance rates for exchanged

Droperties always would be determined by the age of the 

structure, not by time in the hands of the new owner. 

Expenditures for structural additions and modifications that 

exceed a guideline repair allowance would be depreciated as 

new structures. 

Depletion of Mineral Property. For rrineral property

capital assets include the value of the unexploited deposits

in-addition to depreciable productive equipment. The balue 

of the mineral deposit depends upon its accessibility as 

well as the amount and quality of the mineral itself. This 

value may change as development proceeds, and this change in 

value is a component of income. The value of the deposit

will be subsequently reduced, i.e., depleted, as the mineral 
-- 

- 66 -

is extracted. To measure income accurately, a depletion
 allowance should then be provided that is equal to the 
 annual reduction in the value of the deposit. 
 

Unfortunately, the value of a mineral deposit becomes 

known with certainty only as the mineral is extracted and 

sold. Its value at discovery becomes fully known only after 

the deposit has been fully exploited. Yet, the value on 

which to base a tax depletion allowance and an annual 

depletion schedule must be estimated from the beginning of 

production. Uncertainty about the amount of mineral present,

the costs of extraction and marketing, and future prices of 

the product make estimation of annual capital consumption

particularly difficult in the-caseof minerals. The uncertainties are especially great �or fluid minerals. 

An objective market estimate of the initial value of a 

mineral deposit prior to the onset of production is the 

total of expenditures for acquisition and development, other 

than for depreciable assets. IThe model tax would require

that all preproduction expenses be capitalized. All such 

expenditures, except for deprecisl-ould be 

recovered according to "cost depletion" allow= znputed -on the basis of inTtEl production rates combined -with 
 gui=i-dec?%e rates derivedomr-rience. 
 The treatment wouldsTmilar to -+the mo e tEx treatment of 

depreciation for structures. After aeach 5 years of ex erience,

-P or u on exchanqe of property 0-lp, the value -+ --of t e

deposit would be =estimated -an correctionsmade to 

subsequent annzl allowances. But, as with depreciation,

total deductions are not to exceed the (inflation-adjusted) 

cost basis. All -postproduction expenditures, except for 

depreciable assets, also must be capitalized and recovered 

Y- b 
 cost depletion acaingothe rules in emct for that

year. 
 

Self-Constructed Assets 
 

Capital assets that are constructed for use by the 

builder, rather than for sale, are an example of a case in 

which a market transaction normally used in the measurement 

of income is missing. The selling price for a building,

machine, or piece of transportation equipment constructed by 

one firm for sale to another helps to determine the income 

of the seller and, simultaneously, establishes the basis for 

estimating future tax depreciation and capital gain of the 

buyer. Income to the seller will be determined by subtracting 
- 67 -

his costs from the selling price, so that (with proper

accounting for inventories over the construction period) all 

income generated in the construction process will have been 

subject to tax as accrued. However, when a construction 

firm builds an office building, or a shipping company a 

ship, for its own use or rental, no explicit transfer price

is attached to that asset. If any costs associated with 

construction of the building or ship can be deducted currently for tax purposes, or if any incomes arising from 

construction can be ignored, current income is understated 

and a deferral of tax is accomplished. 

Unrecognized income is derived from inventories of 

unfinished buildings, for example. An independent contractor who produces a building for sale must realize 

sufficient revenue from the proceeds of that sale to compensate

suppliers of all capital, including capital in the form of 

the inventory of unfinished structures during the construction period. But, for self-constructed assets, incomes 

accruing to suppliers of equity during construction are not 

recognized for tax purposes because there is no sale. Under 

current law, certain construction costs, such as taxes and 

fees paid to governments, nay be deducted as current expenses.

The result of these lapses of proper income measurement is a 

tax incentive for self-construction and for vertical integration 

of production that would otherwise be uneconomic. The 

present treatment also encourages various arrangements to 

defer income taxes by providing the legal appearance of 

integration. These arrangements are popularly known as tax 

shelters. 

To provide tax treatment equivalent to that of assets 
 

depreciated according to the regular rules. 
 

Other Business Income Accounting Problems 
 

A number of other problems of inventory valuation 

must be faced in order to specify a fully operational comprehensive income tax. Also, special rules would be xequired

for several specific industries, in addition to minerals, 
- 68 -

to improve the measurement of income as compared to the 

present law. For example, agriculture, banking, and 

professional sports have presented special difficulties. 

This section has not spelled out all of these special rules,

but has attempted to suggest that improvement of business 

income measurement for tax purposes is possible and desirable 

INTEGRATION OF THE INDIVIDUAL AND CORPORATION INCOME TAXES 

Strictly speaking, the uses concept of income -- consumption plus change in net worth -- is an attribute of 

individuals or families, not of business organizations,

Corporations do not consume, nor do they have a "standard of 

living." The term "corporate income" is shorthand for the 

contribution of the corporate entity to the income of its 

stockholders. 

The Corporation Income Tax 
 

Under existing law, income earned in corporations is 

taxed differently from other income. All corporate earnings 

are subject to the corporate income tax, and dividend 

distributions are also taxed separately as income to shareholders. Undistributed earnings are taxed to shareholders 

only as they raise the value of the common stock and only

when the shareholder sells his stock. The resulting gains upon sale are taxed under the special capital gains provisions

of the individual income tax. Thus, the tax on retained 

earnings generally is not at all closely related to the 

shareholder's individual tax bracket. 

-. An exception to these 

general rules exists for corporations that are taxed under 

subchapter S of the Internal Revenue Code. If a corporation

has 10 (in some cases 15) or fewer shareholders and meets 

certain other requirements, it may elect to be taxed in a 

manner similar to a partnership. The income of the entity

is attributed directly to the owners, so that there is no 

corporate income tax and retained earnings are immediately

and fully subject to the individual income tax. For earnings

of these corporations, then, complete integration of the 

corporate and individual income taxes already exists. 

Inefficiency of the Corporation Income Tax 
 

The separate taxation of income earned in corporations

is responsible for a number of serious economic distortions. 

It raises the overall rate of taxation on earnings from 
- 69 -

capital and so produces a bias against saving and investment. It inhibits the flow of saving to corporate equities

relative to other forms of investment. Finally, the separate 

corporate tax encourages the use of debt, relative to 

equity, for corporate finance. 

The existing differential treatment of dividends and 

undistributed earnings also results in distortions. Distribution of earnings is discouraged, thus keeping corporate

investment decisions from the direct test of the capital

market and discouraging lower-bracket taxpayers from ownership of stock. 

Owners of closely held corporations are favored relative 

to those that are publicly held. Gwner-managers may avoid 

the double taxation of dividends by accounting for earnings 

as salaries rather than as dividends, and they may avoid 

high personal tax rates by retention of earnings in the 

corporation with eventual realization as capital gains.

Provisions of the law intended to minimize these types of 

tax avoidance add greatly to the complexity of the law and 

to costs of administration. 

A Model Integration Plan 
 

Because the direct attribution of corporate income to 
 shareholders most nearly matches the concept of an integra­
 ted tax, a particular set of rules for direct attribution 
 is prescribed as the model tax plan. However, there are 
 potential administrative problems with this approach. These 
 problems will be noted and alternative approaches described. 
 

The model tax treatment of corporate profits may be 

summarized by the following four rules: 

1. 	 The holder of each share of stock on the first day

of the corporation’s accounting year (the “tax 

record date”) would be designated the “shareholder 

of record.” 

2. 	 Each shareholder of record would add to his tax 

base his share of the corporation’s income 

annually. If the corporation had a loss for the 

year, the shareholder would subtract his share of 

loss. 
 
- 70 -

3. 	 The basis of the shareholder of record in his 

stock would be increased by his share of income 

and decreased by his share of loss. 

4. 	 Any shareholder's basis in his stock would be 

reduced, but not to below zero, by cash dividends 

paid to him or by the fair market value of property

distributed to him. Once the shareholder's basis 
 had been reduced to zero, the value of any further 
 distributions would be included in income. (A

distribution after the basis had been reduced to 

. 	 zero would indicate the shareholder had, in the 

past, income that was not reported.) 

Designation of a shareholder of record to whom to 

allocate income earned in the corporation is necessary for 

large corporations with publicly traded stock. This treatment is designed to avoid recordkeeping problems associated 

with transfers of stock ownership within the tax year and to 

avoid "trafficking" in losses between taxpayers with different 

marginal rates. 

Importance of the Record Date.' Suppose that the record 

date were at the end of the taxable year when reliable 

estimates of the amount of corporate earnings or losses 

would be known. Shortly before the record date, shareholders 

with high marginal rates could bid away shares from shareholders with relatively low marginal rates whose corporations are expected to show a loss. 

The losses for the year then would be attributed to the 

new shareholders for whom the offset of losses against other 

income results in the greatest reduction in tax liability.

Thus, a late-year record date would have the effect of 

reducing the intended progressivity of the income tax 

and would bring about stock trading that is solely tax 

motivated. 

The earlier in the tax year that the record date were 
 placed the more the shareholder's expected tax liability
 would become just another element in the prediction of 
 future returns from ownership of stock in the corporation, 
 as is now the case under the corporation income tax. 
 If the record date were the first day of the tax year,
 the tax consequences of current or corporate earnings 
 or losses already accrued in the corporation could not 
 be transferred to another taxpayer. 
 
- 71 -

Treatment of the Full-Year Shareholder. Under the 

model tax scheme, a shareholder who holds his stock for 

the entire taxable year would be taxed on the full 

amount of income for the year (or would deduct the full 

amount of loss). Any gain from sale of the stock in a 

future year would be calculated for tax purposes by

subtracting from sale proceeds the amount of his 

original basis plus the undistributed earninqs upon

which he has been subject to tax. His corporation

would provide him with a statement at the end of each 

taxable year that informed him of his share of corporate

earnings. He then could increase his basis by that 

amount of earnings less the sum of distributions 

received during the year. For full-year stockholders, 

then, basis would be increased by their share of taxable 

earnings and reduced by the amount of any distributions. 

It should be noted that, under this treatment, dividends 
 would not be considered income to the shareholder, but would 
 be just a partial liquidation of his portfolio. Income would 
 accrue to him as the corporation earned it, rather than as 
 the corporation distributed it. Hence, dividend distributions 
 would merely reduce the shareholder's basis, so that 
 subsequent gains (or losses) realized on the sale of his 
 stock would be calculated correctly. 
 

Treatment of a Shareholder Who sells During the Year. 

A shareholder of record who sells his stock before the end 

of the tax year would not have to wait to receive an end-ofyear statement in order to calculate his tax. He simply

would calculate the difference between the sale proceeds and 

his basis as of the date of sale. The adjustment to basis 

of the shareholder's stock to which he would be entitled at 

the time of the corporation's annual accounting would always

just offset the amount of corporate income or loss that he 

would normally have to report as the shareholder of record. 

Therefore, the income of a shareholder who sold his shares 

would be determined fully at the time of sale, and he would 

have no need for the end-of-year Statement. 

A numerical example may be useful in explaining the 

equivalence of treatment of whole-year and part-year stockholders. Suppose that, as of the record date (January 11, 

shareholder X has a basis of $100 in his one share of stock. 

Ey June 2D, the corporation has earned $10 per share, and X 

sells his stock for $110 to Y. The shareholder would thus 

realize a gain of $10 on the sale, and this would be reported 

as income. 
- 72 -

To illustrate that subsequent corporate earnings would 

be irrelevant to the former shareholder's calculation of 

income for taxes, suppose the corporation earns a further 

$15 after the date of sale, so that as the shareholder of 

record X receives a report attributing $25 of income to him, 

entitling him to a $25 basis increase (on shares he no 

longer owns). One might insist that X take into his tax 

base the full $25 and recalculate his gain from sale. In 

this event, the increase in basis from $100 to $125 would 

convert his gain of $10 from sale to a loss of $15 (adjusted

basis = $125: sale price = $110). The $15 loss, netted 

against $25 of corporate income attributed to him as the 

shareholder of record, yields $10 as his income to be 

reported for tax, the same outcome as a simple calculation 

of his gain at the time of sale. The equivalence between 

these two approaches may not be complete, however, if the 

date of sale and the corporate accounting occur in different 

taxable years. Nonetheless, in the case cited, the model 

plan appears superior in the simplicity of its calculations, 

in allowing the taxpayer to know immediately the tax consequences of his transactions, and in its better approximation to taxing income as it is accrued. 

In the event there had been a dividend distribution to 
 

X of the $10 of earnings before he sold, this distribution 

would be reflected in the value of the stock, which would 

now command a market price of $100 on June 20. The amount 

of the dividend also would reduce his basis to $90, so that 

his gain for tax purposes would be $10, just as before. The 

dividend per se has no tax consequences. At the end of the 

year he again would be allocated $25 of corporation income, 

but, as before, an offsetting increase in basis. Thus, he 

will not report any income other than his gain on the sale 

of the share on June 20. 

Note that the same result would obtain in this case if 

the shareholder included the dividend in income but did not 

reduce his basis. There would then be $10 attributable to 

the dividend and no gain on the sale. This treatment of 

dividends in the income calculation gives correct results for 

the shareholder who disposes of his shares. However, it 

would attribute income to a purchaser receiving dividends 

before the next record date even though such distributions 

would represent merely a change in portfolio composition.

This approach (all distributions are taken into the tax 

base with only retained earnings allocated to record date 

shareholders and giving rise to basis adjustments) might, 
- 73 -

nevertheless be considered an alternative to the treatment 
 of the model plan because it is more familiar and would 
 involve fewer basis adjustments and hence a reduced record-
 keeping burden. The substance of the full integration
 proposal would be preserved in this alternative treatment. 
 

The proposed full integration system would make it 

possible to tax income according to the circumstances of 

families who earn it, regardless of whether income derives 

from labor or capital services, regardless of the legal form 

in which capital is employed, and regardless of whether 

income earned in corporations is retained or distributed. 

To the extent that retained earnings increase the value of 

corporate stock, this system would have the effect of taxing

capital gains from ownership of corporate stock as they

accrued, thereby eliminating a major source of controversy

and complexity in the present law. 

Administrative Problems of Model Tax Integration 

The Liquidity Problem. Some problems of administration 

of the system just described would remain. One such problem

is that income-would be attributed to corporate shareholders 

whether or not it actually was distributed. To the extent 

the corporation retained its earnings, the shareholders 

would incur a current tax liability that must be paid in 

cash, even though their increases in net worth would not 

be immediately available to them in the form of cash. 

Taxpayers with relatively small current cash incomes might

then be induced to trade for stocks that had higher rates 

of dividend payout to assure themselves sufficient cash 

flow to pay the tax. 

Imposition of a withholding tax at the corporate level 

would help to reduce this liquidity problem and perhaps also 

reduce the cost of enforcement of timely collections of the 

tax. 

One method of withholding that is compatible with the 

model tax method for assigning tax liabilities is to require

corporations to remit an estimated flat-rate withholding tax 

at regular intervals during the tax year. This tax woula be 

withheld on behalf of stockholders of record. Stockholders 

of record would report their total incomes, including all 

attributed earnings, but also would be allowed a credit for 

their share of taxes withheld. Taxpayers who hold a stock 
-- 

-- 

- 74 -

throughout the entire year would receive OA~ additional 
 piece of tax information from the corporation the amount 
 of their share of tax withheld throughout the year and 
 would subtract the tax withheld as a credit against their 
 individual liability. 
 

This withholding system would complicate somewhat the 

taxation of part-year stockholders. As explained above, the 

taxable income of the corporation attributed to stockholders 

could be determined fully at the time of sale as the sum of 

dividends received during the year and excess of sale price 

aver basis that existed on the record date. However, if 

withholding were always attributed to the shareholder of 

record, he would be required to wait until corporate income 

for the year had been determined to know the amount of his 

tax credit for withholding during the full tax year. The 

selling price of the stock may be expected to reflect the 

estimated value of this prospective credit in the same way

that share prices reflect estimates of future profits. But, 

in this case, the seller who was a stockholder of record 

would retain an interest in the future earnings of the 

corporation, because the earnings would determine tax credit 

entitlement to the end of the tax year. Despite this 

apparent drawback, such corporate-level withholding would 

insure sufficient liquidity to pay the tax, except in cases 

where the combination of distributions and withheld taxes 

is less than the amount of tax due from the shareholder of 

record. 

Audit Adjustment Problem. Another administrative 

problem could arise because of audit adjustments to corporate

income, which may extend well beyond the taxable year. This 

would appear to require reopening the returns of shareholders of earlier record dates, possibly long after shares 

have been sold. Ln the present system, changes in corporate

income and tax liability arising from the audit process are 

borne by shareholders at the time of the adjustment. Precisely

this principle would apply in the model plan. Changes in 

income discovered in audit, including possible interest or 

other penalties, would be treated like all other income and 

attributed to shareholders in the year the issue is resolved. 

Naturally, shares exchanged before such resolutions but 

after the matter is publicly known would reflect the anticipated outcome. 

Deferral Problem. There are also some equity consideratlons. A deferral of tax on a portion of corporate

income may occur in a year when shares are purchased. The 
-- 

- 75 -

buyer would not be required to report income earned after 
 the date of purchase but before the end of the taxable year.
 All earnings in the year of sale that were not reflected in 
 the purchase price would escape tax until the buyer sells 
 the stock. 
 

The 1975 Administration Proposal for Integration 
 

In the context of a thorough revision of the income 

tax, integration of the corporate and personal tax takes on 

particular importance. The model tax plan has provisions

designed to assure that the various forms of business income 

bear the same tax, as nearly as possible. If incomes from 

ownership of corporate equities are subject to greater, or 

lesser, tax relative to incomes from unincorporated business 

pension funds, or bonds, the economic distortions would be 

concentrated on the corporate sector. For this reason, a 

specific plan for attributing to stockholders the whole 

earnings of corporations has been presented here in some 

detail. 

A significant movement in the direction of removing the 

distortions caused by the separate corporation income tax 

would be accomplished by the dividend integration plan

proposed by the Administration in 1975. That proposal may

be regarded as both an improvement in the present code, in 

the absence of comprehensive tax reform, and as a major step

in the transition to a full integration of the income taxes, 

such as the model tax. 

CAPITAL GAINS AND LOSSES 
 

Capital gains appear to be dif�erent from most other 

sources of income because realization of gains involves two 

distinct transactions the acquisition and the disposition

of property -- and each transaction occurs at a different 

time. This difference raises several issues of income 

measurement and taxation under an income tax. 

Accrual Versus Realization 
 

The first issue is whether income (or loss) ought to be 

reported annually on the basis of changes in market values of 

assets -- the accrual concept -- or only when realized. The 

annual change in market value of one's assets constitutes a 

change in net worth and, therefore, constitutes income under 

the "uses" definition. If tax consequences may be postponed 
until later disposition of an asset, there is a deferral of 
 taxes, which represents a loss to the government and a gain 
 to the taxpayer. The value of this gain is the amount of 

interest on the deferred taxes for the period of deferral. 

Distinct from, but closely related to, the issue of deferral 
 is the issue of the appropriate marginal tax rate to be 
 applied to capital gains. If capital gains are to be 

subject to tax only when realized, there may be a substantial 

difference between the applicable marginal tax rate during
 the period of accrual and that faced by the taxpayer upon
 realization. Also, the extent to which adjustment should be 

made for general price inflation over the holding period of 

an asset must be considered. Finally, the desirability of 

simplicity in the tax system, ease of administration, and 
 public acceptability are important considerations. 
 

The range of possible tax treatments for capital gains 

can be summarized in an array that ranges from the taxation 

of accrued gains at ordinary rates to the complete exclusion 

of capital gains from income subject to taxation. Alternatives within the range may be modified to allow for (a)

income averaging to minimize extra taxes resulting from the 

bunching of capital gains and [b) adjustments to reflect 

changes in the general price level. 

Present Treatment of Capital Gains 
 

Present treatment for individuals is to tax gains when 

realized, at preferential rates, with no penalty for deferral. 

There are a number of special provisions. When those assets 

defined in the code as "capital assets" have been held for 6 

months or more,3/ gains from their realization are considered "long-t&m" and receive special tax treatment in two 

respects: one-half of capital gains is excluded from 

taxable income, and individuals have the option of calculating the tax at the rate of 25 percent on the first 

$50,000 of capital gains. There are complex restrictions on 

the netting out of short- and long-term uains and losses, 

and a ceiling of $1,0004/ is imposed on the amount of net 

capital losses that may-be used to offset ordinary income in 

any 1 year, with unlimited carryforward of such losses. 

Also, there are provisions in the minimum tax for tax 

preferences that limit the extent to which the capital gains

provisions can be used to reduce taxes below ordinary rates 

and that deny the use of the 50-percent maximum tax on 

earned income by the amount of such preferences. Limited 

averaging over a 5-year period is allowed for capital gains 

as well as for most other types of income. 
under the model income tax, capital &would k 

subject to full taxation realization ordinarv rates 

after to basls of corporatextock I for 

-nZTe*s<xmed in the integration 

and (2) adjustment to yeneral price inflation. 

Caoital losses couldbetracted in full from uositive 

-. 

I- 

-- 

- 77 -

There are many other capital gains provisions in the 

tax law that (1) define what items may be considered capital 

assets, (2) specify when they are to be considered realized, 

(3) orovide for recapture of artificial accounting gains,

and (4) make special provisions for timber and certain aqricultural receipts. There also are special provisions that 

allow deferral of capital gains tax on the sale or exchange

of personal residences. Much of the complexity of the tax 

code derives from the necessity of spelling out just when 

income can and cannot receive capital qains treatment. 

Model Tax Treatment of Capital Gains 
 

undler the model income tax, capital &would k 

subject -

to full taxat.ion upon realization at ordinarv -rat

after (lrad’ustment (1) adjest% I 

to basls -. of corporate stock Ifor 

retainedl earnings - exmed in the integration oroDosoal)

Iand (2) adjustment tc GZTEX5F basis -for yenera1 
 price inflation.

Caoital losses coulTBetGted in full from uositive 

elements of income to determine the base of tax, but there 

would be no refund for losses that reduce taxable incomes 
 below zero. Adjustment for inflation would be accomplished
 by multiplying the cost basis of the asset by the ratio of 
 the consumer price index in the year of purchase to the same 
 index in the year of sale. These ratios would be provided
 in the form of a table accompanying the capital gains
 schedule. Table 1 is an example of such a table. (Note

that for the last 3 years, the ratios are given monthly.

This is to discourage December 31 purchases coupled with 
 January 1 sales,) No inflation adjustment would he allowed 
 for intra-year purchases and sales. 
 
Table 1 

Inflation Adjustment Factors 

(Consumer Price Index based on December, 1975) 

1930 3.326 : 1940 3.960 : 1950 2.307 : 1960 1.875 : 1970 1.430 

1931 3.647 
 

1932 4.066 
 

1933 4.286 
 

1934 4.147 
 

1935 4.046 
 

1936 4.007 
 

1937 3,867 
 

1941 3.771 
 

1942 3.408 
 

1943 3.210 
 

1944 3.156 
 

1945 3.085 
 

1946 2.843 
 

1947 2.486 
 

1948 2.307 
 

1949 2.329 
 

1973 
 

1.302 
 

1.293 
 

1.281 
 

1,272 
 

1.265 
 

1.256 
 

1.253 
 

1.231 
 

1.227 
 

1.217 
 

1.209 

1.201 
 

1951 2.138 
 

1952 2.092 
 

1953 2.076 
 

1961 1.856 1971 1.371 

1962 1.836 1972 1.327 

1963 1.814 

1964 1.790 

1965 1.760 

1966 1.711 

1967 1.663 

1968 1.596 

1969 1.515 

1975 
 

1.065 
 

1.058 
 

1.054 
 

1.049 
 

1.044 
 

1.035 
 

1.025 
 

1.021 
 

1.017 
 

1.101 
 

1.004 
 

1.000 
 

1954 2.066 

1955 2.074 

1956 2.043 

1957 1.973 

1958 1.920 

1959 1.905 


 


 


 


 


 


 

1938 3.941 

1939 3.998 

January 

February 

March 
 

April 
 

&Y 
 

June 
 

July 
 

August 

September 

October 

November 

December 

Source: 


 


 

1974 

1.190 

1.175 

1.162 

1.156 

1.143 

1.133 

1.124 

1.109 

1.096 

1.087 

1.078 

1.070 

Office of the Secretary of the Treasury 

Office of Tax Analysis, September 28, 1976 
- 79 -
 

Capital Losses 
 

With adequate adjustment for inflation, and for depre­
 ciation in the case of physical assets, capital losses under 
 

the model tax should measure real reductions in the current 
 income of the taxpayer. There is, consequently, no reason 
 to limit the deduction of such losses, as in current law. 
 A forced postponement of the realization of such losses 
 would be like requiring the taxpayer to make an interest-
 free loan to the government. Of course, some asymmetry in 
 the treatment of gains relative to losses would remain, 

because taxpayers could benefit by holdins gains to defer 

taxes but could always take tax-reducing losses immediately. 

Taxation of Accruals in the Model Tax 
 

Corporate Stock. As just describa, the model tax 

would continue the present practice of recosnizina income 

from increases in the value-of capital assefs only upon sale 

or exchange, but some income sources that presently are 

treated as capital gains would be put on an annual accrual 

basis. 
 

If the individual and corporate income taxes were fully

integrated into a single tax so that shareholders are 

currently taxed on retained earnings, a large portion of 

capital gains -- the changes in value of common stock that 

reflect retention of earnings -- would be subject to tax as 

accrued. The remainder of gains would be subject to tax 

only as realized. These gains would include changes in 

stock prices that reflect expectations about future earnings,

and also changes in the value of other assets, such as 

bonds, commodities, and land. 

Ph sical Assets. Depreciable assets, such as machinery
 and bull + ings, are also subject to price variations, but

these variations would be anticipated, as nearly as possible,

by the inflation adjustment and the depreciation allowance. 

If these allowances were perfectly accurate measures of the 

change in value of such assets, income would be measured 

correctly as it accrues, and sales prices would always match 

the remaining basis. Apparent capital ciains on physical 

assets may, therefore, be regarded as evidence of failure to 

accurately measure past income from ownership of the asset. 

Consequently, if under the model tax, depreciation would 

be measured more accurately, the problem of tax deferral due 

to taxation of capital gains at realization would be further 

reduced. However, as in the case of corporate stock, 
- 80 -

some unaccounted-for variation in asset prices undoubtedly
 will occur despite improvements in rules for adjustments 
 to basis. Sales of depreciable assets will, therefore, 
 continue to give rise to taxable gains and losses. Such 
 gains and losses are the difference between sales price and 
 basis, adjusted for depreciation allowances and inflation. 
 

The taxation o� capital gains on a realization basis 

would produce significantly different results than current 

taxation of accrual of these gains. Even if capital gains 

were taxed as ordinary income (no exclusion, no alternative 

rate), the effective tax rate on gains held for long periods

of time but subject to a flat marginal rate would be much 

lower than the nominal or statutory rate applied to the 

gains as if they accrued ratably over the period the asset 

was held. This consequence of deferral of tax is shown in 

Table 2 for an assumed before-tax rate of return of 12 

percent on alternative assets yielding an annually taxable 
 income. Each item in the table is the percent by which the 
 before-tax rate of return is reduced by the imposition
 of the tax at the time of realization. 
 

Table 2 

Effective Tax Rates on Capital Gains 

Taxed as Realized at Ordinary Rates 

Holding Period 

1 year 5 years 25 years 50 years 

Statutory rate of 

50 percent 50% 44% 2 3% 13% 

Statutory rate of 

25 percent 25% 21% 10% 5% 
- 81 -

Accrual Taxation Alternative 
 

Accrual taxation of capital gains poses three problems

that, taken together, appear to be insurmountable. These 

are (1) the administrative burden of annual reportinq; (2)

the difficulty and cost of determining asset values annually;

and (3) the potential hardship of obtaining the funds to pay 

taxes on accrued but unrealized gains. Under accrual taxation, the taxpayer would have to compute the sain or loss on 

each of his assets annually. For common stock and other 
 publicly traded securities, there would be little cost or 
 difficulty associated with obtaining year-end valuations. 
 But for other assets, the costs and problems of evaluation 
 would be very formidable, and the enforcement problems would 
 

be substantial. It would be very difficult and expensive to 
 valuate assets by appraisal; valuation by concrete trans-
 actions, which taxing realizations would provide, has 
 distinct advantages. 
 

For taxpayers with little cash or low money incomes 

relative to the size of their accrued but unrealized capital

gains, accrual taxation may pose cash flow problems. This 

circumstance is similar to that encountered with local 

property taxes assessed on homeowners. There is no cash 

income associated with the asset in the year that the tax 

Liability is owed. However, in cases of potential hardship

certain taxpayers could be allowed to pay a later tax on 

capital gains, with interest, at the time a gain is realized. 

Realization-With-Interest Alternative 
 

An alternative method that attempts to achieve the same 

economic effect as accrual taxation is taxation of capital

gains at realization with an interest charge for deferral. 

But, in addition to the present complex rules defining

realizations that would not be avoided in the model tax 

plan, rules would be required for the computation of interest 

on the deferred taxes. An appropriate rate of interest 

would have to be determined and some assumption made about 

the "tyuical" pattern of accruals. In order to eliminate 

economic inefficiency, the interest rate on the deferral 

should be the individual taxpayer's rate of return on his 

investments. However, because it is impossible to administer 

a program based on each investor's marginal rate of return, 

the government would have to charae a sinale interest rate. 

The single interest rate would itself tend to move alternatives away from neutrality. Moreover, for simplicity, it 

would have to be assumed that the gain cccurred equally over 
- 82 -
 

the period or that the asset's value changed at a constant 

rate. This assumption would be particularly inappropriate

in those cases where basis was changed frequently by inflation adjustments, depreciation allowances, capital improvements, etc. Because a simple time pattern of value change 

would reflect reality in very few cases, the deferral charge

would introduce additional investment distortions. To the 

extent that gains occur early in the holding period, capital

gains would be undertaxed; when gains occur late in the 

period, capital gains would be overtaxed. 

The Income Averaging Problem 

Under a progressive income tax system, the tax rate on 

a marginal addition to income differs depending on the 

taxpayer's other income. Generally, the higher the income 

level, the higher the tax rate. Similarly, under a progressive tax system, people with fluctuating incomes pay 

tax at a higher average rate over time on the same amount of 

total income than do those persons whose incomes are more 

nearly uniform over time. 

Clearly, if a taxpayer's income (apart from any capital

gains] is rising over time, the longer he delays realization, the higher his tax rate will be. Similarly, if he 

realizes qains only occasionally, his gains will tend to be 

larger, and the average tax rate on the gains will be increased. 

The bunching problem could be solved by spreading the gain,

via income averaging, over the holding period of the asset. 

This flexibility would involve great complexity, but the 

result could be approximated reasonably well by a fixedperiod averaging system similar to the general 5-year 

averaging system or the special 10-year averaging system

for lump sum distributions, both of which are in present

law. 

The problem of postponement of tax to periods of higher

marginal rates is a more difficult one. One optional

solution would be to calculate an average marginal tax rate 

over a fixed number of years and to modify the amount of 

gain included in the tax base for the year of realization to 

reflect the ratio of the average marginal rate over the 

period to the marginal rate in the current year. Thus, if 

the current rate were higher, some of the gain could be 

excluded from income; if the current rate were lower, more 
- 83 -
 

than 100 percent of the gain would be included. As is the 

case with charges of interest for deferral, however, such 

systems would add significantly to the complexity of the tax 

law, and represent inexact adjustments besides. 

Inflation Adjustment 

The proper tax treatment of capital gains is further 

complicated by general price inflation. Capital gains that 

merely reflect increases in the general price level are 

illusory. For example, suppose an individual's capital 

assets increase in value, but at a rate precisely equal to 

the rise in the cost of living. His net worth will not have 

increased in real terms, and neither, therefore, will his 

standard of living. If no basis adjustment is made to 

account for inflation, the reported capital gain �or an 

asset held over a period of time will largely reflect the 

level of prices in previous years. This contrasts with 

other income flows, such as salaries, that are always

accounted �or in current dollars. 

Accounting for other transactions that are affected by

inflation, such as borrowing and lending, is largely corrected for anticipated inflation by market adjustments. For 

example, a lender will insist on a higher interest rate to 

compensate for taxes against the depreciating value of the 

principal. Therefore, an adjustment of basis for inflation 

is desirable in the case of ownership of capital assets to 

avoid overtaxation of capital gains relative to other 

income sources, even if general indexing of income sources 

and/or tax rates is not prescribed. 

Inflation adjustment would introduce additional complexity. The basis for each asset would have to be revised 

annually, whether sold or not. For this reason, it might be 

desirable to restrict the inflation adjustment to those 

years in which the inflation rate exceeds some "normal" 

amount, such as 2 or 3 percent. 

Clearly, there are competing objectives of simplicity,

equity, and economic efficiency involved in the tax treatment of capital gains. In this case, the model tax treatment would favor simplicity by foregoing accrual treatment 

that would require annual valuation of all assets, or interest 

charges for deferral. On the other hand, clear moves in the 

direction of accrual taxation are taken by introducing current 

taxation of corporate-retained earnings and more accurate 

measurement of depreciation. Annual adjustment of basis for 

general inflation also is judged to be worth the additional 

administration and compliance cost. 
-- 

--- 

- 84 -

STATE AND LOCAL BOND INTEREST 
 

The annual receipt or accrual of interest on State and 

local obligations unquestionably increases the taxpayer's

opportunity to consume, add to wealth, or make gifts. It 

is, therefore, properly regarded as a source of income. 

However, such interest is not included in income under 

current law; this is not to say that owners of such bonds 

bear no consequence of the present income tax. Long-term 

tax-exempt bonds yield approximately 30 percent less than 

fully taxable bonds of equal risk -- a consequence that may

be regarded as an implicit tax. However, because problems

of equity and inefficiency remain, this lower yield on taxexempt bonds does not substitute for full taxation. Under 

the model income tax, interest on State -and local bonr 
 Gld be fully taxable. 
 

Inefficiency of Interest Exclusion 
 

The difference in interest costs that the State or 

local government would have to pay on taxable bonds and that 

which they actually pay on tax-exempt bonds is borne by the 

Federal Government in the form of reduced revenues. The 

subsidy is inefficient in that the total cost to the Federal 

Government exceeds the value of the subsidy to the State and 

local governments in the form of lower interest payments.

Estimates of the fraction of the total Federal revenue loss 

that is not received by the State and local governments vary

widely, but the best estimates seem to be in the 25- to 

30-percent ranqe. 

Inequity of the Exclusion 

The subsidy also may be regarded as inequitable. The 

value of the tax exemption depends on the investor's marginal 

tax rate. Thus, higher-income taxpayers are more willing

than lower-income individuals to pay more for tax-exempt

securities. The concentration of the tax savings among the 

relatively well-off reduces the progressivity of the Federal 

income tax as compared with the nominal rate structure. The 

exemption also results in differential rates of taxation among

higher-income taxpayers who have incomes from different 

sources. Investors who would otherwise be subject to 

marginal rates above 30 percent may avoid these rates by

purchasing tax-exempt bonds. Those with equal incomes from 

salaries or from active management of business must pay

higher rates. 
- 85 -

Alternatives to Tax-Exempt Bonds 
 

The taxation of interest from State and local bonds 

would present no special administrative problems, except for 

transition rules, but alternative means of fiscal assistance 

to State and local governments may be desirable. Among the 

alternatives that have been suggested are replacement of the 

tax exclusion with a direct cash subsidy from the Federal 

Government (as under revenue sharing), or replacement with a 

direct interest subsidy on taxable bonds issued by State and 

local governments at their option. The mechanism for an 

interest subsidy may be either a direct Federal payment or a 

federally sponsored bank empowered to buy low-yield State 

and local bonds and issue its own fully taxable bonds. 

OWNER-OCCUPIED HOUSING 
 

Under present law, homeowners are allowed personal
 deductions for mortgage interest paid and for State and 
 local property taxes assessed against their homes. Further-
 more, there is no attempt to attribute to owner-occupiers
 the income implied by ownership of housing equity. (In
 the aggregate, this is estimated in the national income and 
 product accounts at $11.1 billion per year, an amount that 
 does not include untaxed increases in housing values.) 
 

Imputed Rental Income 
 

Any dwelling, whether owner-occupied or rented, is an 

asset that yields a flow of services over its economic 

lifetime. The value of this service flow for any time 

period represents a portion of the market rental value of 

the dwelling. For rental housing, there is a monthly

contractual payment (rent) from tenant to landlord for the 

services of the dwelling. In a market equilibrium, these 

rental payments must be greater than the maintenance expenses,

related taxes, and depreciation, if any. The difference 

between these continuing costs and the market rental may 

be referred to as the "net income" generated by the housing

unit. 

An owner-occupier may be thought of as a landlord who 

rents to himself. On his books of account will also appear

maintenance expenses and taxes, and he will equally experience

depreciation in the value of his housing asset. what do 

not appear are, on the sources side, receipts of rental 

payment and, on the uses side, net income from the dwelling.

viewed from the sources side,this amount may be regarded as 
--- 

- 86 -

the reward that the owner of the dwelling accepts in-kind,
 instead of the financial reward he could obtain by renting 
 to someone other than himself. Since a potential owner-
 occupier faces an array of opportunities for the investment 
 of his funds, including in housing for rental to himself or 
 others, the value of the reward in-kind must be at least the 
 euual of these financial alternatives. Indeed, this fact 
 provides a possible method for approximating the flow of 
 consumption he receives, constituting a portion of the value 
 of his consumption services. Knowing the cost of the asset 
 and its depreciation schedule, one could estimate the reward 
 necessary to induce the owner-occupier to rent to himself. 
 

In practice, to tax this form of imputed income, however 
 desirable it might be from the standpoint of equity or of 
 obtaining neutrality between owning and renting, would 
 severely complicate tax compliance and administration. 
 Because the owner-occupier does not explicitly make a rental 
 payment to himself, the value of the current use of his 
 house is not revealed. Even if market rental were ,estimated,
 perhaps as a fixed share of assessed value of the dwelling,
 -5/ the taxpayer would face the difficulties of accountina 

for annual maintenance and depreciation to determine his net 

income. 

The present tax system does not attempt to tax the 

imputed income from housing. This is, perhaps, because 

there would be extreme administrative difficulties in determining it and because there is a general lack of understanding of its nature. The incentive �or home ownership

that results from including net income from rental housing

in the tax base while excluding it for owner-occupied housina 

also has strong political support, although the result is 

clearly a distortion from the pattern of consumer housing

choices that would otherwise prevail. Primarilv for the 

sake of 

--I

from the tax 

7

to owner-occum 
 income arising -

is proposed.

D l 
 

Present law allows the homeowner to deduct State and 

local property taxes assessed against the value of his 

house as well as interest paid on his mortaage. The appropriateness of each of these deductions is considered next,

beginning with the property tax. 
-- 

- 87 -

The model tax would allow no deduction for the local 
 I_

roperty taxnTGrZFEEcupiea Fmes or on oGr~pZTTF

{rooertv L -
 that also have tax-free rental values, e.a.. 

automobiles. This treatment is based on the propoiition
 that deduction of the property tax results in further under-
 statement of income in the tax base, in addition to the 
 exclusion of net rental income. This cannot be justified, 
 as can the exclusion of net income from the dwelling, on 
 grounds of measurement difficulty. Allowing the deduction 
 of property taxes by owner-occupiers results in unnecessary
 discrimination against tenants of rental housing. Elimination of the deduction would simplify tax administration and 

compliance 'and reduce the tax bias in favor of housing
 investment in general, and owner-occupancy in particular. 
 

Local housing market adjustments normally will insure 

that changes in property taxes will be reflected in rental 

values. When the local property tax is increased throughout 

a market area, the current cost of supplying rental housing

increases by the amount of the tax increase. Over time, 

housing supplies within the area will be reduced (and prices

increased) until all current costs are again met and a 

normal return accrues to owners of equity and suppliers of 

mortgages. Accordingly, rents eventually must rise dollarfor-dollar with an increase in property tax. (Note that, 

in a equilibrium market, deductibility of the local tax 

against Federal income tax would not result in reduced 

federal liability for landlords because the increase in 

gross receipts would match the increased deduction.) Tenants 

will experience an increase in rent and no change in their 

income tax liability. 

Owner-occupiers provide the same service as landlords,

and, therefore, must receive the same rental for a dwelling

of equal quality. Hence, market rentals for their homes 

also would rise by the amount of any general property tax 

increase. If owner-occupiers were allowed to deduct the tax 

increase from taxable income while not reporting the increased 

imputed rent, they would enjoy a reduction in income tax 

that is not available either to tenants or to landlords. 

To smarize the effect of the property tax increase, 

the landlord would have the same net income and no change in 

income tax; the tenant would have no change in income tax 

and higher rent; and the owner-occupier would have higher

(imputed) rent as a "tenant," but the same net income and a 
 reduction in his income tax as a "landlord." He would be 
 
-- 

favored relative to the renter first by receiving income 
 from assets free of tax, and, in addition, his advantage 
 over the tenant and landlord would increase with higher 
 rates of local property tax. This advantage would not be 
 present if the property tax deduction were denied to the 
 owner-occupier. He would be treated as the tenant/landlord
 that he is paying higher rent to himself to cover the 
 property tax while his net income and income tax were unchanged. 
 

Deductibility of Mortgage Interest 
 

The mortgage interest deduction for owner-occupiers is 

often discussed in the same terms as the foregoing property 

tax argument. There are, however, quite significant differences, and, because of these, the model -

tax treatment

would continue -to allow deductibility6fome I- mortgage
 interest. 
 

The effect of this policy may be equated to allowing any 
 taxpayer to enjoy tax-free the value of consumption services 
 directly produced by a house (or other similar asset),
 regardless of the method he uses to finance the purchase of 
 this asset. The tax-free income allowed is thus the same 
 whether he chooses to purchase the asset out of funds 
 previously accumulated or to obtain a mortgage loan for 
 the purpose. 
 

This position is based on the reasoning that, given

the preliminary decision (based on measurement difficulty) 

not be attempt to tax the net income received from his 

house by the person who purchases it with previously accumulated or inherited funds, it would be unfair to deny a 

similar privilese to those who must borrow to finance the 

purchase. 
 

There is a related reason in favor of allowing the 

mortgage interest deduction, having to do with the diEficuLtq

of tracing the source of funds for purchase of an asset. 

Prospective homeowners of little wealth are obliged to 

offer the house as security to obtain debt financing. By 

contrast, an individual of greater wealth could simply

borrow against some other securities, use the proceeds to 

purchase housing equity, and take the normal interest 

deduction. In other words, a mortgage is not the only way 

to borrow to finance housing, and it is very difficult, if 

not impossible, to correlate the proceeds of any other loan 

with the acquisition of a house. 
-- 

- a9 -

Nevertheless, a case may be made for disallowing interest 

deduction for borrowins identifiably for the purpose of 

financing an owner-occupied home (or other consumer durable).

There is no doubt that most people finance home purchases

with a'rnortgage using the home as security. Mortgage interest 

payments are surely highly correlated with net income produced by the associated housing, and denying the deduction 

would increase the tax base by an amount equal to a siqnificant fraction of the aggregate net income from owner-occupied

dwellings. For those who cannot otherwise finance home purchases, it would end the tax bias against renting. These 

considerations deserve to be weighed against the view taken 

here that the efficiency and equity gains from denying the 

mortgage interest deduction are insufficient to counterbalance the equity losses and the increased administrative 

complexity of the necessary rules for tracing the sources of 

funds. 

Consumer Durables 
 

Precisely the same arguments that have been made 

concerning houses also apply to consumex durables, such as 

automobiles, boats, and recreational vehicles. These assets 

generate imputed incomes and may be subject to State and 

local personal property taxes. The model tax would treat 

these assets in the same way. That is, property -

tax assessed

against consumer durables would not be deductible, -

but

-

all interest including those related to purchase

of durables, allowed -as 
 deductions.

MEDICAL EXPENSES 
 

The present tax law allows the deduction of uninsured 

medical expenses, in excess of a floor, and partial deduction for medical insurance premiums. The principal argument

for deductibility is that medical expenses are not voluntary

consumption. Rather, they are extraordinary outlays that 

should not be included in the consumption component of the 

income definition. 

Opponents of deductibility can cite a fairly high
 degree of "consumer choice" in the extent, type, and quality
 of medical services that may be elected by persons of 
 similar health. At the extreme, health care choices inc1ud.e 
 cosmetic surgery, fitness programs at resorts and.spas,
 frequent physical examinations, and other expenditures that 
 are not clearly distinguishable from ordinary consumption.
 The remainder of medical expenditures is generally insurable, 
 
- 90 -

and insurance premiums may be regarded as regular, predictable

consumption expenditures. Indeed, tax deductibility of 

medical expenses may be viewed itself as a type of medical 

insurance that is inadequate in amount for most taxpayers

and has some quite unsatisfactory features. 

Model Tax Treatment 
 

law as well as recordkeeping for households. It also would 

eliminate the necessity of making the sometimes difficult 

administrative determination of eligibility of a medical 

expense for deduction. 

An optional treatment is presented here that would 

provide a refundable tax credit for a taxed share of large

medical expenses. This optional approach is intended as an 

explicit medical insurance program, administered under the 

tax law. There is a presumption here, however, that administration of such a program by the tax authorities would be 

preferred to other alternatives. 

"Tax Insurance" Under Present Law 
 

Under present law, eligible medical expenses in excess 

of 3 percent of adjusted gross income (AGI) are partially

reimbursed by "tax insurance" equal to the deductible 

expenses multiplied by the taxpayer's marginal tax rate, 

e.g., 25 percent. The taxpayer pays only the coinsurance 

rate, in this example 75 percent, times the medical expenses.

Therefore, itemizers are uninsured (by the tax system) for 

medical expenses up to an amount that varies in proportion 

to their income, and above that amount they pay a coinsurance 

rate that decreases as marginal tax rates increase. Lowincome taxpayers are more likely to exceed the floor on 

deductibility (3 percent of AGI), but higher-income taxpayers receive a higher rate of insurance subsidy. 

A family with $10,000 of salary receipts might be at 
 the 19-percent marginal tax rate, and thus have a "tax 
 insurance" policy that requires that family to pay 81 
 percent of medical expenses in excess of $300 per year. A 

famiiy with $50,000 of salary at the 48-percent marginal 

rate has a "policy" that requires payment of only 52 pescent

of expenses above $1,500 per year. The same type of tax 

insurance is provided for medicines and drugs to the extent 
 that they exceed 1 percent of AGI. 
 
-- 

-- 

-- 

- 91 -

Present law also allows deduction of half of private

insurance premiums (up to a deduction Limit of $150) without 

regard to the floor, the balance being treated as uninsured 

medical expenses subject to the 3-percent floor. Insurance 

proceeds are not taxable so long as they do not exceed 

actual expenses. In the case of fully insured expenses, the 

result is the same as including all insurance proceeds in 

income, allowing deduction of all outlays without floor, and 

allowing deduction for a share of premiums as well. Hence,

total medical costs -- insurance premiums plus uninsured 

losses -- are partially deductible without floor to the 

extent of insurance coverage and fully deductible above a 

floor for the uninsured portion. Those who cannot itemize 

have no "tax insurance," while itemizers pay a coinsurance 

rate ranging from 30 percent to 86 percent -- that varies 

inversely with income. 

Optional Catastrophe Insurance Provision 
 

Viewed as a mandatory government insurance program, the 

present tax treatment of medical expenses deserves reconsideration. One alternative is a policy that would provide 

a subsidy either in the form of a refundable tax credit 

or direct appropriation for very large medical expenses.

Under such a scheme, the floor for the deduction would be 

raised, but the "coinsurance" rate would be increased for 

all taxpayers and made uniform, rather than dependent 

on the taxpayer's marginal rate. For example, if a tax 

credit were used, its amount might be equal to 80 percent of 

expenses in excess of a flat floor, say, $1,000 per year.

Alternatively, the floor amount might be made a share of 

income. 

While a catastrophe insurance provision would be a 

major change in the system of financing medical care, it 

need not have a large budgetary consequence when combined 

with repeal of the present deductions. For the level of 

medical expenses prevailing in 1975, elimination of the 

present deduction for premiums and expenses would finance 

complete reimbursement of all medical expenditures that 

exceed 10 percent of AGI. Full reimbursement would, however,

have the undesirable effect of eliminating the market 

incentives to restrain medical costs. Some rate of coinsurance 

is desirable to help ration medical resources. Supplemental

private insurance would undoubtedly be made available for 

insurable medical expenses not reimbursed by the tax credit. 

No deduction would be allowed for private medical insurance 

premiums, but proceeds would not be taxable. 
- 92 -

STATE AND LOCAL TAXES 
 

The way State and local government should be treated in 

a comprehensive income measurement system presents difficult 

conceptual problems. These units might be treated simply as 

the collective agencies of their citizens. Ideally, in this 

view, the value of consumption services provided in-kind to 

the members of the group would be attributed to the individuals 

and counted on the uses side of their individual income 

accounts. The same amounts would appear on the sources 

side, as imputations for receipts in the form of services. 

Payments to the group would be deducted, as not directly

measuring consumption, and payments received from the group

would be added to the sources side of the individual income 

calculation. 

The difficulty is in measuring the value of services 

provided by the collective unit. This problem is solved for 

such a voluntary collective as a social club by disallowing 

any deductions for payments made to it by members. In 

effect, these payments are regarded as measuring the consumption received by members. When it comes to a larger

collective organization, such as a State aovernment, this 

approach is much less satisfactory. The payments to the 

organization are no longer good proxies for the value of 

services received. For that reason there is a stronq equity 

case for allowing a deduction of such payments in calculatinq

individual income (including, in individual income, any 

grants received -- "negative taxes"). 

Unfortunately, there is no practical method for 

imputing to individuals the value of services received, 

so that it is not possible to carry out the complete

income measurement system. As in the case of services from 

owner-occupied homes, the model plan concedes that the 

value of most services provided collectively will be 

excluded from the tax base. And as with owner-occupied

housing, there is a resulting bias introduced by the 

Federal tax system in favor of State and local collection 

expenditure over individual expenditures. The general

principle, then, is that payments to the State or local 

government are excluded from the tax base other than in 

cases when there is a reasonable correspondence between 

payments and value of services received. There remains,

however, the question of what constitutes "payment" for 
-- 

-- 

- 93 -

this purpose, and here particular difficulty is presented

by indirect taxes such as sales taxes. Analysis of this 

issue, together with considerations of simplicity in 

administration, lead to the prescription of the model 

tax system that

-

a deduction is allowed &Ifor State and 

local income taxzs. Other tzes -be deducted only 
 as costs of doing business. 
 

Income Tax Deductibility 
 

Income taxes represent the clearest analogy with dues 

paid into ,a voluntary collective. These payments reduce 

the resources available to the payor for consumption or 

accumulation, and hence they are properly deductible. 

Property Tax Deductibility 
 

The issue of property tax deductibility for homeowners 

has been discussed above. Deduction of that tax should not 

be allowed so long as the associated implicit rental income 

from housing is excluded from taxable income. Other State 

and local taxes that are generally deductible under present

law are income taxes, general sales taxes, and motor fuel 

taxes. 

Sales Tax Deductibility 
 

General sales taxes, it may be argued, should not be 
 deducted separately because they do not enter household 
 receipts. Unlike the personal income tax, which is paid by
 

households out of gross-of-tax wages, interest, dividends, 
 and the like, the sales tax is collected and remitted to 
 government by businesses that then pay employees and suppliers
 of capital out of after-sales-tax receipts. Therefore, the 
 sum of all incomes reported by households must be net of the 

tax; the tax has already been "deducted" from income sources. 

TO allow a deduction to individuals for the sales tax would 

be to allow the full amount of the tax to be deducted twice. 

The argument above is modified somewhat to the extent 

that the rate of sales tax varies among States and localities 

that trade with each other. Jurisdictions with high sales 

tax rates may sustain locally higher prices if they can 

effectively charge the sales tax to their own residents who 

purchase goods outside the jurisdiction. In this case, 

compensating higher wages, rents, etc. (in money terms) must 

also prevail in the high-rate area to forestall outmigration

of labor and capital. The additional tax will increase 

nominal income receipts in the region of high tax rates. 
- 94 -

The question is an empirical one on the degree to which 
 sales taxes do result in price level differences among 
 

taxes do cause price level differences, the choice of finan­
 cing investment by State and local governments will be 
 biased toward income and away from sales taxes. 
 

Alternative Treatments of Sales and Income Taxes 
 

An alternative treatment of both sales and income taxes 

may be considered, whereby a deduction is allowed only for 

amounts in excess of a significant floor (possibly expressed 

as a fraction of: the tax base). As at present, standard 

amounts of sales tax, related to income, could be included 

in the income tax form, with sales taxes on large outlays

(e.g., for an automobile) could be allowed in addition to 
 making the calculation. This approach would relieve most 
 taxpayers of recordkeeping and be rouuhly equivalent to 
 including at least some of consumption services that are 
 provided by State and local governments in the tax base. 
 (The floor could even be related to an estimate of the 

extent to which State and local taxes finance transfer 

payments, included in the base by recipients.) 

Benefit Taxes 
 

Certain State and local qovernment services are financed 

by taxes and charges that are closely related to the taxpayer's own use of those services. Such taxes can be looked 

upon as measures of the value of consumption of those 

services and so should not be excluded from income. This 

aruument holds especially for State and local taxes on motor 

fuels that are earmarked for the construction of highways

and for other transportation services. The amount of 

gasoline consumed is a rough measure of the value of these 

services used, and, conversely, the consumer can choose the 

amount of highway services used, and taxes paid, by choosina 

the size of vehicle and the amount of his driving. 

Other State and local user charges and special taxes,
 such as sewer assessments, fishing licenses, and pollution 
 taxes, are not deductible under current law. This treatment 
 is consistent with the arguments above. In addition, there 
 
-- 

- 95 -

are a number of local excise taxes that were enacted at 

least partly for the parpose of contrulling consumption

Allowing deduction of such taxes, e.g., on gambling,

alcohol, tobacco, firearms, etc,, would be adverse to this 

purpose. 

CONTRIBUTIONS TO CHARITIES 

Contributions to qualified charitable organizations are 

presently deductible, subject to certain limits, as an 

indirect subsidy to philanthropy. Gifts are arguably also 

of a different nature than ordinary consumption for the 

donor, and therefore not part of income. Against this view, 

the voluntary nature o� contributions may be cited as 

evidence that contributors derive satisfaction from giving

just as they do from other uses oE resources. Since eontributions are not taxed to donees, either when received by

philanthsoptc organizations or when distributed to ultimate 

beneficiaries, a component af income fs clearly lost -to the 

tax base as a result of the present policy. Taxation of the 

donor may be regarded as a substitute for taxation of the 

donee. 
 

Accordingly, the model tax would allow no deduction 

to the donor -for gifts 'tocharitableorganiz~tl~ns- 1 -- ­and -c_

would 1A& include benefEs of such donations -in income 

-.to reclplents. 

'She guestion of how to treat charitable contributions 

extends beyond issues of income measurement, however. Mahy 

persons would regard the benefits of a tax incentive to 

philanthropy as more valuable than the potential benefits of 

tax simplification and horizontal equity of the model tax 

treatment. Consequently, optional methods for providing an 

incentive to charity, in the farm of donor deductibility or 

a tax credit, also are discussed. 

Charity as Income to Beneficiaries 

A charitable contribution is a transfer between a donor 

and beneficiaries with a philanthropic organization as an 

intermediary, The philanthropic organization usually converts 

cash contributions into goods and services, such as hospital. 

care, education, or opera performances, that are subsidized 

or provided free to the beneficiaries. ~n many case5, e,glr 

cancer research, the benefits are very broadly diffused 

throughout society. The value of these services is a form 

of income-in-kind to the beneficiaries, but under present

law there is no attempt to tax beneficiaries on that income, 
- 96 -

The logic of the tax treatment of charitable cantributions Fs much the same as that for gifts wr bequests to 

individuals. A gift does not add to the standard of living

of the donor, although it does for the beneficiary, If the 

taxpayers standard of living is the appr~priate,criterion

for taxability, proper treatment would be to allow deduction 

af the gift as at present, but with taxation to the recipient,

subject only to the general exemption of very low-income 

taxpayers c 

There is, however, no generally satisfactory way to 

measure or allocate the benefit-in-kind resulting from 

charitable donatiuns. While total benefits might be measured 

by their cost, a large input to benefits-in-kind is voluntary

effort that is very difficult to value, 

Charities as Public Goods 

Even if it were practical to tax benefits-in-kind, it 

still could be argued that the benefits should not be taxed 

because they flow to society generally as well as to the 

individual recipient. Many philanthropic actfvities provide

services, e.g., basic research, education, etc., that 

benefit the public at large. Deductibility o� contributions 

to such activities provides an incentive for this provision

without direct government control. 

On the other hand, 30me persons-argue that this kind of 

hidden public finance should not be given to programs that 

are under private, and perhaps even individual, control. 

Moreover, it may be viewed as inequitable that some beneficiaries should receive untaxed benefits if others must pay 

the full cost for similar benefits Ie.g., education, health 

care, etc.). 

A Practical Alternative to Taxing Charitable Organizations 

If it is considered logical but impractical to tax 

benefits to the beneficiary, an alternative approximation is 

to tax the donor by denial of deductibility. The charitable 

contribution is easily measurable and taxable in a practical 

sense. If the donor reduces his contributions by the amount 

of the additional tax he pays, the donor indirectly shifts 

the tax burden to beneficiaries. Denial of deductibility,

therefore, may be viewed as a proxy for taxing beneficiaries, 

This describes the present treatment of gifts between 

individuals. The model tax repeats this treatment for gifts 

to organizations. 
 
- 97 -

Alternative Tax Incentives for Philanthropy 

The rationale for deductibility of gifts and exemption

from income of charitable institutions comes down to providing a tax incentive to encourage their activities. On 

the other hand, concern for tax equity only would suggest

taxation of the full value of the charitable contribution 

on at least one side of the transfer. The latter conclusion 

may be reached whether one invokes a "standard-of-living" 

or an "ability-to-pay" criterion of equity. 

Optional Tax Credit. The use of the tax system to 

provide an incentive for charitable activities may be 

accomplished by an alternative policy option -- the replacement of the deduction with a tax credit. A flat credit 

(percentage of contribution) could be provided at a level 

that would just balance the revenue gain from denying

deductibility. A credit of, for example, 25 percent would 

provide additional tax savings to those with marginal tax 

rates below 25 percent and impose more taxes on those with 

marginal rates in excess of 25 percent. In addition to this 

redistributive effect, this alternative tax incentive may

result in certain activities, such as education, health 

care, and the arts, bearing the additional burden nominally

imposed on the higher-income contributors. Other activities, 

such as religion and welfare, might be more likely to 

benefit from the tax savings given to lower-income contributors. 

The choice between tax credits and deductions thus 

requires a judgment about the desired amount of stimulus 

among types of charities. The relative fairness of these 

devices may be judged according to one's concept of income. 

If gifts are regarded as reductions in the donor's income, 

and if rates of tax are chosen to produce a desirable degree

of tax progressivity, then the deduction is to be preferred 

on equity grounds. Conversely, if charitable giving is a 

use of one's income that is to be encouraged by public

subsidy, a subsidy per dollar of gift that does not vary

with the taxable income of the donee may be more appropriate. 

CASUALTY LOSSES 
 

Model Tax Treatment 
 

The issue of deductibility of casualty losses is 

analogous to that of the property tax deduction. Damage to 

property due to accidents or natural disasters reduces 
-- 

-- 

- 9a -

the present and potential income from ownership of that 

property. Consequently, casualty losses are properly

deductible business expenses. However, as argued previously,

owner-occupied houses and consumer durablas produce incomes 

equal to a certain portion of the current rental value to 

the uses, and that income is fully exempt from tax under 

present law and would be under the model tax. Deduction of 

casualty losses would represent: an asymmetric treatment of 

these household assets their incame is exempt from tax, 

but interruption of the flow of income due to casualty would 

provide a tax reduction. _iThe model tax would allow 

deduction -for casualty losses except to business"property. 

Casualty insurance premiums -for houseGld property would 

7

not -be deductible and insurance benefits would not be 

includd -' _Iin " "' income. ­

Present Law Treatment 
 

Under current law, insurance premiums are not deductible, 

but proceeds offset the deduction for actual losses. Kence, 

the effect for insured losses is the same as full deduction 

of losses, without floor, and inclusion of insurance proceeds

in income. 

The logic cited above far refusing the deductiun of 

losses would suggest that insurance premiums for household 

assets also are a cost of maintaining tax-exempt income. 

Such costs, therefore, should not be deductible. Because 

insurance premiums are approxhately equal to the expected

value of insurance benefits, if no deduction is allowed for 

premiums, the aggregate of insurance benefits may be regarded 

as tax-prepaid. Consequently, these benefits should not be 

taxable as income when paid. 

INTERNATIONAL CONSIDERATIONS 
 

The Residence Principle 

There are two basic prototype approaches to the taxation of international flows of income. The first is the 

residence principle, under which all income, wherever 

earned, would be defined and taxed according to the laws of 

the taxpayer's own country of residence. The second prototype is the source principle, which would require the 

taxpayer to pay tax according to the laws of the country or 

countries in whSch his income is earned, regardless of his 

residence. Aboptian of one prototype or the other, as 
- 99 -

compared with the mixed system that now prevails, would 
 have the desirable effect of insuring that no part of 
 an individual's income would be taxed by more than one 
 country, and would seduce the number of bilateral treaties 
 necessary to assure against double taxation. 
 

A number of considerations point to the residence 

principle as the more desirable principle to establish. 

First, the concept of income as consumption plus change in 

net worth implies that attribution of income by source is 

inappropriate. Income, by this definition, is an attribute 

of individuals, not of places. Second, if owners of factor 

services are much less'mobileinternationally than the 

factor services they supply, variations among countries in 

taxes imposed by residence will have smaller allocation 

effects than tax variations among places of factor employment. Third, the income redistribution objective manifested 

by the use of progressive income taxes implies that a 

country should impose taxes on the entire income of residents. 

The usual concept of income distribution cannot be defined 

on the basis of income source. 

For these reasons, the model plan recommends that 
 the United States seek, as a long-run objective, a world 
 wide system of residence principle taxation. This objective
 would be made much more feasible with the integration of 
 individual and corporate income taxes. Clearly, the residence 
 principle requires that a taxable income be attributable to 
 persons. If taxable income were attributed to corporations,
 they would be encouraged to move their residence to 
 countries with.low tax rates. 
 

Even after establishment of the residence principle, 
 some problems would remain. For example, individuals who 
 live in countries that tax pensions upon realization might
 be induced to retire to those countries that require prepay­
 ment of taxes on pensions by including pension contributions 
 in taxable income. Such international differences in tax 
 structure would contine to require bilateral treaty agree­
 ments. 
 

Establishing the Residence Principle 
 

To encourage the establishment worldwide of the residence 

principle, the model tax would reduce in stages, and according 

to the outcome of international treaty negotiations, 7 the 

rates of US. withholding taxes -on income -to foreign -I-
-- 

--- 

-- 

- LOO -

residents Iand the foreign Ttax credit allowed to U.S. 
 

residents on foreign source income. This process would 

dependoncorrespondinq reductions a foreign countries -in 
 

I 

the taxation -of income of ments. 
 

The first step in the process of establishing the 

residence principle is to define a unique tax residence for 

each individual. These definitions would be established 
 initially by national statute, and ultimately settled by
 international tax treaty. The second step would be 
 to devise a tax system that encouraged other countries to 
 forego taxation of U.S. residents on income earned abroad. 
 

This fundamental change in tax jurisdiction will take time,
 and it is important that international flows of labor, 
 capital, and technology not be hampered by double taxation 

during the transition period. Accordingly, transition to 

the model U.S. tax system would be designed as a slow but 
 steady movement toward residence principle taxation. 
 

Interim Rules 
 

Foreiqn Shareholders. As a practical matter, it would 

not be feasible to exempt foreign shareholders from U.S. 

taxation until such time as the residence principle received 

broad political acceptance both in the United States and 

abroad. Initially, therefore, foreign shareholders might be 

subject to a withholding tax of perhaps 30 percent on their 

share of corporate income (whether or not distributed), with 

the rate of taxation subject to reduction by treaty. other 

forms of income paid to foreign residents would continue to 

be subject to withholding tax at existing statutory or 

treaty rates. These rates also could be reduced by treaty. 

Foreiqn Tax Credits. Eventually, a deduction not a 

credit -- should be allowed for foreiqn income taxe, because 

they are not significantly different from State and local 

income taxes, for which a deduction is also allowed. This 

approach would encourage foreign governments to provide U.S. 

fxms operating abroad with benefits approximately equal to 

the amount of taxes. Otherwise, U.S. firms would qradually

withdraw their investments. However, it will take time for 

foreign qovernments to accept the residence principle, just 

as the United States is not immediately willing to foreqo

withholding taxes on U.S. source incone paid to foreign

residents. In the meantime, for reasons of international 

comity, and in order not to interrupt international flows of 

factor services, the United States would continue to allow a 

foreign tax credit to the extent of its own withholding tax 
- 101 -

on foreign income. In the case of corporate-source income, 
 the initial credit limitation rate would be 30 percent (and
 the remainder of foreign taxes would be allowed as a deduc­
 tion). In the case of other income, the credit limitation 
 would be determined by the U.S. statutory or treaty withholding 
 rate on the particular type of income. 
 

Foreign Corporations. In keeping with the model income 

tax definition of income, the earnings of a foreign corporation controlled by U.S. interests would flow through to the 

domestic parent company and then to the shareholders of the 

domestic parent. The U.S. parent corporation would be 

deemed to receive the before-foreign-tax income of the 

subsidiary even if no dividends were paid. This would 

eliminate deferral here just as the integration plan

eliminates shareholder deferral of tax as income in the 

form of corporate retained earnings. A foreign tax credit 

would be allowed for the foreign country's corporate income 

tax and withholding tax to the extent of the 30-percent

limit. Excess foreign taxes would be deductible. 

The earnings of foreign corporations that are not con-
 trolled by U.S. interests would be taxable in the hands of 
 U.S. shareholders only when distributed as dividends, and, 

therefore, a deduction rather than a credit would be allowed 

for any underlying foreign corporate income tax. A foreign 

tax credit would be allowed to U.S. shareholders only to the 

extent of foreign withholding taxes, and limited by the U.S. 

withholding rate on dividends paid to foreign residents. 

(The remainder of foreign withholding taxes would be allowed 

as a deduction.) 

Other Foreign Income. Other types of foreign income 

paid to U.S. residents would be similarly eligible for a 

foreign tax credit, again limited by the U.S. tax imposed on 

comparable types of income paid to foreigners. Thus, a U.S. 

resident earning salary income abroad would be allowed to 

claim a foreign tax credit up to the limit of U.S. withholding 

taxes that are imposed on the salary incomes of foreign

residents in the U.S. 

THE FILING UNIT 
 

To this point, the concern of this chapter has been to 

develop a practical definition of income for purposes of a 

comprehensive income tax. That discussion has involved 

issues of timing, valuation, and scope, as well as considerations of administrability. The major issues that 

remain to be discussed have to do with assessment of the tax 

against income as defined. 
-- 

-- 

- LO2 -

Model Tax Treatment 

Among the more difficult problems of translating an 

income definition into a tax system are (11 to determine 

what social or economic unit should be required [or allowed) 

to file a tax return and (2) how rates are to be applied to 

filing units having different characteristics. -The model 
 tax would designate -the Eamil. as the primary -tax un'Lt, 

a-h s-eparate -rate schedules, asuzr cvrrent law, 'for 

three types of families -- unmzrled

-

individuals without 

dependents, =xed ih-dividuals-with d-ependgnts (heads

of households), -and ­married couples with or withuut

denendents. L Other - ~rovisions * - for two-earner families and

for dependent care are described below. 

Problems of Taxation of the FilLino Unit 

To illustrate the issues involved in choosing among

alternative tax treatments o� families, consider the 

following potential criteria: 

1. 	 Families of equal size with equal incomes should 

pay equal taxes. 

2. 	 The total tax liability of two individuals should 

not change when they marry. 

Both of these appear to be reasonable standards. Yet, there 

is no progressive tax system that will satisfy them simultaneously. This Is readtly illustrated by the following 

hypothetical case. Both partners of married couple A work, 

and each has earnings of $15,000. Married couple B has 

$20,000 of earnings from the-labor of One partner and 

$30,000 from the other. 

If individual filing were mandatory, with tho same rate 

structure for ail, couple A may pay less tax than couple B. 

This is a consequence of applying progressive rates separately 

to the earnings of each partner. Suppose marginal rates 

were 10 percent on the first $15,000 of income and 20 percent 

on any additional income. In this example, couple A would 

awe $1,500 on each partner's income, or a total of $3,000. 

Couple B would owe $2,500 on the larger income and $1,000 on 

the smaller, or a total of $3,500. This violates the first 

criterion. 
- 103 -

Now consider a system of family filing in which all 

income within the family is aggregated and the tax is calculated without regard to the relative earnings of each 

partner. (Unmarried individuals would be subject to the 

same rates as a family.) In this case, the two couples

would pay the same tax on their total income of $30,000. 

However, both couples would be financially worse off than if 

they were unmarried. Each couple would now pay a tax of 

$3,500 on the total of $30,000. As compared with separate

filing, more income is taxed at the higher marginal rate. 

This violation of the second criterion is sometimes referred 

to as a "marriage tax." 

The simplest device for dealing with this penalty on 

marriage is "income splitting," whereby the combined income 

of a married couple is taxed as though it were attributed 

half to one spouse, and half by the other. Each half is 

subject to the rate schedule applicable to an unmarried 

individual. To continue the above example, each couple with 

a total income of 530,000 would, with income splitting, pay 

a rate of 10 percent on each $15,000 share, or a total of 

$3,000 in tax. Notice that there may be a "marriage benefit" 

so long as each prospective SPOUSE does not have the same 

income. Upon marriage, the combined tax for couple B would 

fall from $3,500 to $3,000. 

Choice of the Filing Unit 
 

Direct appeal to the concept of income does not settle 

these issues, because that concept presupposes the definition 

of an accounting unit. There are legal, administrative, and 

even sociological factors involved in the choice. The major 

arguments in favor of mandatory individual filing can be 

summarized a5 follows: (1) no marriage tax; (2) no discrimination against secondary workers; and (3) the administrative 

ease of identifying individuals without the requirement of a 

definition of families. By contrast, the arguments in favor 

of family filing are: (1) families with equal incomes should 

pay equal taxes; (2) families typically make joint decisions 

about the use of their resources and supply of their labor 

services; and (3) family filing makes it unnecessary to 

allocate property rights, as in the case of community 

property laws, and to trace intrafamily gifts. 

The last point is critical. A concept of income as a 

use of resources implies that each individual's ability to 

pay includes consumption and net worth changes financed by 
-- -- 

-- -- 

- 104 -

transfers from other family members. Carried to extreme,

this separate treatment of family members would suggest 

assessment of tax even to minor children. Chiefly because 

of this problem, it is recommended that the family Ibe 
 made the primary tax unit. 
 

The definition of a family is, of necessity, somewhat 
 arbitrary, as is the application of progressive rate schedules 
 to families of different types. The following definition of 
 a family is adopted here 6/: The family unit consists of 
 husband and wife and their children. The children are 
 included until the earliest date on which one of the fol­
 lowing events occurs: 
 

. They reach 18 years of age and they are not then 

attending school; or 

. They receive their baccalaureate degree or; 

. They attain age 26; or 

. They marry. 

Single persons are taxed separately. Persons not currently
 married and their children living with them are treated as 
 family units. 
 

The Problem of Secondary Workers 
 

A system of joint family filing may cause an efficiency

loss to the economy; namely, the discouragement of labor 

force participation by secondary workers in a family. If a 

partner not in the labor force is thinking of entering it, 

the tax rate that person faces is the marginal rate applying 

to the prospective total family income. This rate may be 

much higher than that for a single wage earner. This 

consequence of family filing is sometimes referred to as the 

"wife tax." 

Two-earner families and single-adult families with 

dependents also face expenses for dependent care, which may

be regarded as altering such families' ability to pay taxes. 

Hence, taxability of families will vary according to the 

number of adults, the number of wage earners, and the number 

of children. 
- 105 -

Compare the circumstances of three three-person families 

of equal income: family X has two adult wage earners: 

family Y has two adults, only one of whom is a wage earner; 

and family 2 has only one adult, who is a wage earner. 

Family Y alone receives the full-time household and child 

care services of one adult member and may be regarded as 

better off on this account. Family X alone bears the wife 

tax associated with secondary wage earners. Family 2 has 

the additional child care responsibility but also the 

smaller subsistence outlays associated with two children in 

place of an adult and one child. The model tax would 

recognize the difference of the type illustrated by these 

three families by two special adjustments to taxable income, 

and by separate rate schedules -- one for families with one 

adult and another for those with two adults. 

Tax Adjustments for Differences in Family Status 
 

The first adjustment in the model tax is that only 

percent of the income of secondary earners would beincluded in-lly income. Th'is lower rate of inclusion 

would appF only tomited amount of earnings of the 

secondarg worker. In the model tax this limit would be 

$10,000. Earnings of the secondary worker means the income 

of all family wage earners, except that of the member with 

the largest wage income. This provision would reduce the "wife 

tax" on families with more than one wage earner. 

The second ad'ustmentwould child care deduction 
 

egualtohalff *. actual c ildre -c o s to~ a limit of either35m the taxable earnin- the secondary

worker, whichever is smaller. This-deduction would be 

allowed only for a spouse who is a secondary worker, or for 

an unmarried head of household, The aependent care adjustment would provide some allowance for the reduced standard 

of living associated with the absence of full-time household 
 services of a parent. 
 

The model tax would provide separate rate schedules, as 

in present law, for single individuals, for families with a 

married couple, and for families with a single head of 

household. Rate schedules applicable to individuals would 

be set so that a two-adult family would pay slightly higher 

tax than two unmarried individuals whose equal taxable 

incomes sum to the same taxable income as the family. A 

single individual would, of course, owe more tax than a 

family with the same amount of taxable income. The schedule 
-- 

- 106 -

of rates for a family with a single head of household 

would be designed so that the tax liability would be the sum 

of (l),half the tax calculated from the single rate schedule 

and (2) half the tax from the rate schedule for couples. 

The mdel tax also would have, as part of its rate 

schedule, a "zero rate bracket" that would exempt a fixed 

amount of income on each return from tax. The level of this 

exemption could be adjusted to reduce the potential marriage

benefit that may result from different schedules of positive 

rates for married as compared to single filers. The desired 

relation in level and progressivity of tax among taxpayers

of different family status would be achieved, therefore, 

by a combination of rates and rate brackets that-is different 

for each type of family, and also by specifying a level of 

exemption per filing unit. 

Provision of an exemption for each filing unit would 

have much the same ef�ect as the standard deduction under 

present law* The exemption would provide a minimurn level, of 

income for each %arniLyor individual that would not be 

subject to tax. However, unlike the present law, the use of 

the exemption by a family would not disalluw any other 

subtractions from receipts in the determination of taxable 

income. Under the model tax, deductions for employee

business expenses, State and local incgme taxes, pension

contributions, interest payments, etc. would not be reduced 

by, nor dependent uponl the exemption of a subsistence 

amount of income. 

ADJUSTING FOR FAMILY SIZE 

Most observers would agree that the tax treatment of 

families should vary by family size, as well as by marital 

status and the number of wage earners. The model -tax would

adjust for famil size a means of a specified exemption 

per fam- mem 9-er, as in present law. 

Exemgtions Versus Credits 

The use of the personal exemption as an adjustment for 

family size has been much criticized. One line of criticism 

is that the dollar value of an exemption increases with the 

family's marginal tax rate, so that it is worth more for 

rich families khan for poor families. This observation has 

Led some people to suggest either a vanishing exemption,

which diminishes as income increases, or institution of a 
- 107 -

tax credit for each family member in place of the exemption.

The latter approach has been adopted, in a limited way, in 

the “personal exemption credit” provision of the 1975 Tax 

Reduction Act, which has been extended temporarily by the 

1976 Tax Reform Act. A tax credit reduces tax liability by

the same amount for each additional family member regardless

of family income. 

The argument for a vanishing exemption or family credit 

often reflects a misunderstanding of the relationship of 

these devices to the overall progressivity of the income 

tax. It is true that trading an exemption for a credit 

without changing rates will alter the pattern of progressivity,

making the tax more progressive for large families, less for 

small families and single persons. But it is also true 

that, for any given level of exemption or credit, any degree

of progression among families of equal size may be obtained 

by altering the rate schedule. Therefore, in the context of 

a basic reform of the tax system that involves revision of 

the rate structure, there is no reason that the substitution 

of tax credits for exemptions should result in a more 

progressive tax. 

If the change in the standard of living that accom­
 panies the addition of a family member is akin to a reduc­
 tion in the family‘s income, then an exemption would be an 
 appropriate family-size adjustment. If, on the other hand, 
 one views the family-size adjustment as a type of subsistence 
 subsidy for each member of a taxpayer’s family, a credit may
 be more appropriate. The model tax reflects the former 
 view. 
 

The point to be emphasized here is that this choice is 

often argued in the wrong terms. If tax rates are adjustable, the issue of exemptions versus credits is essentially 

a question of the proper relative treatment of equal-income

families of different sizes at various points of the income 

distribution. Should the tax reduction on account of 

additional family members be greater as family income 

increases? Or is this, per se, inequitable? 

SAMPLE COMPREHENSIVE INCOME TAX FORM 

In order to summarize the major provisions of the model 

comprehensive income tax, and to provide a ready reference 

to its provisions, a listing of the items of information 

that would be required to compute the tax is provided below. 

In a few cases -- unincorporated business income, capital 
-- 

- 108 -

gains and losses, and income from rents and royalties

supplemental schedules would be required to determine 

amounts to be entered. However, as compared with present

law, recordkeeping requirements and tax calculation would be 

simplified greatly, despite the fact that several presently

excluded items of income are added. 

For most taxpayers, the only calculations that would 
 be complicated would be the exclusion of a portion of wages
 of secondary workers and the child care allowance for 
 working mothers and heads of households. The rest of the 
 calculation would simply involve the addition of receipts,
 subtraction of deductions and exemptions, and reference to a 
 table of rates. For single individuals and couples with 
 one wage earner who have only employee compensation and 
 limited amounts of interest and dividends, a still simpler
 form could be devised. 
 

Sample Tax Form for the Comprehensive Income Tax 

Filing Status 
 

1. Check applicable status 
 

a. Single individual 

b. Married filing joint return 

c+ Unmarried head of household 
 

d. Married filing separately 

Family size 
 

2. Enter one on each applicable line 

a. Yourself 

b. Spouse 
 

3. Number of dependent children 

4. Total family size (add lines Za, 2b, and 3) 
. - 109 -

Household Receipts 
 

5a. Wages, salaries, and tips of primary wage earner 

(attach forms W-2)7/ 

b. 	 Wages, salaries, and tips of all other wage earners 
 (attach forms W-2) 
 

c. 	 Multiply line 5b by .25; if greater than $2,500, enter 

$2,500 

d. 	 Included wages of second worker, subtract line 5c from 
 line 5b 
 

e. Wages subject to tax, add lines 5a and 5d 
 

6. 	 Receipts of pensions, annuities, disability compensation, unemployment compensation, workmen's compensation, and sick pay. (Includes social security benefits, 

except Medicare, and veteran's disability and survivor 

benefits.) 

7. Interest received (attach forms 1099) 

8. 	 Rents, royalties, estate and trust income, and allocated earnings from life insurance reserves (attach

schedule E) 

9. Unincorporated business income (attach schedule C) 

10. Net gain or loss from the sale, exchange, or distri­
 bution of capital assets (attach schedule D) 
 

11. Allocated share of corporate earnings (attach forms WX) 

12. 	 Public assistance benefits, food stamp subsidy, fellow-
 ships, scholarships, and stipends (attach forms w-y) 
 

13. Alimony received 
 

14. Total receipts (add lines 5e and 6-13) 
- 110 -
 

Deductions 
 

15. 	 Employee business expense (includes qualified travel, 
 union and professional association dues, tools, materials,
 and education expenses) 
 

16. Nonbusiness interest expense (attach statement) 
 

17. State and local income tax 
 

18. Alimony paid 
 

19. Child care expenses 
 

a. 	 If line lc is checked and line 3 is not zero, or 
 if line lb is checked and both lines 3 and 5b 
 are not zero, enter total child care expenses 
 

b. Multiply line 19a by .5 
 

c. Enter smaller of line 19b or $5,000 
 

d. 	 Child care deduction. If unmarried head of house-
 hold, enter smaller of line 19c or line 5a 
 

e. 	 If married filing joint return, enter smaller of 
 line 19c or line 5d 
 

20. Total deductions (add lines 15-18, and 19d or 19e) 
 

Tax Calculation 
 

21. 	 Income subject to tax. Subtract line 20 from line 14 
 (if less than zero, enter zero) 
 

22. Basic exemption. Enter $1,600 
 

23. Family size allowance. Multiply line 4 by $1,000 
 

24. Total exemption. Add lines 22 and 23 
 

25. Taxable income. subtract line 24 from line 21 
 

26. Tax liability (from appropriate table) 
 

27. a. Total Federal income tax withheld 
 

b. Estimated tax payments 
 

C. Total tax prepayments (add lines 27a and 27b) 
 
- 111 -

28. If line 26 is greater than line 27c, enter BALANCE DUE 

29, If line 27c is greater than line 26, enter REFUND DUE 
- 112 -

FOOTNOTES 
 

1/ The use of food stamps is restricted to a class of - consumption items, but the range of choice allowed to 

recipients is sufficiently broad that the difference 

between the face value and the purchase price of the 

coupon may be resarded as a cash grant. 

-2/ This imputed income estimates the return to both equity

and debt supplied during construction. To include 

interest paid in the calculation would count the debt 

portion twice. 

-3/ To be increased in increments to 12 months according to 

the Tax Reform Act of 1976. 

-4/ To be increased in increments to $3,000 according to 

the Tax Reform Act of 1976. 

-5/ A rule of thumb that is commonly suggested is that 

monthly rental is 1 percent of market value. However, 

as experience with local property taxes has shown, 

accurate periodic assessment is technically and politically

difficult. 

6/ This definition is based upon that of Galvin and - Willis, "Reforming the Federal Tax Structure," p. 19. 

Wages reported by the employer would exclude employee
 contributions to pension plans and disability insurance, 
 and would also exclude the employee's share of payroll 
 taxes for social security retirement and disability 
 (OASDI) . Pages would include employer contributions to 

health and life insurance plans, the employee's allocated share of earnings on pension reserves, and the 
 cash value of consumption goods and services provided 
 to the employee below cost. 
 
- 113 -

Chapter 4 
 

A MODEL CASH FLOW TAX 

INTRODUCTION 
 

This chapter presents a proposal for a consumption

base tax as an alternative to a comprehensive income tax. 

Called a "cash flow" tax because of the simple accounting 

system used, this tax is designed to replace the current 

taxes on the income of households, individuals, trusts, and 

corporations. 

The mayor difference between the cash flow tax and the 

comprehensive income tax outlined in chapter 3 is that the 

change in an individual's net worth is effectively excluded 

from the base of the cash flow tax. In many other respects,

the two taxes are alike. Consumption is included in both 

tax bases. The measure of consumption in the cash flow 

proposal is broadly similar to that in the comprehensive

income tax proposal; it differs mainly in that it includes 

the flow of consumption from consumer durables and owneroccupied housing and certain other forms of in-kind consumption. The treatment of the family unit for tax purposes

is the same in both the comprehensive income and cash flow 

proposals. 

The concern of this chapter is to define the appropriate

base of the cash flow tax system. The issue of the progressivity of the tax system is a separate problem that 

would have to be resolved for either the cash flow tax or 

the comprehensive income tax. This issue is considered for 

both taxes in chapter 5. 

Cash Flow Accounting 

The central feature of the model tax system is the use 

of cash flow accounting for financial transactions to obtain 

a measure of annual consumption �or any individual or household. The principle involved is very simple. A household 

could use monetary receipts in a year for three purposes:

personal consumption, saving, and gifts. By including -all 

monetary receipts in the tax base, including the entire 

proceeds of sales of assets and gifts received, and allowing

deductions for purchases of assets and gifts given, the 

annual consumption of a household could be measured without 

directly monitoring the purchases of goods and services. 
-- ---- 

-- 

--- 

- 114 -
 

The use of cash flow accounting of financial asset 
 transactions to compute the tax base is illustrated, for an 
 average wage earner, in the following example. Suppose a 
 worker earns $10,000 per year in wages, of which he uses 
 $9,000 for personal consumption and $1,000 for saving.

Under the cash flow tax outlined in this proposal, the 

worker could deduct $1,000 from his $10,000 of wages, if 

he had deposited the $1,000 in a qualified account. 
 

Use of Qualified Accounts. Qualified accounts would be 

e s t a b p financial institutions, which 

would keep records of deposits and withdrawals. The worker's 

$1,000 deposit in the account could be used to purchase any 

type of financial asset -- savings bank deposits, corporate

shases, bonds, mutual funds, or any other claim to current 

or futuse income. The future balance in the qualified 

account would depend, of course, on the profitability of 

his investments. No tax would be assessed against interest, 

dividends, or capital gains as they are earned, but the 

taxpayer would be required to include in his tax base 

the full --withdrawals -

from his qualified

account thatere not =invested in similar accounts. The 
 use of qualified accounts to handE financial transactions 
 would ease the taxpayer's recordkeeping burden and would 
 enable tax authorities to trace the annual flow of funds 
 available for consumption uses. 
 

The qualified accounts described here are very similar 
 to qualified retirement accounts under current law. These 
 accounts include Keogh plans and Individual Retirement 
 Accounts (IRA'S), which provide the taxpayer a current 
 deduction for contributions to funds for retirement and, 
 then, include withdrawals from the fund in the tax base 
 after retirement. There are two major differences between 
 the qualified accounts proposed here and qualified retire­
 ment accounts provided for in the current tax code. First, 

withdrawal of funds from the qualified account would be 

allowed without penalty at any time during a taxpayer's

lifetime. Second, there would be no statutory limit to the 
 amount a taxpayer could contribute to a qualified account. 
 

Thus, in the example above, if the worker deposited

$1,000 in a savings account, his tax would be computed on an 

annual cash flow base of $9,000. I�, in the following year,

he consumed his entire salary of $10,000 and in addition 

withdrew $500 from his savings account to purchase a color 

television set, his cash flow tax base in that year would be 

$10,500. His tax base is geared to the use of his receipts

for consumption, currently or in the future. 
- 115 -

Alternative Treatment of Investments. X? alternative
 way of hanelinq investments that would enable an ineividual 

to alter the timing bur not the expected present value of 

his cash flow tax base would be to include the purchases of 

assets in che tax base, bst to exempt all reruns from 

assets from. tax. To continue the example above, %he worker 

could deposit $1,000 of his $10,000 of annual wages ir. a 

savings Sank, but without usinq a qmlified account. If :?e 

did sc, the entire $10,000 of wagc receipcs woul2 be included 

in his =2x base in the ifiitial year, but acy future interest 

earned 3n the savings deposit and any withdrawal of the 

principal wotld be excluded from the tax base. As will be 

discussed more fully below, rhe expected present value of 

the worker’s lifetime rax base would be the same for either 

method of accounting, if he consumes the proceeds of his 

accounc durino his liferme. 

lnvestments handled in this alternative way would be 

treated very sinply for tax purposes. The amount ir.vested 

would be included in the tax base -- the same as consumption -- but all subsequent returns on the investmect would be 

untaxed. In effect, the tax that would otherwise be due on 

consumption from the .sroceeds of the investment would be 

prepaid at the time the investment is nade. A1lowir.g

taxpajrers the choice of chis alternative way of handlinT 

investncnt accounts has some advancages, but could create 

problercs, which are discussed below. 

?he possibility is discussed of dealinc wiLh these 

nroblcms 3y inzroducinp resrrictions on the types of investmer.:L that may or must be made through qualified accoonts. 

AlthoLqh few restrictions are recommended in the model plan, 

i7 sk.o.Jld be srressed c5az to increase their rurcber or 

szrir.rJency would be 

2f chc cash flov tax ard woulc not alter its most inportant

fully consistent wit:? the basic concept

feat2res. 
 

The remainder of this chapter presents the details a 

nodel 

?he next section points out the tax 

solutions in the model conprehensive

income cax and the model cash flow tax. Then, a seczion is 

devoted to the major differences between the two tax bases, 

including a full dcscriFtion of the cash flow tax treatment 

ck.araczeristics. 
 issues that have cornor. 
 

of investmenc assets and consumer durables. Another section 

discusses the economic consequences of adopting a cash flow 

rax, an8 the final section presents a sample tax calculation 

cash flow tax base and discusses its most important 

form. 
 
-- 

+ 116 -

ELEMENTS IN COMMON WITH THE COMPREHENSIVE INCOME TAX 
 

Several of the issues discussed in the preceding

chapter would be resolved similarly for a cash flow tax. 

These questions include the measurement of consumption 

to be taxed alike in both models -- and the related issue of 

the appropriate treatment of families of varying size and 

circumstances. 

Family Size and Family Status 
 

Under this proposal, the family would be taxed as a 

unit for reasons analogous to those argued in chapter 3. In 

order to assess tax to each family member as an individual, 

it would be necessary to allocate consumption among family

members. This would destroy much of the administrative 

simplicity of the cash flow tax, which rests upon deducting

from receipts certain cash outlays that are usually made on 

behalf of the family as a unit. Receipts are also usually

combined at the family level. The argument that standard of 

Living varies by family size holds for a consumption measure 

of living standard as well as for an income standard. The 

adjustment device in the model cash flow tax plan discussed 

in this chapter -- one exemption per family member -- is 

the same as that proposed for the comprehensive income tax. 

However, differences in the size of the tax base under the 

two taxes might require that the exemption levels be different for model taxes intended to raise the same revenue. 

As in the case of the compsehensive income tax, other 

approaches to the adjustment for family size would be fully

consistent with the cash flow tax base. 

Adjustments that account for differences among families 
 in the number of wage earners and the availability of a 
 full-time adult in the household apply to labor-related 
 earnings and expenses only. They would be just as appropriate,
 therefore, under a consumption tax as under an income tax. 
 The structure of rates required to achieve the desired 
 pattern of progressivity might be different, however. 
 

Deductions for Charitable Contributions, Medical 
 Expenses, and Taxes 
 

Contributions to Charities. As in the case of the 
 comprehensive income tax base, deductions �or charitable 
 contributions would not be allowed under the model cash flow 
 
- 117 -

tax. Conceptually, under a cash flow tax, itemized gifts

should be deductible by the donor and included in the 

receipts of the donee. Following the discussion in chapter

3, including receipts from charities in the tax base of the 

recipient is rejected as impractical. Charity is not 

usually given in cash or in goods that are easy to value,

and sometimes the benefit is to society generally, so that 

beneficiaries cannot be separately identified. Nor should 

the charitable institutions be taxed. They do not consume;

they merely act as intermediaries to distribute the benefits 

to the ultimate recipients. The foregoing suggests that the 

best way to tax consumption resulting from charitable 

activities would be to count charitable contributions as 

consumption by the donor and not to allow a tax deduction. 

In opposition to this proposal, it may be argued that 

tax-free consumption of goods and services provided by

charities should be maintained because these goods and 

services provide a public service function. Proponents of 

this view would argue for either a deduction or some form of 

tax credit for charitable contributions. As noted in chapter

3, however, the decision whether or not to allow the deduction of charitable contributions is not essential to the 

basic integrity of the overall proposal. 

There is one element of the comprehensive income tax 
 discussion of charities that does not apply to a cash flow 
 tax. The undistributed portion of endowment easnings of 
 charitable organizations should not be taxed even if taxation 
 of organizations on the basis of contributions is viewed as 
 feasible and recommended as a general policy. 
 

Medical Expenses. The issues involving medical expenses

and medical insurance are exactly the same for the cash flow 

tax as for the income tax. Consequently, the same policy

options are prescribed for both model taxes. 
 

State and Local Income Taxes. The model cash flow tax 
 treatment of State and Local taxes also would be the same as 

that under the model accretion tax: income taxes would be 

fully deductible because they are not regarded as part of 

consumption. Other taxes would not be deductible, except as 

business expenses. 

Property Taxes. No property tax deduction would be 

allowed to homeowners under either of the model taxes. The 

rationale for denying deduction of the property tax for 
-- 

-- 

- 118 -

owner-occupied homes is, however, somewhat different in the 

case of the cash flow tax. The cash flow tax would measure 

the owner's consumption of housing services as the purchase

price (or capital value) of the dwelling. In a market 

equilibrium, this price is the present value of the prospective stream of imputed rents less current costs. These 

costs include property taxes. Therefore, a higher local 

property tax, if uncompensated by services to the property,

would result in a lower market price of the dwelling. In 

this way, the property tax is excluded from the base of the 

cash flow tax without an explicit deduction. 

~ 

Those types of insurance that are purchased for a 1-

year term and pay benefits directly t'o the insured -- health, 

disability, and unemployment insurance are no different 

in concept or model tax treatment under the cash flow tax 

than under the accretion tax. They are included in the 

definition of consumption. The differences in treatment 

among them -- taxation of benefits in the case of disability

and unemployment, and of premiums for health insurance 

are explained in the preceding chapter. The model tax 

treatment is the same for each of these items whether the 

insurance is public or private, employer-paid or employeepaid. However, life, casualty, and old-age insurance do 

present differences in concept under the consumption tax and 

will be discussed below. 

Casualty Losses 
 

Casualty losses would not be deductible under the model 

comprehensive income tax or under the cash flow tax. Again,

however, the rationale for not allowing the deduction under 

the cash flow tax is slightly different. Under the cash 

flow tax, changes in net worth would not be included in the 

tax base, and, therefore, reductions in net worth, in 

general, should not be deducted. Further, as explained

below, all taxation for the consumption of consumer durables 

would be prepaid at the time of purchase, and subsequent

sales of consumer durables, at whatever price, would not be 

included in the tax base. Following the same reasoning, the 

premiums for casualty insurance would -not be deductible

under the cash flow tax proposal, and the proceeds would be 
 excluded from the tax base. 
 
- 119 -

DIFFERENCES BETWEEN THE CASH FLOW TAX AND THE COMPREHENSIVE 

INCOME TAX 

The major difference between the cash flow tax outlined 

here and the comprehensive income tax presented in chapter 

3 follows directly from the definition of the two bases. 

Under the cash flow system, changes in net worth would not 

be included in the tax base, but the comprehensive income 

tax would attempt to include all changes in net worth to the 

extent administratively feasible. Thus, the cash flow tax 

and the income tax differ in their treatment of purchases of 

assets and returns from asset ownership. Specifically, the 

two taxes differ most in the handling of corporate profits,

income from unincorporated business, capital gains, interest 

received on savings and interest paid on loans, rental 

income, income accrued in retirement plans and life insurance, 

and casualty losses. 

The first part of this section discusses in some detail 

the treatment of investment assets and consumer durable6 

under the cash flow tax proposal. In the second part, 

a comparison is made between specific provisions of the 

model comprehensive income tax and the handling of corresponding items under the model cash flow tax. 

The Treatment of Assets under a Cash Flow Tax 
 

The cash flow tax would greatly simplify tax accounting

and tax administration regarding real and financial assets. 

Accounts to determine capital gains, depreciation, and 

inventories -- among the most complex necessitated by the 

current tax code -- would no longer be required. For many

individuals, no accounting would be necessary for asset 

purchases nor for receipts associated with asset ownership.

For other taxpayers, simple annual cash flow data would 

provide all the necessary information for computing tax 

liability. The taxpayer would merely recosd the net annual 

deposits ox withdrawals from qualified accounts. Accounting

for the cash flow tax would rest solely on marketplace

transactions for the current year, thus minimizing the need 

for long-term recordkeeping. 

Family-Owned Businesses. The simplicity of cash flow 

tax accounting is best illustrated by the model tax treatment of a family-owned business. All cash in-flows would be 

counted as receipts. Cash outlays that represent business 

expenses -- including all purchases o� equipment, structures, 
-- 

- 120 -

and inventories -- would be deducted from receipts; that is, 

instantaneous depreciation for tax purposes would be allowed 

on all investments regardless of the durability of the asset 

purchased. The difference between receipts and cash outlays

would be included in the individual's tax base. If cash 

outlays exceed business receipts in any year, the difference 

would reduce receipts from other sources. 

For example, suppose a family derived all its receipts

from a family-owned grocery store. To compute its tax base, 

the family would add up all cash receipts from sales and 

subtract from this amount all business outlays, including 

payments to employees and cash outlays for electricity, rent 

payments for the store, purchases of machinery, and purchases

of inventories. These would be the only calculations the 

family would make to determine its tax base under the cash 

flow tax. No data on capital gains or depreciation would be 

required to determine taxable receipts. 

Financial Assets. Financial assets, including stocks, 

bonds, and savings deposits, owned by taxpayers via qualified 

accounts would be recorded for tax-purposesin the same way 

as annual purchases and sales associated with a family-owned

business. All deposits for purchases of assets would be 

deducted from other receipts in computing the tax base. All 

withdrawals, whether arising from dividends, interest, or 

asset sales, would be included in the 'tax base. NO distinction 

would have to be made between the gain from sale of an asset 

and the return of capital invested. 

For example, suppose an individual deposits $100 in a 

qualified savings bank account, where it earns 10 percent

annual interest. In the year he makes the $100 deposit, he 

would be allowed to deduct $100 from current receipts in 

computing his tax base. If, in the following year, he 

withdraws the principal plus earned interest -- now equal 

to $110 the amount withdrawn would be added to receipts

from other sources in computing the tax base. If, instead, 

the savings deposit were left in the bank to accumulate 

interest, there would be no current tax consequences. Any

future withdrawal would add to taxable receipts in the year

it is made. 

Deductions for the purchase of assets would be allowed 

only if the purchase were made through a qualified account. 

This device would offer a simple way to insure compliance

with the cash flow tax. Individuals would be permitted to 
- 121 -

keep qualified accounts with savings banks, corporations,

stockbrokers, and many other types of financial institutions. 

The net amount of deposits in, and withdrawals from, qualified 

accounts during the year would be reported by the institution to both the taxpayer and tax authorities. The present

dividend-reporting requirements for corporations may be 

viewed as a model for the way financial institutions would 

report net withdrawals and deposits from qualified accounts 

for the cash flow tax. 

The tax base of an individual would include the sum of 
 net withdrawals from all qualified accounts. If deposits
 exceeded withdrawals, the excess would be subtracted from 

other receipts in computing the tax base. The sale of one 

asset out of a qualified account and subsequent purchase in 

the same year of another asset of equal dollar value would 
 have no net tax consequences if the new asset were also 
 purchased in a qualified account. 
 

Consumer Durables. It is technically feasible, but 

practically unattractive, to apply the cash flow concepts 

just described to the purchase of consumer durables. Unlike 

financial assets, consumer durables such as automobiles, 

houses, and major home appliances, all yield flows of 

services to the owners that are not measured by annual 

monetary payments. Thus, to allow a deduction for consumer 

durable purchases and then to include only future monetary

receipts in the tax base would amount to excluding from the 

tax base the value of consumption services yielded by

durable goods. Because it is difficult to determine the 

annual value of the use of consumer durables the same concepts

used for financial assets cannot be easily applied. 

For example, suppose an individual purchased an automobile for $4,000 and sold it for $2,000 3 years later. If 

a deduction were allowed for the purchase and, then, the 

sale value included in receipts, the individual's total tax 

liability would be lowered by owning the automobile. 

However, the individual would have expended $2,000 plus some 

foregone interest for the consumption services of the 

automobile over the 3-year period. The depreciation and 

foregone interest measure the cost of the consumption

services and should be included in the tax base. If the 

automobile were taxed the same way as an asset in a qualified 

account, this consumption value would escape the tax. 
- 122 -

To assure that the entire consumption value is included 

in the tax base, the appropriate treatment of consumer 

durables is to allow no deduction on purchase and to exclude 

sales receipts from the tax base. In other words, purchase

of a consumer durable would be treated the same way as 

current consumption of goods and services. The reason for 

this approach is that the price paid for a consumer durable 

should reflect the present value of future services the 

buyer expects to receive. Including the value of durable 

goods in the tax base at the time of purchase produces, in 

effect, a prepayment of the tax on the value of future 

consumption services. 

According to this treatment, the $4,000 for the purchase

of the automobile would not be deducted from the tax base. 

Similarly, the $2,000 from sales of the automobile 3 years

later would not be included in the tax base. Thus, if an 

individual sold a used car and bought another used car for 

the same price, or used the proceeds for current consumption,

there would be no tax consequences. If he sold a used car 

for $2,000 and invested the proceeds in a gualified asset,

he would deduct $2,000 from his tax base in the year of the 

transaction, 

In summary, the purchase of a durable good would be 

treated as present consumption even though the good yields

consumption services over time. The reason for this approach is that the price of the good reflects the expected 

present value of its future stream of services. Measuring

annual service flows directly would require the measurement 

of annual depreciation and annual imputed rent on the value 

of the asset. This would introduce unwanted and unnecessary

complexity into the cash flow tax system. 

Checking Accounts. Deductions should also be derived 

for purchases of certain types of financial assets that 

yield their primary benefits in the form of services received,

rather than monetary returns. For example, non-interestbearing demand deposits provide services .fordepositors in 

place of interest. Deductions, thesefore, should not be 

allowed for deposits in checking accounts, and withdrawals 

from checking accounts should Inot be included in the tax 

base. That is, checking accounts should not be qualified 

accounts. 
-- 

- 123 -

Equivalence of Qualified Account Treatment and Tax Prepayment 

Approach 

The equivalence noted above between the purchase price

of a consumer durable good and the present value of its 

expected future services suggests an analogous equivalence

between the price of a business or financial asset and the 

present value of its expected future stream of returns. 

This equivalence can best be illustrated by a simple example.

Suppose an individual deposits $100 in a savings account at 

10 percent interest in yeas 1. In year 2, he withdraws the 

$100 deposit plus $10 earned interest and uses it to buy

consumption goods. 

Qualified Accounts Treatment. If the savings account 

is a qualified account, the individual would reduce his tax 

base by $100 in year 1 and raise it by $110 when he withdraws his funds from the account in year 2. At an interest 

rate of 10 percent, the discounted present value in year 1 

of his secondyyear tax base would be $llO/l.lO, or $100. 

Tax Prepayment Approach. Now, suppose instead that the 

savings account is not a qualified account. In this case, 

the individual is not allowed a deduction for the deposit

and is not taxed on interest earned or on funds withdrawn in 

year 2. The discounted present value of his tax base would 

be the same in this case as under the cash flow rules 

initially presented. The tax base in year 1 would be $100 

higher, and the discounted present value of the tax base in 

year 2 would be $100 lower, than if a qualified account were 

used. In other words, allowing a deduction for purchases of 

assets and taxing withdrawals the qualified accounts 

treatment --is equivalent to allowing no deduction for the 

asset purchase and exempting all interest earnings from 

tax -- the “tax prepayment” approach. 

The consequences to the government of the two ways of 

taxing the purchase of assets would also be the same in 

present value terms. If the individual bought the asset 

through a qualified account, the Government would collect 

revenue on a tax base of $110 in year 2. If the interest 

were exempt from tax, and no deduction for the asset purchase

allowed, the government would collect revenue on a tax base 

of $100 in year 1. This revenue would grow to $110 by year 

2 at 10 percent interest. Ignoring possible variations in 

average tax rates, the government would be left with the 

same revenue at the end of year 2 in both cases. 
- 124 -
 

The example above suggests that all assets may be 

treated according to the tax prepayment method for required 

consumer durables. Asset purchases would not -be deducted 

from the tax base, and all earnings from assets and sales of 

assets would not be included in the tax base. Thus, for 

assets not purchased through qualified accounts, it would 

not be necessary to keep any records for tax purposes. The 

expected present value of the tax base would be the same for 

both methods of tax treatment of assets, although the 

timing of payments would be different. Both methods of tax 

treatment of assets are consistent with a cash flow approach 

to taxation. 

It is worth repeating that allowing an alternative 

treatment of financial assets outside of qualified accounts, 

tax prepayment, is not essential to the integrity of the 

proposal, but it would provide convenience and some other 

advantages. In the cash flow proposal presented in this 

study, purchases of financial assets except for investments 

in a family business or closely held corporation, would be 

allowed to have tax-free returns if the investment were not 

deducted. Alternative rules are possible: (I) to require all 

asset purchases, except for consumer durables, to be made 

through qualified accounts: or (2) to continue to tax returns 

from assets purchased outside of qualified accounts (i.e.,

dividends, interest, rental income, capital gains) as they

would be taxed under either a comprehensive income base 

(described in chapter 3) or under the current tax law. The 

current taxation of returns would strongly encourage, but 

not require, taxpayers to purchase income-earning assets 

through qualified accounts. Otherwise, the present value of 

tax liability would ordinarily be higher and recordkeeping

and tax accounting more costly. 

Treatment of Borrowing and Lending 

The equivalence between the amount invested in an asset 

and the expected present value of returns also permits two 

alternative ways of treating loan transactions. Normally,

under cash flow accounting, receipts from a loan would be 

handled through qualified accounts. An individual would be 

required to report the loan proceeds in his tax base in the 

initial year. (Of course, if he used the loan proceeds to 

purchase investment assets through a qualified account in 

the same tax year, there would be no net tax consequence.)

Subsequent interest and principal payments would then be 
- 125 -

deductible from the tax base in the following years. If the 

individual sold assets that had been purchased through

qualified accounts in an amount just sufficient to pay the 

loan interest and principal, the net tax consequence would, 

again, be zero. On the other hand, if the loan were taken 

outside a qualified account, proceeds of the loan would -not 

be included in the tax base, and repayments of interest and 

principal would -not be deductible. Note, again, that the 

present value of the tax liability would be the same in 

either case. The discounted value of future interest and 

principal payments on a loan would be equal to the current 

proceeds of the loan. 

and Borrowing 

There are significant advantages to a flexible cash 

flow tax that allows a taxpayer to chose, subject to certain 

limits, whether or not to use qualified accounts to make 

financial transactions. 

averaging of Consumption. One advantage is the potential

for eveninq out over time larqe outlays that are made 

irregularl;, such as the purchase of a house or an automobile, 

or payment for college. According to the rules suggested

above, cash outlays for consumer durables would not be 

deductible, so that borrowing via a qualified account would 

produce taxable receipts for which there would be no immediate 

offset. In buying a home, an individual probably would wish 

to borrow outside a qualified account. Otherwise he would 

pay tax on the entire mortgage in the year of the purchase.

If the loan were not obtained through a qualified account,

the proceeds of the loan would not be included in the tax 

base, but future principal and interest payments would not 

be deductible. Thus, tax liabilities from consumption of 

the good financed by such a loan would be spread out over 

the period of repayment, as the taxpayer used receipts from 

other sources, such as current wages, to pay the loan 

interest and principal. 

The existence of alternative ways of treating financial 

assets and loans for tax purposes would give individuals 

considerable flexibility in the timing of their tax liabilities. 

This feature of the cash flow tax is desirable because it 

would minimize the need for special averaging provisions.

Averaging is desirable because increasing marginal rates 

would be applied to increases in the tax base for any single 

year. 
- 126 -

With increasing marginal rates, an individual with a 

tax base of $10,000 in year 1 and $30,000 in year 2 will pay

higher taxes than an individual with a tax base of $20,000 

in both years. Whether the tax base is comprehensive income 

or consumption, it is hard to see why the first individual 

should be considered to be in a better position to pay taxes 

than the other. 

An example of the optional use of qualified accounts 

for the purpose of averaging consumption is the following:

Suppose an individual purchased a $40,000 house, on which 

the bank-made available a $30,000 mortgage. If the individual chose not to include the loan proceeds from the 

$30,000 mortgage in his tax base, he could not deduct 

mortgage payments in future years. In effect, the individual could pay the principal and interest on the mortaage 

every year out of current receipts from other sources. The 

receipts used for the annual mortgage payments would be 

included in the tax base. Thus, the tax base on the mortgage

could be made to approximate the schedule of mortgage 

payments on the house. 

This leaves the problem of the'down payment. The 

$10,000 used for the down payment, if withdrawn from a 

qualified account, would be included in entirety in the tax 

base in the year the house was purchased. The individual, 

if he had foreseen buying a house, could have avoided this 

problem by saving outside the qualified account. The money

devoted to acquiring these financial assets would have been 

included in the tax base every year but, the tax having been 

prepaid, the lump sum withdrawal would not be subject to 

tax. These savings could then be transferred to the purchase

of equity in housing. The prepayment of taxes would continue to apply to the stream of consumption services from 

housing, as it did to the yield from financial assets. 

In most other cases, individuals would probably want to 

save in qualified accounts for averaging purposes. Most 

people save during their most productive years, when income 

is highest. The savings are used to finance consumption

after retirement. By saving in qualified accounts, an 

individual could reduce his tax liability in the years when 

his income is high relative to consumption, and raise it in 

the future when income is low. On the other hand, saving

outside of qualified accounts might be an individual's best 

strategy when he anticipates large consumption expenditures 
-- 

-- 

- 127 -

such as a down payment for a house or college expenses. To 

the extent that the taxpayer remains in the same tax bracket 

for substantial variations in his tax base, the choice among 

types of accounts for reasons of averaging would be unnecessary. 

Privacy. A second advantage of allowing optional 

treatment of asset purchases is that taxpayers would not be 

compelled to make 211 financial investments through a thirdparty broker. The existence of assets not monitored by

third parties, or by the government, would allow a person 

to maintain the privacy of his accounts without changing the 

present value of his tax base. 

Equality of Treatment Among Asset Types. A third 

advantaae of allowina oDtional treatment for financial.. 

assets is that it would give investors in sLch assets the 
 same opportunities available to investors in consumer 
 durables. For both types of investments the initial and 

subsequent amounts would not be deductible and all returns, 

including sale of the asset, would not be subject to tax. 

Lifetime Perspective of the Cash Flow Tax 

At this point, it is worth emphasizing again the lifetime perspective of the cash flow tax system. The flexibility of asset treatment and the use of individual 

discretion over _ _ any 1 year's tax liability would allow both 

postponement and advancement of tax Liabilities. By allowing

individuals to avoid taxes totally in some years by judicious 

rearrangement of asset purchases, these provisions might 

appear to provide a tax loophole. However, this loophole is 

apparent only -- any reduction in tax base must be matched 

by a future tax base increase of equal present value. There 

could be no advantage to defersal if interest earnings were 

Positive. Furthermore. because of uroaressive tax rates, 

it -would be to the advantage of tax a ers to ato

average I_--­tGir tax base over time+taxpayer ~wou1d 

have an incentive to Dav some tax every -_ war. even thouah- the means to postpone-the tax is available. . 

An Example. To see how an individual could use the 

system to avoid taxes in a given year, and why it would not 

be to his advantage, consider this example. Suppose a 

workes earned $20,000 per year and accumulated wealth equal 

to $20,000 by saving outside a qualified account. In anather 

year, he deposits the entire $20,000 in a qualified account,

deducting the deposit from his wages. He would then report 
- 128 -

taxable receipts of zero in that year and, thereby, succeed 

in "sheltering" his consumption. (Less than $20,000 would 

need to be switched to a qualified account if there are 

personal exemptions.) However, this way of managing his 

financial portfolio probably would increase, rather than 

decrease, the present value of his tax payments over his 

lifetime. 

This point can be illustrated by showing that taking 

part of the 420,000 deduction in either a previous or future 

year, would yield tax savings. For example, suppose he 

deposited only $19,000 in a qualified account in the year in 

question, deducting the additional $1,000 by depositing it 

in a qualified account on the first day of the following 

year. With increasing marginal tax rates, the increased tax 

liability from increasing the tax base from zero to $1,000

in the current year will be much smaller than the reduction 

in tax liability from the slightly greater than $1,000

reduction in tax base in the following year, when taxable 

consumption is much higher. 

Alternatively, the individual might have taken a $1,000 

deduction by depositing money in a qualified account in the 

last day of the previous year, leaving only $19,000 in 

assets outside qualified accounts in the year in question.

Again, the increased tax liability from a $1,000 increase in 

tax base in the year in question would be smaller than the 

reduced tax liability from a $1,000 reduction in tax base 

through taking the deduction in the previous year, when 

taxable consumption is much greater than zero. 

Thus, with increasing marginal rates, the taxpayer who 

uses the asset flexibility features of the model cash flow 

tax to acquire a year of tax-free consumption pays for that 

privilege. The present value of his tax liability would be 

increased in either prior or future years by an amount 

greater than the present value of tax saving in the "taxfree" year. 

Uncertain Outcomes: A Problem with the Tax-Prepayment Approach 

accounts is that some larqe qains would go untaxed. When an 

asset has been purchased through a qualified account, the 

government could be viewed as participating in the investment, 
- 129 -

by allowing a tax deduction, and also participating in the 

return on the investment, by taxing the gross proceeds. For 

assets purchased outside of qualified accounts, however, the 

investment would not be deducted and the entire proceeds of 

the investment could be liquidated for consumption purposes

tax-free. 

If taxes were proportional, the after-tax rate of return 

would be the same in both cases. With qualified accounts,

the Government in a sense would be a partner in the investment, sharing in the cost and appropriating a fraction of 

the return. When the tax is prepaid, however, the Government "share" in the returns would be zero. For assets 

bought outside of qualified accounts, large winners would 

not pay a higher tax and losers would not receive a loss 

offset. Although both types of tax treatment would allow 

investors equal opportunity to earn after-tax dollars, the 

tax treatment of assets purchased outside of qualified 

accounts would not distinguish between winners and losers of 

investment gambles. Thus, lucky investors might become very

rich and owe no additional tax liability on future consumption

of their wealth, if the initial investment were tax prepaid.

Conversely, unlucky investors will have prepaid a tax on 

expected returns and will then obtain no deduction for the 

losses they incur. 

A second potential problem with tax-prepayment of 

returns from assets would arise if tax rates were subsequently increased sharply -- for example, to finance a war. 

In that case, individuals who had prepaid tax on assets at 

the lower rates would escape taxation at the higher rates 

even if they were using the proceeds of profitable inves'cments to finance current consumption. Of course, in making

the tax-prepaid investments, those individuals ran the risk 

that tax rates might have been lowered, in which case they

would have reduced their tax liability by buying assets 

through a qualified account. 

It may be viewed as desirable in view of these problems 

to modify the current proposal by restricting, or even 

eliminating, the provision for purchase of income-earning 

assets outside of qualified accounts. One possible compromise

would be to force all "speculative'' investments, i.e., land,

stocks, etc., to be purchased through qualified accounts but 

to allow the tax-prepayment option for fixed interest 

securities and savings deposits. 
- 130 -

Consumer Durables. A similar problem would exist for 

consumer durables. Because consumer durables could not be 

purchased using qualified accounts, unanticipated increases 

in the value of consumer durables would be untaxed and 

there would be no tax offset for unanticipated losses. For 

example, if the value of an individual’s house doubled in a 

year, his tax liability would not be affected. The option

of requiring qualified-account treatment is not available 

here, as it is in the case of financial assets, because of 

the difficulty of measuring the value of the consumption

services these assets provide. 

No Optimal Treatment for Nonfinancial Business Assets 

As explained above, investments in individual businesses 

would be eligible only for tax treatment on a current cash 

flow basis. All outlays for the business would be eligible

for deduction, while all net receipts would be subject to 

tax. The reason for not allowing the alternative “taxprepayment” treatment is that it is sometimes difficult to 

distinguish between the profits and wages of individual 

businessmen. If profit alone were exempted from tax, the 

businessman would have an incentive to avoid tax on the 

value of his labor services by paying himself a low wage and 

calling the difference return from investment. This problem

would exist for individual proprietorships and possibly for 

small partnerships and closely held corporations. For such 

enterprises, all net receipts should be taxable and outlays

for capital goods should be eligible for immediate deduction. 

Table 1 below summarizes the proposed rules for tax 

treatment of financial assets, durable goods, loans, and 

family business enterprises. Note that the only restrictions 

are that all investments in a family business must be treated 

as if they were purchased in qualified accounts and consumer 

durable goods could not be purchased through qualified 

accounts. Financial assets could be purchased, and loans 

obtained, either through qualified accounts or outside of 

the system. 
Summary: 
 

1. 	 Financial 
 

Assets 
 

2. 	 Durable . 

Goods 

3. Loans 

4. 	 Family 

Business* 

- 131 -

Table 1 
 

Tax Treatment of Assets Under Cash Flow Tax 

Qualified Accounts Accounts Outside of System 
 

purchases deductible; purchases not deductible; 
 

all withdrawals of interest and return of 
 

earnings and principal capital not taxed 
 

taxed 
 

not available 	 purchases not deductible; 
 

sales not included in tax 
 

base 

receipts in tax base; receipts not in tax base; 
 

repayments deductible repayments not deductible 
 

all outlays deductible, not available 
 

including capital 
 

outlays; all receipts 
 

taxed 
 

* Includes a limited class of small businesses owned and 

operated by the same person(s). 

DIFFERENCES BETWEEN CASH FLOW AND COMPREHENSIVE INCOME 

TAXES: SPECIFIC PROVISIONS 

Pension Plans and Social Security 
 

Under the cash flow tax, all contributions to pension

plans may be viewed as aontributions to qualified accounts, 

whether by the employee or by the employer. By this logic,

contributions would not be included in the tax base, while 

retirement benefits would be included in full. Similarly,

all contributions for social Security would be excluded 

from the tax base, while all Social Security retirement 

benefits would be taxable. There would be no need, under 

the cash flow tax, to compute the income on pension funds 

attributable to individual employees because the accumulation 

would not be subject to tax. 

Life Insurance 
 

Both term life insurance and whale life insurance would 
 be treated differently under the cash flow tax than under 
 the comprehensive income tax. 
 
- 132 -
 

With term life insurance, there is no investment 
 income and, thus, no expected change in net worth. Under 
 the comprehensive income tax proposal, premiums for term 
 life insurance, whether paid by the employer or the employee,
 would be included in the insured's tax base, while proceeds

from term life insurance policies would be tax-exempt. The 

general principle of treatment of gifts under a cash flow, 

or consumption, base tax argues for a different treatment. 

Term life insurance may be viewed as a wealth transfer from 

the policyholder to the beneficiary. Purchase of a term 
 life insurance policy lowers the lifetime consumption of the 
 policyholder and raises the expected lifetime consumption of 

the beneficiary. Thus, a cash flow tax that taxes consumption of individuals should not tax premiums paid by the 
 policyholder but should include proceeds from a term life 
 insurance policy in the tax base of the beneficiary. In 
 practice, this would mean that employer contributions to 
 term life insurance would not be imputed to the tax base of 
 the policyholder, while term life insurance premiums paid
 directly by the policyholder would be deductible. 
 

Whole life insurance poses a different issue, although

it would receive the same treatment as term insurance under 

the cash flow tax. A whole life insurance policy does 

provide investment income to the policyholder in the form of 

an option to continue to buy insurance at the premium level 

appropriate for the initial year. Under a cash flow tax, 

unlike the comprehensive income tax, the increase in the 

value of the option would not need to be computed for tax 

purposes because it would represent a change in net worth 

and not in consumption. However, if the individual cashed 

in the option value, the receipts from this transaction 

would be included in the cash flow tax base. 

Under the model cash flow tax, all premiums paid by

policyholders for whole life insurance would be tax deductible, while premiums paid by employers for policyholders

would not be imputed to policyholders' tax bases. All 

receipts from life insurance policies, whether in the form 

of cash surrender value to policyholder or proceeds to 

beneficiaries, would be included in the tax base of the 

recipient. 
- 133 -

State and Local Bond Interest 
 

Under the model cash flow tax, State and local bond 

interest for securities not purchased through a qualified 

account would remain tax-exempt, as under the present law. 

However, as with the comprehensive income tax proposal,

State and local bonds would lose their special status 

relative to other assets. Under the comprehensive income 

tax, these bonds would lose their special status because 

their interest would become taxable. Under the cash flow 

tax, the bonds would lose their special status because 

returns from all other assets would also become tax-exempt. 

If State and local bonds were purchased through a 

qualified account, all contributions to the account would be 

deductible from the cash flow tax and all withdrawals from 

the account would be subject to tax. Thus, the purchase

price of a State or local bond would be deductible, while 

withdrawals of interest payments and principal from the bond 

to pay for consumption would be subject to tax. 

Interest Paid 
 

Under the comprehensive income tax, all interest paid

would be tax deductible because such outlays represent

neither consumption nor additions to net worth. This would 

include interest payments for mortgages on owner-occupied

homes. Under the cash flow tax, however, if a loan were 

taken through a qualified account, the initial proceeds of 

the loan would be taxable, while subsequent interest and 

principal repayments would be tax deductible. In preseatvalue terms, the net effect of a loan on the tax base would 

be zero. 

Corporate Income 
 

Corporations would not be taxed as entities under 

either the cash flow tax or the comprehensive income tax. 

However, under the cash flow tax, there would be no need to 

impute undistributed income to individuals because taxes 

would be assessed only on funds available for personal

consumption. Consequently, a single cash flow tax applied 

at the household level could be accomplished without the 

rules for integrating corporate and household accounts that 

are conspicuous features of the model income tax. 
- 134 -
 

The treatment of returns from corporate activity under 

the cash flow tax would be exactly the same as the treatment 

of returns from other kinds of investments. These would be 

no separate tax at the corporation level. Individuals would 

be permitted to purchase corporate stock through qualified 

accounts held with brokers. The initial purchase price

would be deductible �rom the tax base at the tima of purchase, 

and subsequent withdrawals from the account as dividends 

received, return of capital, or proceeds from the sale of 

stock would be added alike to the tax base. For stock 

purchased outside of a qualified account, no deduction would 

be allowed for purchases, and neither dividends nor proceeds 

of future sales.would be added to the tax base, Capital gains and capital losses would, therefore, have no tax 

consequences. 
 

CaDital Gains and Losses 

Under the cash flow tax, there would be no need to keep

records of the baais of asset purchases to compute capital 

gains. As explained above, when assets are purchased outside 

of qualified accounts, capital gains would be exempt from 

tax and capital lasses would not be deductible. If assets 

are purchased within qualified accounts so that a deduction 

may be taken for the initial purchase price, no distinction 

would be made betveen the part of the sale that represented

capital gain and the part of the sale that represented 

return of basis. In this latter case, the full amount of 

the sales proceeds, if not reinvested, becmes part of the 

tax base. The size of the capital gain would affect the 

amount of withdrawals for future cunsumption& Hencer when 

qualified accounts are used, the size of capital gains would 

have tax consequences even though no explicit calculation 

of gains (or losses) is necessary. 

Because the cash flow tax does not tax accumulatiun, 

the issues of deferral, inflation adjustment, and the appropriate rate of tax on capital gains need not be considered, 

as they were in the discussion of a comprehensive income 

tax. The concept of deferral of tax would be relevant for 

the cash flaw tax only if me could pastpane without hterest 

the tax liability associated with current consumption.

Similarly, the value o� assets or changes in the value of 

assets, whether related to general inflation or not, would 

not be relevant for the cash flow tax until they are withdrawn to finance consumption+ 
- 135 -

Business Income Accounting 
 

Income accounting for any individual's business under 

the cash flow tax would be strictly on a cash accounting

basis. The individual would have to compute in any year net 

receipts from operating the business. To perform this 

computation, he would add to the sale of goods and services 

during the accounting year any receipts from borrowing and 

would subtract the purchases of goods and services from 

other firms, wages paid to employees, interest paid to 

suppliers of debt finance, and all purchases of plant and 

equipment. Net receipts calculated by this method would be 

included in the individual's tax base, if positive, and 

would be deducted, if negative. 

Note that the major difference between the cash flow 

tax and the comprehensive income tax with respect to business 

accounting is the treatment of assets. Under the cash flow 
 tax, purchases of assets would entitle the businessman to an 
 immediate deduction for the amount of purchase. Under the 
 comprehensive income tax, deductions each year would be 
 limited to a capital consumption allowance (depreciation),
 which estimate5 the loss in value during the year of those 

assets. 

Also, business loans would be treated differently

under the cash flow tax. All receipts of loans to a business 

would be included in the base, while interest and amorti­
 zation payments would be deductible. Under the Comprehensive
 income tax, loan receipts and amortization payments would 
 have no tax consequences; only the intexest payments would 
 be deductible. When the proceeds of the loan are used 

immediately to purchase materials or services �or the 

business, the deduction allowed under the cash flow tax 

just matches the addition of loan proceeds to the base. 
 

For partnerships, the rules are simpler. A partnership

would be required t~ report the annual cash contribution of 

each owner to the business and the annual distribution to 

each owner. The difference between distributions from 

partnerships and net contributions to partnerships would 

enter the individual owner's tax base. If the ownex sold 

his shares, it would enter the tax base as a negative

contribution. 
- 136 

SPECIAL PROBL'EMS: PROGBESSIVITY, WEALTH DISTRIBUTION, 

AND WEALTH TAXES 

The cash flow tax outlined in this proposal would tax 

consumption but not individual accumulation of assets. 

People are likely to conclude that such a tax would be 

regressive and that it would encourage excessive concentration of wealth and economic power. This section examines 

both these concerns, showing that concern about regressivity

is a misconception and suggesting that the cash flow tax 

could be complemented in any desired degree by a trnnsTer 

tax to influence wealth distribution. The complexities in 

the tax treatment of transfers at death caused by the 

existence of two kinds of financial assets are discussed 

below and some potential solutions are proposed, 

Proaressivitv of the Tax 

Exemption of Capital Earnings, The assertion that a 

consuhption base tax is resressive stems ffom the fact that 

wealth-is concentrated amon6 relatively few housaholds as 

compared to labor earnings. Because the cash flow tax is 

equivalent in present-value terms to exemption of earnings 

from capital, it would necessarily tax labor earnings mote 

heavily to raise the same revenue. Thus, it might appear

that the cash flow tax is a way of shifting the tax buraen 

to the wage-earner class and relieving the wealthy taxpayer. 

Such criticism a� the cash fhw tax may be superficially

plausible but it is misleading on several grounds. First, 

much of what is generally labeled capital. income is really 

a reward for postponing immediate consumption of past wages. 

Laborers as a class do not necessarily lose when the tax 

rate applied to wages immediately consumed is raised to 

enable forgiveness of taxes on the returns for saving out 

of wages. Second, the only other source of funds for 

investment aside from wages is transfers received (including

inheritances), and these would be subject to tax at the 

same rate schedule applied to labor earnings under the 

cash flow tax. (This point is elaborated below.) Finally,

the progressivity of any individual tax is to a large

degree determined by the rate structure. The choice between 

a comprehensive incurnne and a consumption base is independent

o� the degree of vertical progressivity of the rate structure. 
- 137 -

Transfers of Wealth. The mechanism by which aifts and 

inheritances would be included in the tax base is simple.

In order to be eligible for deduction by the donor, all 

gifts would have to be included in the tax base of the 

recipient. Gifts would be recorded only if they were 

transfers between taxable entities. Thus, a gift of a 

father to his 9-year-old son would not be included in the 

family’s taxable receipts (unless it were removed from a 

qualified account). When the son left the family unit, say

when he turned 26, he would become a separate taxpayer. At 

that point, all accumulated wealth from past gifts and 

inheritances would be included in his initial tax base and 

deducted from the family‘s base. If the initial base were 

large, the individual would have an incentive to purchase a 

qualified account to avoid a steep progressive tax, but 

would have to pay tax on subsequent withdrawals for consumption out of that account. Thus, an individual would not - have the opportunity to realize tax-free consumption from 
 a past inheritance. 
 

Similarly, if the family’s deduction for transfers to 
 the son were Large, the family would have an incentive to 
 withdraw assets from a qualified account and treat such 
 assets thereafter as held outside a qualified account. The 
 family need suffer no adverse tax consequence, thereby. 
 

The taxation of gifts and accessions to the donee and 
 the deduction of itemized gifts by the donor are a logical,
 integral part of the cash flow tax system necessary to 
 assure that the tax base is related to the lifetime con­
 sumption of every individual. 
 

To see how inheritances would be included in the tax 

base of a cash flow tax, consider the following example.

Suppose a man died on January 2, 1977 at the age of 70, 

leaving $300,000 in qualified accounts to his 35-year-old 

son, The tax base of the decedent in 1977 included a 

$3D0,00D withdrawal from the qualified account in receipts

and a $300,000 deduction for the bequest of funds, for a net 

tax base of zero. The tax base of the son included the 

receipt of $300,000. With progressive rates, it is likely

that the son would wish to deposit a large part of the 

$300,000 in a qualified account, paying tax only as the 

money was withdrawn for consumption. 
- 138 -
 

A difficulty would arise if the $300,000 of the decedent, or a fraction thereof, were held outside a qualified 

account. while the tax treatment of the recipient's

inheritance would be the same ($300,000of receipts), the 
 estate of the decedent has a large deduction, possibly with 
 no current tax base to offset. The estate might then be 

entitled to a tax refund before the estate were divided up.

This treatment would be appropriate because the decedent 
 had, in effect, prepaid tax for consumption of the proceeds
 of the investment that was never consumed in his lifetime. 

However, an amount, or rate, of refund must be specified.

One possibility would be to allow a refund to the estate 

equal to the value of investment assets outside of qualified 

accounts multiplied by the rate applicable to the lowest tax 

bracket. An alternative solution would be to give no refund 

at all. The inability to consume expected proceeds of a 

tax-prepaid investment because of death may be viewed as one of 

the risks an individual knowingly undertakes when he invests 
 in a tax-prepaid asset. This treatment would also provide
 further incentive �or investments to be made through qualified 

accounts. 

If initial financial endowments and receipts of transfers 

are included in the tax base, there would be no difference 

in tax treatment between an individual who invests an 

inheritance and one who invests his savings out of wages.

Neither would have any additional tax until he consumes the 

amount invested or the earnings. In effect, earnings from 

investment could be viewed as a reward for deferring consumption from wage income or inheritance. If the rate structure 

were appropriately progressive, so that the high-wage 

earners with large accessions would be paying a significantly

higher tax than low-wage earners with small accessions, 

there would seem to be no particular reason to discriminate 

in tax liability between persons with different patterns of 

lifetime consumption. Viewed in that manner, the cash flow 

tax would not favor the wealthy but would favor, relative to 

a comprehensive income tax, those individuals who, at 

any given income level, chose to postpone consumption. 

Lucky Gambles. Another potential objection to the 

proposed system on progressivity grounds is the opportunity

it would afford individuals to acquire wealth by a lucky

investment gamble, and to have paid only a small tax on the 

amount wagered. Some regard this possibility as inequitable.

As noted above, this possibility could be largely avoided, 
- 139 -

at a price in complexity and compliance costs, by taxing the 
 future returns on some or all investments that are not made 
 through qualified accounts, or by restricting the types of 
 investment that could be made outside of qualified accounts. 
 

Accumulation of Wealth. The second major concern about 
 

a c a s p w o u l d place no restraint on the 
 accumulation of wealth. Although-all consumption out of 
 

accumulated wealth would be taxed, the cash flow tax, compared
 with an income tax, would make it easier for individuals to 
 accumulate wealth. The effect of this on the distribution 
 of wealth in the United States cannot be forecast precisely.
 

Presumably, individuals at all levels would tend to hold 
 more wealth, so that the dispersion of wealth might either 
 increase or decrease. At the same time, there might be an 

increase in the size of the largest wealth holdings. 

The cash flow tax -- with wealth transfers deductible 

to the donor and included in the tax base of the recipient -- would be a tax on the standard of living of individuals 

(with some exemption, or credit, for a small consumption

amount), Like the model comprehensive income tax, it could 

be converted to the concept of “ability-to-pay‘’discussed 

in chapter 2. According to that concept, wealth transfers 

would be regarded as consumption by the donor and included 

in the tax base of both donor and recipient. To accomplish

this conversion, gifts would not be deductible to the donor 

and bequests would be taxed as a use of lifetime receipts. 

A simpler approach, and one that is more consistent 

with present policies, would be to retain the estate and 

gift tax as the principal instrument for altering the distribution of wealth. Such a tax, which is levied according to 

the situation of the donor, would be a logical complement to 

the model cash flow tax. The existence of a separate estate 

and gift tax would not damage either the basic simplicity

inherent in the treatment of assets under the cash flow tax 

or the neutrality in tax treatment of those individuals with 

the same endowment who have different time patterns of labor 

earnings or consumption. Under this option, all features of 

the cash flow tax would remain exactly as explained above, 

except for the wealth transfer tax. Tax rates on gifts and 

bequests could be designed to achieve any desired degree of 

equalization in initial wealth of individuals. 
- 140 -

INFORMATION ON SAMPLE TAX FORM FOR CASH FLOW TAX 

Filing Status 

1. Check applicable status 

a. Single 

b. Married filing joint return 

c. Unmarried head of household 

d. Married filing separately 

Exemptions 

2. If applicable, enter 1 on line 

a. Regular 
 

b. Spouse 
 

3. Numberr of dependent children 

4. Total exemptions (add lines 2a, 2b, 31 

Receipts 

5a.l/Wages, - salaries, and tips of primary wage earner 

b. 
 

C. 

d. 
 

e. 

6. 

7. 

{attach farms W-2) 
 

Wages, salaries, and tips of all other wage earners 

(attach forms W-2) 

Multiply line 8b by ,25; if greater than $2,500, enter 

52,500 

Ineluded wages of secondary worker (subtract line 5c 

from 5b) 

*ages subject to tax 

Grass business receipts (frorn schedule C) 

Gross distributions from partnerships (from schedule E) 
- 141 -
 

8. 	 Distributions from pension funds and trusts (includes

social security benefits) 

9. Gifts and inheritances received 

10. Withdrawals from qualified accounts (if positive) 
 

11. 	 Disability pay, unemployment compensation, workmen's 

compensation, sick pay, public assistance, food stamp

subsidy, fellowships, and other cash stipends 

12, Alimony received 
 

13. Total receipts (add lines 5c, and 6 through 12) 
 

Deductions 
 

14. Gross business expenses (schedule C) 

15. Contributions to partnerships (schedule E) 
 

16. Contributions to trusts 
 

17. Deposits in qualified accounts (form S-2) 
 

18. Other deductions (schedule A) 

19. Total deductions {add lines 14 through 18) 
 

Computation of Tax 
 

20. Cash flow subject to tax (subtract line 19 from line 13) 

21. Basic exemption (enter $1,500) 
 

22. Family size allowance (multiply line 4 by $800) 

23. Total exemption (add lines 21 and 22) 

24. Taxable cash flow (subtract line 23 from line 20) 

25. Tax liability (from appropriate table) 

26. a. Total Federal cash flow tax withheld 

b. Estimated tax payments 
 

c. Total tax prepayments (add lines 27a and 27b) 
- 142 -
 

27. If line 26 is greater than line 27c, enter BALANCE DUE 

28. 	 If line 27c Is greater than line 26, enter F!EFUND 

DUE 

Schedule A -- Deductions 

Taxes 
 

1. State and local income taxes 

Gifts, Charitable Contributions, and Alimony -

2. 	 Gifts or donations to an identified taxpayer or entity 

(itEWiiZE3 

9. Alimony paid 

Cost of Earning Income 

4. 

5. 

6. 
 

7a. 
 

b. 
 

3, 

9, 

10. 
 

11. 
 

12-
 

Union dues 

Child care expenses (only for secondary workers or 

single adult households] 

Multiply line 5 by one-half 

Enter line 6 or $5,000, whichever is Smaller 

Enter line 7a or line 4b (line 4a for unmarried head of 

household) from form 1040, whichever is smaller 

Other costs (itemize) 

Add lines 4, 7b, and 3 

Subtract $300 from line 9 

I� line 10 positive, enter line 10: if line 10 negative 

enter 0 

Add lines 1, 3, and 11; enter on form 1040, Line 18 

Schedule C (Business Receipts and Expenses) 

Like current schedule C except 

Line 5 total outlays for purchases of assets 
- 143 -

Enter line 5 (total income) on form 1040, line 6 
 

Enter line 20 (total deductions) on form 1040, line 14 
 

Schedule E -- Note: Partnership will have to send information on form 1065 of gross distributions and gross

contributions 

Form S-2's -- Supplied by brokers of qualified accounts 

1. Total deposits 

2. Total Withdrawals 

3. Net Withdrawal (line 2 minus line 11, if positive 

4. Net Deposit (line 1 minus line 21, if positive 

-1/ Wages reported by the employer would exclude employee

contributions to pension plans, disability insurance,

health insurance and life insurance plans. Wages would 

also exclude the employee's share of payroll taxes for 

Social Security (OASDHI), and the cash value of 

consumption goods and services provided to the employee

below cost. 

-- --

- 145 -

Chapter 5 
 

QUANTITATIVE ANALYSIS 
 

This chapter presents quantitative analyses of the two 

model plans and compares them to present law. The first 

section discusses briefly the nature of the data base used 

to develop and simulate the effects of the model plans. The 

chapter then discusses the estimated magnitudes of the 

various income concepts used in the report and the following

section uses these data to derive exemption and rate structures 

for the comprehensive income tax consistent with achieving 

present revenue yield. This is followed by estimates of the 

magnitude of the cash flow tax base. Finally, the chapter

develops specific provisions of the cash flow tax exemptions and rates and compares the two model plans and 

current law, 

THE DATA BASE 
 

The iirst step in the quantitative analysis of the 

reform plans was to construct a data base representative of 

the relevant characteristics of the U.S. population. A 

file of records was created and stored in a computer, with 

each record containing information for a tax return filing

unit, such as the amount of wages earned by the member or 

members of that unit, dividends received, etc. In all, some 

112,000 records are contained in the file. 

Each of these records stands for a group of taxpayers
 with similar characteristics. Thus, a qiven record may be 
 taken to represent 100 or 1,000 filinu units in the U.S. 
 

population as a whole. To simulate the effect of some 
 change on the whole population, the effect on each record in 
 the file is calculated and multiplied by the number of 
 units represented by that record. 
 

The records in the file were constructed by combining

information from two separate sources: a sample of 50,000 

tax returns provided by the Statistics Division of the 

Internal Revenue Service, and a sample of 50,000 households 

(representing about 70,000 tax filing units) from the 
 Current Population Survey of the Census Bureau. The two 
 data sets were needed because the reform plans base tax 
 liabilities on information not now provided on tax returns. 
 Furthermore, a realistic picture of the U.S. economy requires 
 
- 146 -

obtaining characteristics of "nonfilers," individuals and 

families who are not obliged to file income tax returns 

because they do not have saSSicient taxable income. 

TO represent the incomes generated by the U.S. economy,

these two data sets were merqed by matchinq records of 

taxpayers from the sample of tax returns with records of 

participants in the Current Population Survey, Since 

confidentiality strictures on the release of identifier 

informatian from each of these sources prevented the Literal 

pairing of data on any given taxpayer, the matching was 

accomplished by matching records of similar characteristics 

(age, race, total income, etc.}. The resulting file of 

records is not quite the same as if the Information in each 

record had been obtained for .the same individual or family.

For technfcal reasonsr it has been possible to achieve a 

more faith�ul representation of the U.S. population by using 

some records more than once, Therefore, the number of 

records in the final data file reflects an artificial 

expansion of the number of records in the two original

files . 

Bath samples use 1973 data. Because more recent data 

would be more relevant, the 1973 population and its attributes 

were adjusted by extrapolation to represent the 1976 population. 

The resulting simulations of tho U.S. population should 

be interpreted with some sense of the nature of the data 

set. The original data were subject to the usual smplinq

and processing errom. The processes of merging the two 

data sources and extrapolating the resulting file to a later 

year represent further sources of error, Furthermorer many

items neede6 were not recorded in either of the original 

surveys, and had to be estimated and imputed to each record. 

For these reasons, the file should not be regarded as a 

perfect description sf the U,S. populationc 

Nonetheless, the data have been assembled with great 

care. ~n some cases, adjustments were made to insure that 

the data file produces aqgregate figures (say, on total 

wages paid in the economy) in line with those derived from 

independent statistical sources. In other Gas=, such 

aggregates were used to "validate" the �ih: that is, to 

check its reasonableness. By and larqe, the data pass the 

test of these checks, and the file may be used with some 

confidence. At the same the, it would be a mistake to 

equate the data file with the real world, for QXample?, by 

Wing concerned about small differences in a simulated tax 

burden 
- 147 -

ESTIMATION OF THE INCO-ME CONCEPTS 

The first few tables present various definitions of 

income that were used in the computer simulations. 

Table 1 describes adjusted gross income, or AGI, the 

broadest before-tax concept used for the present inc~metax+ 

Like all of the income concepts, its source is primarily 

currant money wages and salaries;. The remainder, labeled "&her 

AGI" in the table, comes from net self-employment and 

partnership income, capital. income, such as interest and 

dividends, capital gains, and miscellaneous ather elements 

of income. The table shows that "other AGI" is a larger

share of adjusted gross income in the highest income classes. 

The data in table 2 cannot be compared directly with 

AGI as reported on tax returns because information is 

included for nonfilers as well as filers. Thus, table 1 

shows adjusted gross income that would be reported if all 

families and individuals were required to file tax returns 

under current law, and displays the distribution of all such 

filing units by income class. 

The income classes in table I are defined in terms of 

"economic income, " the broadest before-tax income aoneept 

used in this report. As discussed more fully below, this 

income concept is even broader than the tax base described 

in the comprehensive income tax proposal of chapter 3. 

Economic income is used as the classifier In the early 

tables o� this chapter, ln later tables, other classifiers 

are used for reasons explained below. 

Adjusted uross income is not the base Qf the present

individual income tax. Starting from AGI, taxpayers are 

allowed several kinds of deductions to arrive at income 

subject to tax. Table 2 displays the major elements of the 

present individual income tax base. Again, as in table 1,

the information shown includes data for nunfilers as well as 

filers, although nonfilers do not add anything to the 

aggregate taxable income under present law because their 

exemptions and deductions reduce their taxable incomes to 

zero. 
 

III each category of table 2, the mounte shown include 

only income that enters into the calculation of AGI. Thus, 

for examplep portfolio income includes only one-half of 
Economic Number of 

income Eiling 

Class unlts -11 

($000) (,,. millions ....I 

Less than 0 0.2 

0 - 5 33.0 

5 - 10 19.5 

10 - 15 13.9 

15 - 20 12.1 

20 - 30 15+0 

30 - 50 7.1 

50 + 100 2,3 

100 or more -0.5 

Total 108.6 

Table 1 

Present Law 

Adjusted Gross Income 

(1976 Levels) 

Current 

money 

wage 

hCQITH2 

C.*........,...I,..r... 

0.9 

29.5 

81.3 

117.4 

151.9 

261 .o 

157. ‘1 

56.0 

20.0 

875.1. 

Uther 

adjusted 

gross 

idcome 

$ trillions 

-1.8 

12.2 

20.6 

16*1 

16.3 

25 .B 

34.4 

30.9 

25.7 

180,l 

I Total 

adjusted 

gr-oss 

I income

.......................) 

-0.9 

41.7 

101I9 

L33*5 

163. L 

286.8 

191.5 

86.9 

45.7 

1,055.2 

Off-ice of the Secretary of the Treasury, Office of Tax Analysis 

-

I/ Includes all filing units whether OK not they actually file returns or pay tax under present

Law+ The estimated number oE filing units chat do not currently file tax returns is 2L-5 million; 

their adjusted gross income is $4.1 billion. 
Table 2 

Components of thc Present Law Individual Income Tax Base 

(1976 levels) 

Ecortomic : 

' Net : Deduc- : Miscel- : : Present 

income : money :

: 

Pension : employ- : ' port- : tions : laneaus : : Tax :Standard : : law 

: folio :for state: income :Total 11: base : deduc- . Exem'- : income 

class .. wage : 

income ment 

income . income :

' income :and local: minus : : -21 : tions : tions I 

31: subject

: taxes :deducclans: : to tax 

($000) (..............................................*$ tillions ................................................ ) 

Less than 0 0.8 0.2 -4.2 1.5 -0.1 0.2 -1.6 0.5 0.0 -0.1 0.4 

0 - 5 29.2 5.5 n. 1 4.9 -0.5 0.8 40.0 40.6 -26.3 -7*7 6.6 I 

5 - 10 80.4 4.7 4.3 10.3 -1.9 -1.6 96.2 96.7 -28.7 -24.3 43.7 SI 

ILo 

10 c 15 115.6 2.6 5.6 5.5 -4.1 -3.9 121.3 121.5 -19.2 -26.5 75.8 I 

15 - 20 149.8 1.9 6.9 2.5 -7.3 -5.9 147.9 148.1 -14.6 -27.8 105.7 

20 - 30 257.5 2.1 11.2 3.6 -15.2 -10.3 260.9 249.3 -16.9 -37.2 195.2 

30 I 50 154.8 1.7 16.L 11.1 -12.1 -8.5 163.4 163.7 -5.4 -18.0 140.3 

50 - 100 55.1 0.8 15.2 12.6 -6.1 -4.7 72.9 73.1 -1.5 -5.8 65.8 

100 or more 19.7 -0.3 9.8 14.2 --3.3 c -3.7 37.4 A 37 3 -*o. 1 I_ 

-1.4 -35.8 

Total 863.0 19.8 65.3 66.3 -50.6 -37.6 926.0 930.7 -112.7 -148.7 669.2 

Of�ice of the Secretary of the Treasury, Office of Tax Analysis 

Note: The amounts shown In each category include only the income that. actually enters into adjusted gross income 

under present law. -1/ The amounts shown in this column are the sum of the amounts in the preceding columns. 

-2/ The amounts shown in this column differ from the amounts in the "total" column because of the exclusion of negative 

amounts in the total column for individual filing units.

-3/ The amounts shown in this column exclude the value of exemptions that would reduce income subject to tax to 

below zero. 
- 150 -

realized net long-term capital gains. As appropriate, 

expenses were netted against the associated income. Thus, 

wage receipts are net of the recognized expenses of earning

it. SimLlarly, "portfolio income, *I consisting of innerest,

dividends, rent, estate and trust income, and realized 

capital gains, is net of interest expense, "Miscellaneous 

income minus deductions" is an amalgam of income nut otherwise classified, net of all deductions not directly allocable 

to particular income sources. Its negative value results 

from the fact that the itemized deductions allowed under 

present law and not separately deducted frm other components of income are much larger than the miscellaneous 

income items included here, such as State income tax refunds,

alfmony received, prizes, and the Like. 

The present tax base is shown in the column labeled 

"tax base." ExemgtFans and standard deductions (but not 

itemized deductions) are thus treated here as past of the 

rate structure. As table 2 shows, rhe tax base under 

present law is somewhat larger than AGI less itemized 

~eductionsbecause negative net income is never allowed to 

reduce che tax base for an individual return to below zero. 

Similarly, the value of the standard deduction and exenptions cannot reduce irrcume subject to tax to below zero, 

Table 2 indicates that mesent law income subiect to 

tax is only about 63 percentLof adjusted gross incGrte. 

Exemptions, the standard deduction, and itemized deductions 

account for this difference, 

The major components of economic income are tabulated 

separately tn table 3. Many of these components require 

same explanation + "Deferred compensaticm" consists of 

employer contributions to pension and insurance plans,

including social security. "Household property income" 

consists o� rents, interest income net of interest expense, 

estarc and trust income, dividends, capital income of the 

self-employed, and imputed returns from homeownership, life 

insurance policy reserves, and pension ?Lam. "kmcmporate

capital. gains accruals" represents the growth in the real 

value of assets held by indlviduah except for corporate

stock. The latter accruals are asswed to be included in 

corporate retained earnings, as indicated Ln the next 

colmm. In conszructing the simulation of the U,S . taxpayer

population, corporate retained earnings were allocated to 

shareholders in progorcion to their dividend income. 
Table 3 
 

Economic Income 
 

(1976 levels) 
 

:State and: 

Economic : Net :Deferred : employ- : :corporate:Carporate: tion :rnplicit 1

' 

trans- : 

: 

incme Qx: 

: 

income 

: Self- .' Hause-: Non- : 

'Corpora- 1 Net local 
 : Economic 

class labor :property : ;

: capital :retained : income ; taxes : fers : deducincome : 

: wage zcompensa-;

: 

merit gains :earnings : . income . tax . tion 

: income : 

income 

:accrual 6 : : tions : 

($000) (#., ...............,...., , .,.,..,,.,............. $ billions ....,..,............ ..,..,..,....,.............) 

Less than 0 0.8 0.0 0.1 -3.9 0.1 0.1 -0.6 0.4 0.3 -0.1 -2.8 

I 

0 - 5 29.2 2.6 1.0 4.3 0.6 0.3 0.3 -0.5 41.4 -0.1 79.9 

5 - 10 80.4 8.8 4.7 11.5 1.4 1.1 2.5 -1.2 34.3 -0.3 

Lh 

143.2 II 

10 - 15 115.6 14.4 5.9 11.6 1.8 1.0 2.6 -1.0 20.8 -1.0 171.9 

15 - 20 149.8 ia.7 9.0 14.3 2.9 1.1 3.4 -0.7 15.1 -2.1 211.5 

20 - 30 257.5 33.7 14.8 30.4 5.2 2.3 7.1 -0.8 17.8 -4.9 362.9 

30 - 50 154.8 20.9 17.7 44.0 6.2 3.4 10,5 0.3 9.6 -4.7 263.5 

50 - 100 55.1 6.8 13.9 51.9 5.8 4.0 12.3 2.6 3.0 -3.0 152.4 

100 or more 19.7 1.6 -9.4 -28.5 -3.6 -6.2 -7.5 -0.8 10.2 -

-2.0 05.4 

Total 863.0 107.6 76.5 193.3 27.7 19.6 46.0 0.0 152.4 -18.1 1,467.9 

Office of the Secretary of the Treasury 
 

office of Tax Analysis 
 
- 152 -

The entries in the columns "corporation income tax" 

and "implicit taxes" are derived from concepts that may not 

be generally familiar. Sdnce the corporation income tax is 

before-tax income that would be received by individuals were 

it not taken by taxation first, this tax is included in 

before-tax economic income. The burden of the corporation

incame tax was assumed to fall evenly on all individual. 

owners of capital. The logic underlying this position is 

that, in a market system, capital is allocated to equalize 

rates of return. Because of the corporation income tax, 

the capital stock in the corporate sector is smaller than 

it would be otherwise, and the beforetax rate of return 

higher. By the same reasoning, the capital stock in the 

noncarporate sector is higher and rates of return lower 

than they would be otherwise. Through this tax-induced 

movement of capital from the corporate to the noncorporate 

sector, the burden of the corporate tax, that is, its 

effect on reducing after-tax returns, is spread across all 
 

capital income. 
 

Cases can be constructed in which labor income as well 

as capital income bears the real burden of the corporation

income tax, but for the simulations presented in this chapter,

this tax has been allocated in pruportion to all capital

income, with the result shown in table 3. Capital income in 

this table is composed of household property income, noncbrporate 

capital gains accruals, corporate retained earnings, corporation income tax, and hplh~ittaxes. 

The "implicit taxes" shown in table 3, althouqh small 

in amount, illustrate an important phenomenbn affectifig the 

progressivity of the tax structure. Implicit taxes, which 

are quite subtle in concept, are best explained by an 

example, Present law does not tax the interest on municipal 

bonds; therefore, a holder of such bonds receives less 

interest than he might receive if he invested his funds in 

fuLly taxable securities. The difference between what he 

receives and what he could receive is his implicit tax. It 

is Fplicit because no revenue is paid to the U.S. Treasury.

It 1s nonetheless a tax because the bondholder's after-tax 

income is reduced inthe same way as if he paid a tax. Of 

course, the implicit tax may be lower than the actual tax 

payable on fully taxable bonds, and this is why tax-exempt

securities are attractive to high-bracket taxpayers. 
--

- 153 -

Other persons receive benefits from the tax-exemption

of municipal bonds. The attractiveness of municipal bonds 

draws capital out of the private sector, thereby increasing

slightly the before-tax return to investors in other forms 

of capital. The increase in their return is an implicit

subsidy or negative implicit tax. If total income is kept 

constant in the economy, and efficiency losses ignored, the 

positive and negative implicit taxes must balance exactly in 

the aggregate, although not for any particular taxpayer or 

any income class. 

There is an implicit tax corresponding to many tax 

benefits to capital income in the curxent tax structure. 

The simulations included implicit taxes for real estate,

agriculture, mining. and capital gains arising from corporate retained eaxnings and tax-exempt bonds. In each 

case, the tax preference accorded to the activity in question 

attracts capital that would otherwise be applied elsewhere,

and thus reduces the before-tax returns. Since the advantages of these tax benefits -- even taking into account 

the reduced before-tax returns are worth more to those in 

high tax brackets, positive implicit taxes are paid by

higher income taxpayers. Therefore, implicit taxes make the 

present tax structure as measured by effective tax burdens 

somewhat more progressive than it may at first appear. 

Nonetheless, some positive implicit taxes are borne by

filing units in the below-zero income class. This income 

class consists of households sustaining real economic 

losses. To the extent that these losses occurred in taxpreferred activities, they are even qxeater than they would 

have been in the absence of the tax preference, and,

accordingly, implicit taxes are generated for this income 

class. 

"Net transfers" include income support in cash and in 

kind and the excess of accruing claims to future social 

security benefits over current employer and employee contributions. 

Finally, economic income is net of some State and local 

taxes. Since property taxes axe netted in calculating

capital income in the previous columns and sales taxes as 

discussed in chapter 3 are treated as consumption outlays,

only State and local income taxes are subtracted here. 
- 154 -

Economic and Comprehensive IncomeEcOnoIkIiC inc0m.e is an accrual concept. However, as 

chapter 3 makes clear, a pure accrual income concept is not 

practical as a tax base. Table 4 shows the difference 

between economic income and "comprehensive income," which 

was the starting piat for developing the tax base used in 

the comprehensive income tax proposal. 

Four categories of adjustments are Fnvolved in moving

from economic income to comprehensive income. The first; 

adjustment is for pensions. ECOnaIUiC income includes the 

accruing value of future pension benefits for both private

pensions and social security, Comprehensive income, however, 

is on a realization basis in that actual social security and 

pension benefits, rather than their accruing value, are 

included. The: difference is shown in cOlWm 2, 

The second adjustment is for homeowner preferences and 

agricultural income. Comprehensive income does rick include 

the imputed rental incwmle from owner-occupied housing.

Furthermore, all agricultural activity cannot reasonably be 

placed on the accrual accounting standard applied in calculating economic income. The third adjustment accounts for 

the fact that capital gains on noncorporate assets are 

included in comprehensive income when realized rather than 

accrued- Finally, in-kind transfers, such as Medicaid, are 

not included in comprehensive income, As table 4 makes 

evident, the partial shift from an accrual to a realization 

concept of income results in a substantial shrinkage in the 

value of the income measure that serves as the startinq 

point for the model cornorehensive incone tax. 

As discussed in chapter 3, it was principally the 

dhfficult6es in measuring income on ah accretion basis 

that underlay the decision to me comprehensive rather than 

economic income as the, tax base. This decisfon also 

influenced the way in which taxpayers were classified and 

tax budens calculated in the simulations. While economic 

and comprehensive incame are generally highly correlated, 

there are some classes of taxpayers for whom income as 

accrued and income as realized are quite different. This 

is especially the case for taxpayers receiving pension

income, who are drawing down their past accruals of pension 

plan assets. Such taxpayers would find themselves in 

relatively low economic income classes but would be in 

higher comprehensive income classes as a result of realizincr 

the benefits of past contributions to pension plans. 
Table 4 
 

Economic and kmprehensivs Income 
 

{1976 levels) 
 

Adjustments (subtract) 

: Nontaxrd : 

Economic : Economic : homeowner : Nonu 

income income * Pensions , 

; preferences : corporate : In-kind : Comprehensive 

class and : capital : transfers income 

: agricultural : gains 

income 

- I (Sfloo) (.,l.~,.............it......l.l...l.l.....~ $ billions ......,.......,.......,.......+,,~,~...~~} w 

cn 

cn 

I 

Less than 0 -2.8 -Qe2 0*1 0.1 0.1 -2.8 

0 - 5 ?9*9 -18.4 1.0 0.4 6.4 90.4 

5 - 10 143,2 4.6 2.1 0.9 4.0 131*6

10 - 15 171.9 21.5 4.4 1el 1.5 143.4 

15 - 20 211.5 24.2 8.3 1.7 0.8 174.5 

20 - 30 362.9 43.7 15.9 3.1 0.8 299.4 

30 - 50 263.5 24.5 10.7 3.7 0.4 224.1 

50 - LOO 152+4 7-0 3.6 3.5 0,l 138.3 

LOO or more ~ 85.4 -

2.2 -0.0 

Total 1,467.9 120.1 47.2 16.6 14.1 1,269.9 

Office of the Secretary of the Treasury
 Office Of Tax haly8i.B 
 
- 156 -

Table 5 presents a cross-tabulation by economic income 

and comprehensive income of the number of filing units 

receiving pensions in excess of $500. While %hi5 

table indicates that pensioners in higher economic income 

classes are in higher comprehensive income classes as well, 

it also reveals thatr in general, their comprehensive income 

tends to be larger than their econamfc income. If taxes 

were assessed on the basis o� comprehensive income and 

filing units were arrayed hy economic income class, the tax 

structure would appear less progressive. This is because 

pensioners, who are generally in lower income classes, have 

comprehensive income that exceeds economic income. During

their earning years, 40kh economic and comprehensive income 

are relatively high but econwmic exceeds comprehensive

income. 

Both of these effects tend to tilt the structure of 

effective tax rates as measured using econumic income in the 

direction of lower effective rates on higher economic income 

and higher effective rates on lover economic income. What 

appears to be a phenomenon of the aggregate distribution of 

the tax burclen is actually a matter of the timinq of taxes 

at different paints in the fife cycle of the same taxpayer. 

A consequence of these lifetime effects, which are discussed 

in more detail later in this chapter, is that comprehensive

income is a more meaningful classifier for analyzing a tax 

system using a realization basis. Hence, in the tables that 

follow, comprehensive rather than economic income is used to 

identify the income classes of the taxpayers, Even more 

desirable would be a comparison of lifetime ta% burdens with 

lifetime income. 

Present Law Tax 

Table 6 displays the prograssivity of the present

income tax system, the total amount of revenue that it 

raises, and the e�factive tax rates by comprehensive income 

class. The ihdividual income tax is only part of the 

present kax structure. The proposals in this report also 

would replace the corporation income tax and, by including

virtually all income in the tax base, would reduce implicit 

taxes to near zero, Present tax burdens, however include 

all three forms of taxc As shown in table 6, effective tax 

rates 50 derived rise continually with comprehensive income, 
Table 5 
 

Cross-Tabulation of the Number of Filing Units with Substantial 

Pension Income by Economic lncome and by Comprehensive Income L/ 

(1976 levels) 
 

Economic Comprehensive income ($000) 

income .' Up to 0 i 0 - 5 5 - 10 i 10 - 15 i 15 - 20 i 20 - 30 30 - 50 i 50 - 100ior100 : more: Total 

($000) (........................................... thousands ................ .........................) 

Less than 0 -49. 22. , 7. 4. 0. 0. 0. 0. 0. 81. 

0 - 5 4. 9.705. 3,221. 526. 88. 33. 3. 0. 0. 13,581. 

P 

5 - 10 4. 453. 2.839. 1,539. 318. 70. 6. 0. 0. 5,230. ln 

10 - 15 1. 61. 170. 1.080. 472. 172. 22. 0. 0. 1,978. 

15 - 20 0. 27. 17. 152. -640. 382. 55. 1. 0. 1,273. 

20 - 30 1. 22. 4. 13. 185. -914. 208. 12. 0. 1,360. 

30 - 50 0. 10. 2. I. 4. 118. -681. 77. 0. 894. 

50 - 100 0. 6. 0. 0. 0. 0. 26. -276. 22. 331.

100 or more 0. -

4. -2. -0. -0. -0. -0. 55. 68. -6. - - - - Total 60. 10,311. 6,262. 3,316. 1,707. 1,689. 1,001. 372. 77. 24,796. 

Office of the Secretary of the Treasury 
 

Off�ce of Tax Analysis 
 

-11 Pension income of $500 or more. 

I 
- 158 

-
- 159 -

A Proportiondl Comprehensive Income Tax 

It would be possible to replace the present individual 

and corporate income tax with a proportional or flat-rate 

tax on individuals, choosinq the rate in such a way as to 

raise the same total revenue. A reasonable exemption could 

be allowed for a taxpayer and dependent, or the exemption

could be eliminated altogether in favor of a lower rate. 

Two versions of a proportional tax on comprehensive income,

raising the same revenue as the present income tax, are 

shown in table 7. One has no exemption and a tax rate of 

14.35 percent of the comprehensive income base, and the 

other has an exemption of $1,500 per taxpayer and dependent

and a flat rate of 19.35 percent of comprehensive income in 

excess of exemptions. Table 7 shows comprehensive income 

by income class, present law tax burdens, and the results of 

the two proportional rate plans. As compared to present

law, both plans would result in a tax decrease for the 

higher income taxpayers and an increase for those with lower 

incomes. The plan that allows an exemption would come 

somewhat closer to the present distribution of tax burdens, 

but some form of graduated rates is required to achieve a 

close approximation. 

THE MODEL COMPREHENSIVE INCOME TAX 
 

Table 8 shows the steps from comprehensive income to 

the income subject to tax under the model comprehensive

income tax plan and compares that amount to present law 

taxable income. 

The first adjustment is for child care and secondary

workers and applies to joint and head-of-household returns. 

Only 75 percent of the �irst $10,000 of earninqs of workers 

other than the primary wage earner is included in income 

subject to tax. A deduction of one-half of child care 

expenses, up to a maximum deduction of $5,000, is allowed 

against wage earninas of unmarried heads of households and 

against the included wages of secondary workers on joint 

returns. 

The Combination of exemptions and structure of rates 

is designed to yield about the same total revenue, with 

about the same distribution by income class, as the present 

tax. The model comprehensive income tax would allow exemptions

of $1,000 per taxpayer and dependent, plus $1,600 per return 

(half for married persons filing separately). The value of 
 these exemptions is shown in table 8. A deduction for 
 
- 160 -

a 

3 

I. 3. .. 

.. .. .. 
. 

Table 8 

Tax Base for Comprehensive Income Tax Proposal 

(1976 levels) 

:Child care and : : Comprehensive :. Present : Change Cwprehens ive 

: Comprehensive : secondary : Exemptions L/ ' income law i n income 

clam income worker : subject : taxable taxable 

: provisions : ta tax 2/ : income income 

($000) (......... ...................... $billions .........................,.+,...........) 

Less than 0 -3.6 0.0 0.0 0.0 0.8 -0.8 

I 

0 - 5 81.0 -0. L -68.0 12.9 10.1 2.8 P 

m 

i5 - 10 171.2 -1.5 -83.5 86.1 69.2 16.9 I 

LO - 15 205.7 -4.4 -71.7 129.6 111.3 18.3 

15 - 20 209.1 -6.6 -57.1 145.4 129.9 15.5 

20 - 30 253.7 -8.2 -51.4 194.1 164.6 29.5 

30 - 50 169.0 -3.1 -21.4 144.5 97.0 47.5 

50 - 100 120.2 -1.0 -8.5 110.7 54.7 56.0 

100 or more 63.5 --0.3 -2.0 61 2 31.7 29.5 

Total 1,268.9 -25.3 -363.6 884.5 669.2 215.2 

Office of the Secretary af the Treasury 

Office of Tax Analysis 

-I/ The amounts shown do not Lnclude the value of exemptions that, if allowed, would reduce comprehensive income 

subject to tax to below zero. 

-2/ Since comprehensive income subject to tax cannot be Less than zero, it is greater than the sum of the first 

three columns by the amount of the negative income in the first comprehensive income class. 
- 162 -

these amounts yields "comprehensive income sthject to tax," 

the amount to which the rate schedule is applied in the 

model tax. 

Table 8 also indicates the change in taxable income 

from current law as a result of using the model comprehensive income tax. The increase Fn income subject to tax 

is extremely large, approximately onemthird of present

taxable income. Such a substantial broadenins of the tax 

base can permit a marked reduction in tax rates throughout

the entire income range, 

The rate structure for joint returns would. he as 

follows: 

Income Bracket Marginal Tax Rate 

$ 0 - $ 4,600 8 percent 

$ 4,600 - $40,000 25 percent 

Over $40,000 38 percent 

For single returns, the rate structure wmld be as 

follows: 

$ 0 - $ 2,800 8 percent 

$ 2,800 - $40,000 22.5 percent 

over $40,000 38 percent 

nHeads of households," as under present law, would pay the 

average of the amounts they would pay using the sirqle and 

joint schedules. 

The tax revenues that would be raised by this plan, and 

their distribution by income class, are shown in table 9, 

alorq with the corresponding infarmation fur the present 

tax, 'xlhe agreement is quits close and the aggregate tax 

change for each income class is small. Table 10 shows tax 

liabilities by filing status under both the present law and 

the comprehensive income tax proposal. Again, the changes 

are small. The proposed tax plan would favor larger families 
Table 9 

Amount of Tax and Effective Tax Rates under the Present Law Income Tax 

and Model Comprehensive Income Tax 

(1976 levels) 
 

Comprehensive : Present law Comprehensive income tax 

income Tax Effective Effective 

class tax rate A! : Tax tax rate LI 

($000) (, . $ billions ...) (. ,.. percent ....) (. .. $ billions . (. .. percent ,...) 

I 

Less than 0 0.0 -0.6 0.0 0.0 P 

03 

W 

I 

5 - 10 10.9 6.4 10.4 6.1 

10 - 15 20.5 9.9 20.5 10.0 

15 - 20 26.5 12.7 27.0 12.9 

20 - 30 39.1 15.4 40.1 15.8 

30 - 50 33.4 19.8 32.6 19.3 

50 - 100 30.3 25.2 31.2 26.0 

20.6 32.4 20 8 32.7

0 - 5 1.4 1.7 1.0 1.3 

100 OT more - _c A - Total 182.6 14.4 183.7 14.5 

Office of the Secretary of the Treasury

Office of Tax Analysis 

-l/ Tax e8 a percentage of comprehensive income. 
Amount of Tax AccordLng to FFlhg Status under the Present Law Income Tax and Model Comprehensive Income Tax 

(1976 1evels) 

Present law : Model comprehensive Filing status income tax income tax 

(, ................. $ billions ....p...,+r~+++.,] 

Single ...................................................... 32.3 32.3 I 

P 

Married fLlLng separately ................................... 2.5 3.0 m 

bb 

Head of household ,............................,....~..~..~.* 6.4 6,9 

I 

Joint and certain surviving spmtses ......................... 141.4 141.5 

No dependeats ............................................. 54.3 57.3 

One dependent ............................................. 28.2 27.3 

Two dependents ............................................ 29*0 27.9 

Three dependents .......................................... 17.5 16.8 

Four dependents ............................................ 7.8 7.4 

Five or more dependents ................................... 4.6 4.3 

All retu-cns ................................................. 182.6 183.7 

Returns with one or more aged ............................... 21.6 25.8 

Office of the Secretary of the Treasury 

Office of Tax Analysis 
- 165 -

slightly compared to present law. Filing units with one or 

more aged members would pay somewhat higher taxes because 

they would lose the extra age exemption and because social 

security cash grants are included in the tax base. 

Although tax liabilities by income class and filing 
 status do not change greatly on the average, the proposed
 comprehensive income tax would alter significantly the tax 
 liabilities of many individual taxpaying units. Those 
 whose income is not fully taxed under current law would 
 pay more tax under this comprehensive plan, while others 
 would benefit from the generally lower rates. Also, many
 would be relieved of the burden of double taxation on 
 corporate income. 
 

Table 11 shows the number of filing units in various 

categories that would have their tax liabilities either 

increased or decreased by more than 5 percent of present law 

tax or by more than $20. The average amount of decrease for 

those returns with decreases is almost $380, while the 

average amount of increase among the gainers is nearly $650. 

The average gains and losses are similarly large for virtually all the categories shown on the table. 

This finding of large average amounts of gains and 

losses should be interpreted with great care. It is inevitable that any such tax change will involve substantial 

redistribution within income classes even if the total tax 

collected within each class remains the same. Furthermore, 

to some degree, the simulated comparisons are spurious

because it is not proposed to adopt the model plan overnight.

Indeed, the existence of a large number of gainers ahd 

losers is in itself evidence that careful transition rules 

are needed to facilitate the movement toward a reformed tax 

structure. 

It should also be noted that the nature of the data 
 base biases the result in the direction of a finding of 
 extensive redistribution. This is so because the individual 
 records in the file of taxpayers in the simulation were 
 constructed by matching information about different indi­
 viduals in the taxpayer and Current Population Survey
 samples. As a result, current and new tax liabilities for 
 a given record in the data base may, in fact, be based on 
 information concerning different people. 
 
Table 11 

Piling Units with Gains and Losseg under the Comprehensive Income Tax 

86 Cmpared to the Present Law Income Tax l/ 

(1976 levels) 

Tax decrease - Tax hcreas e.. 

:Number of :Amount of :Average decrease :Number of :Amount of :Average increase 

: ffling : tax :for filing units: filing : tax :for filing units 

: unit-3 : change ; with decrease - upits : change : with increase 

(millions)I$ billions) {dollars) iinilktone} ($ billion$ (dollars} 

All ftlfng unfts with gains and lasses -,,.,,. 60.9 23 .O 378 37.2 24.1 668 I 

b' 

m FiZ5ng units with $500 or more of pension m 

fncome ................................... 5.0 2.2 43 1 17.7 13.5 764 i 

Filhg units with less than $500 of pension 

income ................................... 55.9 211.9 37 3 19.5 10.6 543 

Single filers ............................ 27.7 4-1 148 3.6 2.2 33I 

Age lssa than 22 ....................... 23.7 0.6 46 1.0 0.1 1Of 

Age 22 to 61 ........................... f3.0 3.2 2k5 2.4 1.0 42 7 

Age 62 or ovex ......................... 1.0 0.3 293 0.2 0.1 25 4 

JDht filers ............................. 24.2 15.8 654 12.9 8.4 65 3 

Earning atetug ! 

One earner ........................... 10.2 6.7 657 3.6 5.2 608 

Two or more earnerti .................. 14.0 9.1 652 4.3 3.2 742 

Depetldeficy atatus : 

NQ dependenrs ........................ 6.9 5.1 745 4.4 2.9 643 

Two dependents ....................... 5.8 3.5 607 2.8 1.7 624 

Four dependents ...................... 1.7 I+I 6k9 0.7 0.5 747 

FilLne Y units with means-tested cash Rrant -

incms ................................... 2.7 0.2 ,, 59 3.9 1.1 270 

Office of the Secretary of the Treasury, Office of Tax AnalyBis 

- Filing units whose tax liabiIitLes would change by more than 5 percent: of present law tax or by mofe than $20.
- 167 -
 

Aside from such statistical details and the question of 

transitdm rules, comparisons a� gainers and Losers may be 

misleading QTI other grounds, The redistributions of income 

indicated may refleet not only changes in tax burdens among

different taxpayers, but, perhaps more importantly, changes

between the taxpayer at one point in his life and the same 

taxpayer at another point. For example, employee contributions to social. security are excluded from taxable 

income, but social security benefits are included, As a 

result, the simulations show a decrease in tax for present 

wage earners and an increase in tax far pensioners, 

Indeed, table I1 shows that almost half of those with 

tax increases are receiving $500 or more in pension income. 

Th5s gives a misleadins impression of the distributional 

consequences of the change, because present wage earners are 

future xetirees. A more satisfactory comparison would be 

one that reflected the overall lifetime tax burden o� 

different individuals under various plans. It has not been 

possible to perform simulations of such lifetime affects. 

Thus, the simulations that are shown tend to be biased 

toward a finding of greater redistribution than actually

would be implied by the model plan. 

Table 12 shows, �or each comprehensive income class,

the derivation of grass consumption from comprehensive 

income. "Imputed consumption from owner-occupied housing"

consists of the net rental value of owner-occupied dwellinqs,

and is included in gross consumption even thouqh a ca3h 

outlay may not be made for the rental services. "Corporate 

retained earnings" are deducted because they represent

saving on behalf of households. Similar savinq occurs in 

the form o� earnings on life insurance policies, contributions to and earnings of private pension plans, and employee

contributions to social security, "Direct saving" represents

household net purchases of real and financial assets. In 

table 12, gross consumption is derived by subtracting the 

sum of all forms of saving from the sum of comprehensive 

income plus imputed consumption. 

The term "QSDSS consumption" is used because consumption is here considered to be gross of Sncsme taxes paid 

under current law; in other wards, gross consumption represents

before-tax cansumptbn. Gross consumption is the startfng 

point of the cash flow tax in the same way that comprehensive

income is the startinq point of the comprehensive hmme 

tax. 
Table 12 

Comprehensive Income and Gross Consumption 

(L976 levels) 

Saving Imputed :Saving in life : Cmprchenslve * : Comprehensive ' : consumption .

: Corporate : insurance, : Direct Gross income - ; retained :pension plans, : saving : COnvumption class income : occupied : earnings and hausing . :social. sscurlty : 

Lees than 0 -3.6 0*1 

0 - 5 81.0 L.3 

5 - 10 171.2 3.6 

0.1 0.0 -5.9 

0.3 0.4 3,o 

0.9 2, L 8.1 

2.3 
 P 

rJI

78,6 M 

163 7 

10 -
 15 2O5,7 7.0 1.1 3.3 14.0 194.4
 

1s - 20 209.3. 8.3 1.3 4.0 18.3 193.a 

20 - 90 253.7 9.7 2.b 5.6 26.7 228*7 

30 - 50 169.0 4*9 3.5 3,z 18.9 148.3 

50 - 100 120.2 2.1, 4.0 1.3 16.8 100.2 

Total 1,Z69,9 37.8 19.6 20.5 106.7 1,160.9 

-

Office of the Secretary of the Treasury 

Office of Tax Analysis 

Note: Gross consumption equals comprehensive income plus irnguced consumption from owner-occupied housing mfnus all of 

the following forms of savings: corporate retained earnings, saving In life insdtance plan$, Social security 

contrlbutiona, and direct saving. 

1 

I 
- 169 -
 

As was explained earlier in connection with the comprehensive income tax, taxpayers must be classified properly

before the distribution of tax burdens can be analyzed.

All tables dealing with the cash flow tax will use gross

consumption for classificatioil purposes. 

Table 13 shows the derivation of the cash flow tax 

base. The provisions for child care and secondary workers 

are the same for the cash flow tax as for the comprehensive

income tax. Exemptions under the cash flow tax are $1,500 

per return and $800 per taxpayer and dependent. Adjustinu 

gross consumption for the child care and secondary worker 

provisions and for exemptions yields the mount of cash 

flow subject to tax. A comparison of the amounts subject to 

tax in the two model plans, as shown in tables 8 and 13,

indicates that the amount of cash flow subject to tax is 

about 7 percent less than the amount of comprehensive incone 

subject to tax. Nonetheless, the amount of cash flow 

subject to tax is 23 percent more than present taxable 

income, as shown in table 8. Thus, even though saving is 

deaucted, the model cash flow tax accomplishes a substantial 

broadening of the tax base. 

The rate structure for joint returns under the cash 

flow tax would be as follows: 

Income Bracket Marginal Tax Rate 

$ 0 - 5,200 10 percent 

5,200 - 30,000 28 percent

Over 30,000 40 percent 

For single returns, the rate structure would be as 

follows: 

Income Bracket Yarginal Tax Rate 

$ 0 - 3,200 10 percent

3,200 - 30,000 26 percent

Over 30,000 40 percent 

Heads of households, as under present law, would pay the 
 average of the amounts under the single and joint schedules. 
 

Table 14 shows the distribution of tax liabilities and 

effective rates of tax under the model cash flow tax and 

present law. The model cash flow tax nearly reproduces the 
Table 13 

Cash Flow Tax Base 

(1976 levels) 
 

: Child care and : Cash flow Gross Nmber of Gross 

worker to consumption ' : filing units I/ : consumption T 

: secondary 1 Exemptions 2,' I subject 

class provisions tax

CSoao) (... mflIfons ...) ~...-.,.,,,..,,C++~............ $ billions .,..................~.*~.,...tl.) 

Less than 0 0.0 0. Q 0.0 0.0 0.0 

0 - 5 40.7 84.2 -0+1 -66.2 17.9 

5 + LO 24,3 173.9 -1.8 -76 + 6 100.5 

10 - I5 17.4 221.4 -5.7 -47+f 148.6 

15 - 20 11.8 202.9 -7.3 -47.3 147,8 

20 - 30 8.7 208.5 -6.8 -36.0 165.6 

30 * 50 3.7 136.3 -2.6 -14.9 118,8 

50 - 100 1+3 88.2 -0.8 -5.5 81.9 

100 or more -0,3 40.6 .-o._? L -1 1 -

39.2 

Totd ma. 6 1,160.9 -25,3 -315.2 1320.4 

Y 

Office of the Secretary of the Treasury 

Office of TzXx Analysis 

I/ hcludes all �fling units whether or not they actually fEle returns or pay tax under current law. I.Z/ The amounts shm dQ not include the value of exmptionb that, Lf allowed, wouLd reduce cash flow 

aubjecr to tax to bdow zero, 
Table 14 

Amount of Tax and Effective Tax Rates under the Present Law Income Tax and under Model Cash Flow Tax 

Gross 

consumption 

class 

~$000) (... 

Less than 0 

0 - 5 

5 - 10 

10 - 15 

15 - 20 

20 - 30 

30 - 50 

50 - 100 

1DO or more 

Total 

Office of the Secretary of 

office of Tax Analysis 

1/ Tax as a percentage of 

(1976 levels) 

Present law tax Cash flow tax 

Effective Effective Tax tax rate -1/ ; 

Tax tax rate L/ 

$ billions ..) (. ,.,, percent ...) (.,. $ billions ..) (..... percent ...) 

0.0 0.0 0.0 0.0 

1.8 2.2 1.8 2.1 

13.2 7.4 13.7 7.7 

26.2 11.8 26.3 11.9 

30.0 14.8 30.6 15.1 

37.5 18.0 38.2 18.3 

32.2 23.6 31.4 23.1 

27.1 30.7 26.8 30.3 

L_ 

14.6 -36.0 14.5 -

35.7 

182.6 15.7 183.3 15.8 
 

the Treasury 

gross consumption. 
- 172 ­
 

progressivity of the present tax structure. It is clear 
 that taxing consumption is perfectly consistent with a 
 

progressive structure of tax liabilities. 
 

Although the model cash flow tax preserves the averaae 

progressivity of current law, it would extensively redistribute 

tax burdens. Table 15 tabulates filing units whose tax 

change would be more than 5 percent of present law tax or 

more than $20. This table yields essentially the same 

results as those presented in table 11 for the comprehensive

income tax. The caveats in interpreting the results of 

table 11 apply with equal force to table 15. 

COMPARISONS OF TAX LIABILITIES UNDER THE DIFFERENT PLANS 

Up to this point, this chapter has presented simulations 

of the effects of the model tax plans on all taxpayers.

This section examines the tax liabilities of taxpayers in 

particular situations. These materials illustrate the 

differences among the present law income tax and the two 

model plans. Since the data are hypothetical, they do not 

represent the situations for any particular taxpayer. -

The Marriaqe Penalty 
 

A subject of continuing controversy and interest is the 

division of the tax burden between married and unmarried 

individuals. Table 16 shows, for current law, the additional 

tax paid by a married couple filing a joint return over what 

would he paid if both persons could file single returns. 

The left-hand column shows the cauple'stotal income. The 

subsequent columns present different shares of the total 

income earned by the lesser-earning spouse. For example,

in the first column, one spouse earns all of the income. 

This column shows that a married couple would pay a lower 

tax than would a single individual with the same income 

because of the favorable rate structure of the joint return 

schedule. In the last column, earnings are derived equally

from the wages of both spouses. In this case, the married 

couple would pay a higher tax than would two unmarried 

individuals, with a marriage penalty of $4,815 on a joint

income of $100,000. 

Table 17 shows the same data for the model compre­
 hensive income tax plan. The area of marriage penalty has 
 increased somwehat as compared to current law. However, the 
 rate structure and exclusion of a portion of the earnings of 
 
Table 15 

Filing Units with Gains and Lasses under the Cash Flow Tax Compared with Present Law Income Tax 11 

(1976 levels) 

Tax decrease Tax increase 

:Number of:Amount of:Average decree5e:Number of:Amount of:Average increase 

: filing : tax :for filing units: filing : tax :for filing units 

: unira : charae : with decrease : units : chanze : with increase 

(nillione)@ billions) (dollars) (millione) 6billiond (dollara) 

All filing units with gains and losaes ........ 53.6 31.0 577 44.7 31.7 708 

Filing units with $500 or more of pension 

incme .................................... 5.1 3.5 700 17.9 13.7 765 

I 

r 

4 

Filing unite with less than $500 of pension 

income .................................... 48.6 27.4 564 26.8 18.0 671 

W 

I 

Single Lilera ............................. Age less than 22 ........................ Age 22 to 61 ............................ Age 62 or over .......................... 

24.5 

12.6 

11.0 

0.9 

4.9 

0.5 

3.9 

0.4 

199 

43 

360 

410 

6.6 

2.0 

4.3 

0.3 

2.0 

0.3 

1.7 

0.1 

309 

130 

392 

313 

J’oint filers .............................. 20.6 21.4 1,037 16.6 14.6 880 

Earning status: 

One earner ............................ 8.9 9.6 1,075 10.0 8.8 876 

Two OT more earners ................... 11.7 11.8 1,007 6.6 5.9 a85 

Dependency status: 

No dependents ......................... Two dependents ........................ Four dependents ....................... 

6.8 

4.6 

1.3 

8.0 

4.3 

1.3 

1,174 

933 

1,060 

4.6 

4.0 

1.1 

4.1 

3.5 

1.0 

889 

884 

924 

Filing units with means-tested cash grant 

incwe .................................... 2.4 0.2 73 L.t4 1.5 35 2 

Office of the Secretary of the Treasury, Office of Tax bslysis 

-I/ Filing units whose tax liabilities would change by more than 5 percent of present law tax or by more than $20. 
. 

Table 16 

Marriage Penalties in 1976 Law 

The Marriage Penalty is the Excess of the Tax a Couple Pays wich a Joint Return 

Over What It Would Pay if Both Persons Could File Single Returns 

Total Dollar amount of marriage penalty when share of income earned by lesser-earnin?, spouse is: 

family : None 10 percent : 20 percent ,' 30 percent . 40 percent . 50 percent income : 

(..+.................................... No Marriage Penalty .......................................) 

S 0 S 0 $ 0 $0 $ 0 $ 0 $ 0 

5,000 -233 - 149 -69 12 a7 130 I 

w 

7,000 -266 -137 -18 t 101. 201 212 .I 

4 

10.000 

15;OOO 

-383 

-527 

-163 

-187 

I

I 

43 

97 

191 

162 

2 16 

237 

221 

263 

I 

20,000 -762 -240 56 189 258 243 

25,000 -1,085 -324 29 235 319 365 

30,000 -1,406 -442 13 320 497 565 

40,000 -2,013 -657 149 661 1,034 1,188 

50,000 -2,697 -799 334 1,188 1,743 1,910 

100,000 -6,810 -2,532 605 2,819 4,275 4,815 

I (................. Marriage Penalty ...................) 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

Note: In ell tax calculations, deductible expenses are assumed to be 16 percent 

of income, and the maximum tax is not used. 
Table 17 

Marriage Penalties in the Model Comprehensive Income Tax 

The Marriage Penalty is the Excess of the Tax a Couple Pays with B Joint Return 

Over Whet It Would Pay if Both Persons Could File Single Returns 

I

5,000 -80 -50 -20 10 40 62 

P 

-4 

7.000 -312 -169 - 25 46 72 58 01 

lo;000 -441 -278 -116 I 15 97 122 I 

20.000 -191 

1

I 134 347 425 300 175 

25;OOO 340 555 45 6 300 300 

30,000 515 675 488 425 425 

40,000 
 

50,000 
 

309 

244 

a47 

1,477 

800 

1,432 

675 

1,432 

675 

1,432 

675 

1,432 

15,000 -316 -72 I 140 263 300 206 

LOO, 000 
 244 1,835 3,385 4,935 6,485 6,888 

(. ................................ Marriage Penalty ..................................... ) 
- 176 -

the secondary worker would result in some changes relative 

to current law. This may be seen most clearly in the last 

column. Although the marriage penalty paid by a couple

earninq $100,000 would increase, for all other families in 

which equal earners marry, the marriage penalty would be 

reduced compared to current law. As the first column shows, 

the differences between married couples and unmarried 

individuals are, in ueneral, reduced in the model comprehensive income tax plan compared to current law. This is 

because the broader tax base permits a less steep prouression

of marginal tax rates. Table 18 shows the marriage penalties

under the model cash flow tax. 

Lifetime Comparisons 
 

As suggested above, a desirable point of view from which 

to assess the relative tax burdens among individuals is that 

of the complete lifetime. The tables presented thus far 

do not reflect this lifetime perspective. If either of the 

model tax plans had been in effect as long as the present 

tax, the income and tax situations of taxpayers would be 

different from those shown in the simulated results. 

This is particularly true of saving, which is subject 

to considerably different treatment under the model plans.

For persons accumulating for their retirement years in 

savings accounts, the present law would collect tax on the 

income from which the saving is made and again on the 

interest earned on the savings. Withdrawal of funds,

however, would have no tax consequence. Under the cash flow 

tax,savingswould not be subject to tax: rather,taxes would 

be assessed when the proceeds are withdrawn for consumption.

The comprehensive income tax would be levied both on income 

saved as well as on interest earned, but the broader base 

would permit lower fates than under present law. 

since one objective of savinp is the reallocation of 

lifetime consumption, these three tax systems would be 

expected to alter the timing of income, consumption, and tax 

liabilities. Table 19 summarizes these effects. It shows 

summary statistics for a family whose saving strategy is to 

maintain a constant level of consumption throughout working

and retirement years. This table provides a very direct and 

convenient way of comparinq the different systems, since tax 

burdens may be determined directly from the level of consumption. The higher is the level of consumption attainable, the lower is the tax burden. In this example, the 
Table 18 

Marriage Penalties in the Model Cash Plow Tax 

The Marriage Penalty ie the Excess of the Tax a Couple Pays with a Joint Return 

Over What It Would Pay if Both Persons Could Pile Single Returns 

Total Dollar amount of marriage penalty when share of income earned by lesser-earning spouse is: 

family : None 10 percent : 20 percent 30 percent 40 percent : 50 percent income :

(....................................... No Marriage Penalty .......................................) 

$ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 

3,000 -70 -40 -10 0 0 0 I 5,000 -80 -42 -5 1 32 70 88 

I I 

4 

7,040 -320 -156 77 80 63 4 

10,000 -494 -304 96 106 4 

15,000 -394 -109 296 191 

20,000 -294 396 256 116 

25,000 -194 391 216 216 

30,000 -94 406 596 3 86 316 316 

40,000 -144 886 1,244 1,044 1,044 1,044 

50,000 -144 1,086 1,366 2,066 2,444 2,444 

100,000 -144 1,366 2,766 4,166 4,488 4,488 

(........................... Marriage Penalty ............................ ) 
- 178 -

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- 179 -
 

present law tax burden is somewhat higher (consumption is 
 lower) than that implied by the model comprehensive income 
 tax, which in turn is higher than that under the cash flow 
 tax. 
 

- 181 -

Chapter 6 

TRANSITION CONSIDEWTIONS 
 

INTRODUCTION 
 

Major changes in the tax code such as would accompany a 

switch to either the comprehensive income tax or the cash flow 

tax may lead to substantial and sudden changes in current 

wealth and future after-tax income flows for some individuals. 

Transition rules need to be designed to minimize unfair 

losses, or undeserved windfalls, to individuals whose 

investment decisions were influenced by the provisions of 

the existing code. 

This chapter discusses the major issues in transition 

and suggests possible solutions to problems arising from 

transition to both the comprehensive income tax and the cash 

flow tax. It outlines the major wealth changes that can be 

expected under a switch to either of the two model taxes,

and discusses the relevant equity criteria to be applied in 

the design of transition rules. Instruments for ameliorating

transition problems, including phasing in provisions of the 

new law and grandfathering, or exempting, existing assets 

from the new rules are discussed. The effects of applying

these transition instruments to different types of changes

in the tax law are outlined. Transition rules to be applied 

to specific changes in the tax law included in the model 

comprehensive income tax in chapter 3 are considered. 

Special problems of transition to a cash flow tax are discussed 

also, and a plan is suggested for transition to the cash 

flow proposal described in chapter 4. 

WEALTH CHANGES AND THEIR EQUITY ASPECTS 

Two separate problems requiring special transition 

rules can be identified: carryover and price changes.

Carryover problems would occur to the extent that changes in 

rhe tax code affect the taxation of income earned in the 

past but not yet subject to tax or, conversely, income taxed 

in the past that may be subject to a second tax. Price 

changes would occur in those instances where changes in the 

tax code altered the expected flow of after-tax income from 

existing investments in the future. 
- 182 -

Carrvover Problems 

Under the present tax system, income is not always

taxed at the time iC accrues. For example, increases in net 

worth Fn the -Form 05 ca.pital aains are not taxed before 

realization. A change ';n the-tax rate on realized capital

gains, therefore, would alrer the tax 1LabilLty on gains

accrued but nor realized before the effective date of the 

tax reform. Application of the new rules to past capital

gains would either raise lower the applicable tax on that 

partion of past income, depending on whether Zhe increase in 

tax from including all capital gains in the incone base 

exceeded the reductJan in tax caused by any allowance of a 

basis adjustment for inflation. 

The problem of changes in the timing of tax liabLlity

would be especially severe if the current tax system were 

changed tro a consumption base. Under a consumption base, 

purchases of assets would be deductible from tax and sale$ 

of assets nut reinvested would be fully taxable. Under the 

current tax sysrem, b0-t.h the income used ro purchase assets 

and rhe capital gain are subject: to tax, the latter, however, 

at a reduced 'rate. Recovery of the original investment is 

bot raxed. An imediate change to a consumption base would 

penalize individuals who saved in the past and who are 

currently selling assets for consumption purposes. Having 

already paid a tax an the income used to purchase the asset 

under the old rules, they would also be required to pay an 

additional tax on the entire proceeds from the sale of the 

asset. On the other hand, if omers of assets were allowed 

to Ereat rhose assers as tax-prepaid, rhey would receive a 

gak to the extent they planned t~ use them for future . consumption or b.equest. Income on past: accumulated wealth 

would then be free from future taxes, and the government

would have to make up the difference by raising the tax rate 

on the remaining consumption regarded as non-p~etaxed. 

Orher carryover problems include excess deductions or 

credits unused in previous years and similar special technical features of the tax Law. In general, carryover can be 

viewed as being conceptually different from changes in the 

price of assets, In the case of capital gains tax, for 

example, the change in an individual's tax liabiliry for gains

that have arisen by reason of a past increase in asset values 

does not affect the tax Liability of another individual 

purchasing an asset from him; in general, the asset price

depends only on future net-of-tax earnings. However, the 

new tax law -and the transition rules, by altering future 

net-of-tax earniggs, would change the price of assets. 
- 183 -

In mosc cases, carryover problems could be handled by

special rules that define the amount of income attributable 

to increases in asset values not realized before the effective 

date of LmpIementatiaa of the new law- Changes in the 

definition of an individual’s past income would alter asset 

prices only if they provided an incentive for pre-effective

date sales of existing assets. For example, if, under the 

new system, past capital gains were taxed at a higher rate 

than under the old system, an incentive might be created for 

sales of assets prior to the effective date. 

Price Changes 
 

Adoption of a broadly based tax system would change

prices of some assets by changfng the taxation of future 

earnings. Under the comprehensive income tax, for example,

the following changes in the tax code would alter tax rates 

on income from existing assets: integration of the corporare

and Dersonal income taxes; taxation of all realized capital

gain; at the full rats; adjustment of asset basis for 

inflation (or deflation); inclusion of interest on State and 

local gove&nant bands in the tax base; elimination of 

accelerated depreciation provisions that lower the effective 

rate of tax on income arising in special sectors, including

minerals extraction, real estate, and same agricultural

activities; and elimination of the deductibility of property 

taxes by homeowners. Adoption of these and other changes in 

the tax code wuuld alter both the average rate of taxation 

on income from all assets and the relative rates imposed 

among types of financial claims, legal entities, and investments 

in d-if ferent industries. 

The effects of changes in taxation on asset values 

would be different for changes in the average level of 

taxation of the associated returns and changesineha

relattve rates of taxation on different assets. A change in 

the average rate of taxation on all income from investment, 

while it would affect the future ner return from wealth or 

accumulated past earnings, would not be likely in itself to 

change individual asset prices significantly. For any

single asset, an increase in the average rate of taxation 05 

returns would reduce net after-tax earnings roughly in 

proportion to the reduction in net after-tax earnings on 

alternative assets. Thus, the market value of the asset,

which is equal to the ratio of returns net of depreciation 

to the. interest rate (after tax), would not tend to change.

On the other hand, an increase in the relative rate of 

taxation on any single asSet generally-would lead to a fall 

in the price of that asset, because net after-tax earnings

would fall relative to the interest rate. The opposite

holds far a decrease in the relative rate of taxation. 
- 184 -

The behavior of the price of any single asset in 
 response to a change in the relative rate of taxation of its 
 return depends on the characteristics of the asset and the 
 nature of the financial claim to it. For example, suppose
 the asset is a share in an apartment project. In the long 
 run, the price of the asset will depend on the cost of 
 building apartments; if unit construction costs are inde­
 pendent of volume, they will not be altered by changes in 
 the tax rate on real estate profits. 
 

Bow, suppose the effective rate of taxation on profits

from real estate is increased. The increase in tax will 

drive down the after-tax rents received by owners. Because 

the value of the asset to buyers depends on the stream of 

annual after-tax profits, the price a purchaser is willing 

to pay also will fall. With the price of the structure now 

lower than the cost of production, apartment construction 

will decline, making rental housing more scarce and driving 

up the before-tax rentals charged to tenants. In final 

equilibrium, the before-tax rentals will have risen sufficiently to restore after-tax profits to a level at which 

the price buyers are willing to offer for the asset is again

equal to its cost of production. However, for the interim 

before supply changes restore equilibrium, after-tax returns 

would be Lowered by the price change. 

Thus, the immediate effect of the change in the rate of 

taxation would be to lower the price of equity claims to 

real estate. The wealth loss to owners of those shares at 

the time of the tax change would depend both on the time 

required for adjustment to final equilibrium and the extent 

to which future increases in the gross rentals (from the 

decline in housing supply) were anticipated in the marketplace. The faster the adjustment to equilibrium and the 

larger the percent of gross rentals change that is anticipated, the smaller the fall in asset price will be for any

given increase in the tax on the returns. 

If the asset is a claim to a fixed stream of future 

payments (e.g., a bond), a change in the rate of taxation 

would alter its price by lowering the present value of the 

future return flow. For example, if interest from municipal

bonds became subject to tax, the net after-tax earnings of 

holders of municipal bonds would fall, lowering the value of 

those claims. New purchasers of municipal bonds would 

demand an after-tax rate of return on their investment 

comparable to the after-tax return on other assets of 

similar risk and liquidity. The proportional decline in 

value for a given tax change would be greater for bonds with 

a longer time to maturity. 
- 185 -

The effect of corporate integration on the price of 

assets is less certain. If the corporate income tax is 

viewed as a tax on the earnings of corporate equity shareholders, integration would increase the rate of taxation on 

income from investment of high-bracket shareholders and 

lower the rate of taxation on such income of low-bracket 

shareholders. 1,’ In addition, many assets owned by corporations also can be used in the noncorporate sector. To 

the extent that relative tax rates on income arising in the 

two sectors were altered by integration, those assets could 

easily move from one sector to the other, changing relative 

before-tax earnings and output prices in the two sectors,

but keeping relative after-tax earnings and asset prices the 

same. 

In conclusion, raising the relative rate of taxation on 

capital income in industries and for types of claims currently receiving relatively favorable tax treatment would 

likely cause some changes in asset prices. Immediate asset 

price changes generally would be greater for long-term fixed 

claims, such as State and local bonds, than for equity

investments; greater for assets specific to a given industry 

(e.g.. apartment buildings) than �or assets that can be 

shifted among industries; and greater for assets the supply

of which can only be altered slowly (e.g., buildings and 

some mineral investments) than for those the supply of which 

can be changed quickly. 

The net effect of integration on asset values may not 

be large. On the other hand, changes in the special tax 

treatment currently afforded in certain industries, for 

example in real esrate and mineral resources, and changes in 

the treatment of State and local bond interest, would likely 

cause significant changes in values of those assets. 

The Equity Issues 

Considerations of equity associated with changes in tax 

laws are different from equity considerations associated 

with the overall design of a tax system. Changes in the tax 

code would create potential inequities to the extent that 

individuals who made commitments in response to provisions

of the existing law suffer unanticipated losses (or receive 

unanticipated gains) as a result of the change. These gains

(and losses) can be of two types: (1) wealth changes to 

indivtduals resulting from changes in tax liabilities on 

income accrued in the past but not yet recognized for tax 

purposes, and (2) changes in the price of assets or the 
- 186 -

value of employment contracts brought about by changes in 

future after-tax earnings. These two types of problems, 

carryover and prlce change, pose somewhat different equity 

issues. 

Carryover poses the problem of how ro tax equitably

income attributable to an earlier period, when a different 

set of tax laws was in effect.. For example, consider one 

aspect of the proposed change in the tax treatment of 

corporations under the comprehensive income tax. At present, 

capital gains are subject: to lower tax rarcs than dividends,

especially when realization is deferred for a long period of 

time. Individuals owning shares of corporations paying high

dividend rates relative to total earnings pay more tax than 

individuals owning shares of corporations with low dividends 

relative to total earnings. As both types of investment are 

available to everyone, individuals purchasing shares in 

high-dividend corporations presumably are receiving something (possibly less rhk or more liquidity) tn exchange for 

the higher cax liability they have to assme. To subject

shareholders of low-dividend corporations to the same rate 

of taxation as they would have paid if income accumulated In 

the form Qf capital gains before the effective date had been 

distributed would be mfair4 

Carryover poses another equity problem: some taxpayers 

may be assessed at musually high or low rates on past

income because of changes in the timing of accrual of tax 

liability4 The above example can be used to illustrate this 

point tor>. Under current law, the special tax treatment of 

capital gains in part compensates shareholders for t;ke extra 

tax on their income ar the corporate levela Under the integration proposal presented in chapter 3, the separate corporate

income tax would be eliminated, but shareholders would be 

required to pay a full tax on their attributed share of the 

corporation ‘s income, whether 01: not distributed. 

Now, suppose integration is introduced and a shareholder 

has to pay the full tax on the appreciation of his shares 

that: occurred before the effective date. 2/ The taxpayes

would, in effect, be taxed too heavily on-that income, 

because it was subject to taxation at the corporate level 

before being taxed at the full individual income tax rate. 

Before integration, he would, in effect, have paid the 

corporate tax PLUS the reduced capital gains rate on the 

gains attributable to that income; after integration, he 

would be liable for the tax on ordinary income at the full 

rate. Thus, in the absence o� transition rules, he would be 
- 187 -

subject to a higher tax on income in the form of capital

gains accrued before, but not recognized until after, the 

effective date of the new law than on income earned in a 

similar way under a consistent application of either present

law or the comprehensive income tax. 

The most desirable solution to the problem of equity

posed by carryover is to design a set of transition rules 

that insure that, to the maximum extent consistent with 

other objectives, tax liabilities on income accrued before 

the effective date are computed according to the old law and 

tax liabilities on income accrued after the effective date 

are computed according to the new law. 

Changes in future after-tax income brought about by tax 

reform raise a different set of equity issues. A complete

change in the tax system, if unexpected, would cause losses 

in asset value to investors in previously tax-favored 

sectors. Imposition of such losses may be viewed as unfair,

especially since past government policy explicitly encouraged

investment in those assets. 

For example, as between individuals in a given tax 

bracket one of whom held State and local bonds producing a 

lower interest rate because such interest was tax-exempt and 

the other of whom held taxable Treasury bonds producing

higher interest but the same after-tax return, it seems 

reasonable to compensate the holder of the State and local 

bonds for the loss suffered upon removal of the tax exemption 

so that he ends up in the same position as the holder of 

Treasury bonds. Note that this concept of distributive 

justice does not imply that a third taxpayer, who earns 

higher after-tax income from tax-free bonds than from 

Treasury bonds because he is in a higher tax bracket than 

the other two, should retain the privilege of earning taxfree interest. Equity does not require that the tax system

maintain loopholes; it does require some limitation on 

wealth losses imposed on individuals because they took 

advantage of legal tax incentives. 

The counterargument to the view that justice requires

compensation for such wealth changes is that all changes in 

public policy alter the relative incomes of individuals and,

frequently, asset values. For example, a government decision to reduce the defense budget will lower relative 

asset prices in defense companies and their principal

supplying firms and also lower relative wages of individuals 

with skills specialized to defense activities (e.g., many

engineers and physicists). Although some special adjustment 
- 188 

assistance programs exist, 3J ir; is not common practice to 

compensate individuals for Fhanges in the value of physical

and human assets caused by changes in government policies.

In addition, it can be argued that, because investors in 

tax-favored industries know the tax subsidy may end, the 

risk of a public policy change is reflected in asset prices

and rates of return. If, for example, Lt is believed that 

the conzinuing debate over ending remaining special. tax 

treatment of oil industry assets poses a real threat, it can 

be argued that investors in oil aye already receiving a risk 

premium in the form of higher than normal net after-tax 

returns, and further compensation for losses upon end of the 

subsidy is unwarranted. 

The discussion above suggests that a case can be made 

both for and against compensation of individuals for losses 

in asset values caused by radical changes in tax policy.

Because the asser value changes resultfng from the tax change

alone are virtually impossible to measure precisely, designing a method to determine the. appropriate amount of 

compensation would be difficult on both theoretical and 

practical grounds. However, it would be desirable to design

transition rules SO that unanticipated losses and gains

resulting from adoption of a comprehensive tax base would be 

moderated. Two possible design features, grandfathering

existing assets and phasing in the new rules slowly, are 

discussed next. 

INSTRUMENTS FOR AMELIORATING TRANSITION PROBLEMS 

Objectives 
 

The main criteria that transition rules should satisfy 

are; (1) simplicity, (2) minimizing incentive problems, and 

(3) minimizing undesirable wealth effects 

Simplicity. The transition rules in themselves should 

not introduce any major new complexity in the tax law. To 

the extent possible, transition-rules should not require

that corporations or individuals supply additional data on 

financial transactTons or asset values. 

Minirn2,zix-wIncentive Problems- The transition rules 

should be designed to minimize the probability of action in 

response to special features of rhe change from one set of 

tax rules to another. In particular, there should not be 

special h-ducements either to buy 01tD sell particular 

klnds of assets just before or after the effective date of 

the new Law. 
- 189 -

Minimizing Undesirable Wealth Effects. Transition 

rules should moderate wealth losses to individuals holding 

assets that lose their tax advantages under basic tax reform 

as well as gains to those whose assets are relatively

favored. At the same time, special transition rules to 

protect assetholders from loss should -not give them the 

opportunity to earn windfall gains. 

Alternatives 
 

TWO alternative methods of reducing capital value 
 changes are discussed here: grandfathering existing assets 
 and phasing in the new law. 
 

Grandfathering. The grandfather clause was originally

used by some southern States as a method for disenfranchising

black voters following the Civil War. It exempted from the 

high literacy and property qualifications only those voters 

or their lineal descendants who had voted before 1867, More 

recently, grandfather clauses have been used to exempt 

present holders of positions from new Laws applicable to 

those positions, e.g., setting a mandatory age of retirement. In the context of tax reform, a grandfather clause 

could be used either to exempt existing assets from the new 

law as long as they are held by the current owner or to 

exempt existing assets from the new law regardless of who 

holds them. A grandfather clause also could be applied to 

capital gains accrued but not yet realized at the time the 

new law went into effect. 

Consider, for example, the effect of eliminating the 

special depreciation rules chat result in a low rate of 

taxation on income from real estate investments. A grandfather clause that exempts existing buildings only so long 

as they are held by the current owner(s> would mean that 

current owners could depreciate their buildings to zero 

according to the old rules, but that new owners could not do 

so. Grandfathering the buildings independently of their 

owners would allow subsequent purchasers to depreciate

according to the old rules. 4/ This would have the effect 

of raising the value of the hildings. Elimination of tax 

incentives in real esrate would discourage new construction, 

reducing the supply of housing and raising gross renrals 

before tax. Thus, grandfathering, by making existing 

property more valuable, would give a windfall gain to 

investors in real estate tax shelters. On the other hand,

grandfathering the buildings only for cursent owners would 

not prevent a wealth loss to real estate investors, because 
- 190 -

the value to new buyers would decline. The Loss would be 

mitigated by the anticipated increase in after-tax profits 

to current Investors (because of the decline in housing 

supply) * 

The effect of grandfathering on asset prices far fixedinterest securities is less certain. For example, if 

existing municipal bonds were grandfathered, annual interest 

received net of tax wuuld be unchanged. However, the value 

of the tax savdng from owning municipal bonds would change

for two reasons. First, there would be no new tax-exempt

municipal bond issues under the new rules; with fewer 

available tax-exempt bonds, the price of tax-exempt: securities 

will rise, as will the marginal tax bracket at which such 

securities offer a net advantage. Second, the other changes

in the tax system which would enable marginal tax rates in 

the highest brackets to fall, would reduce the gain from tax 

exemptions, driving down the demand for, and the price of 

tax-exempt securities. As demand and supply will both fall, 

it is pot clear in what direction the price of the grandfathered

securities would change, though the price change would be 

smaller than if tho new rules were adopted imediately for 

all tax-exempt securities. 

One problem of grandfathering is that it can provide an 

unanticipated gain to current owners of assets subject to 

favorable tax treatment. These owners would receive a gain

because the new tax law would reduce the supply of previously

favored assets, thus raising before-tax profits. 

Gsandf athering probably should be limited to cases 

where gross returns are not likely to be altered significantly by the change in taxatfan. For example, changes in 

the tax treatment of pensions would not be likely to affect 

before+tax labor ccmpensatfon significantly, assuming the 

supply of labor to the economy is relatively fixed. While 

grandfathering tax treatment of pensions in current employment contracts would not be likely to raise significantly

the value OE those contracts relative to their value under 

the old law, an immediate shift to the new law would reduce 

the value of previously negotiated pension rights. 

Pbasinp. In. &I alternative method of avoiding drastic 

changes in asset values is to introduce the new rules 

gradually. For example, taxation of interest: on currently 

tax-exempt State and local bonds could be introduced slowly

by including an additional 10 percent of interest in the cax 

base every year for 10 years. Phasing in the new rules 

would not alter the direction of asset value changes, but it 

would reduce their magnitude by delaying tax liability

changes. 
- 191 -

Assuming that the market incentives under the new law 
 are preferable to the incentives under the current law,
 phasing in poses distinct disadvantages. Phasing in would 
 delay application of the new rules, thus reducing the 
 present value of the economic changes that would be en­
 couraged and which are an important objective of the new 
 rules. Phasing in also may introduce substantial complexity
 The length of the phase-in period would depend on the 
 desired balance of the gains in efficiency and simplicity
 from changing the tax system against the distributive 
 inequities resulting from imposition of asset value changes 
 on some investors. 
 

Combination of Phasing In and Grandfathering. A 

possible variant on the two approaches outlined above is to 

adopt the new rules immediately for new assets while phasing

in rhe new rules for existing assets. In many cases, grandfathering existing assets when new assets would be taxed 

nore heavily under the new tax law would raise the market 

price of the old assets. By phasing in the new rules for 

the old assets, it would be possible to moderate the increase 

in present value of future tax liabilities, while at the 

same time reduced supply of new assets would raise beforetax returns on both new and existing assets. The two 

effects may roughly cancel out, leaving asset prices almost 

the same throughout the early transition period. For example, 

a gradual introduction of new, and more appropriate, depreciation schedules for existing residential real estate, 51 

with a concurrent adoption of the new rules for new builzings, would have the same incentive effects on new building 

as immediate adoption of the new law. 3efore-tax rentals on 

existing real estate would rise gradually, as supply growth

is reduced, while tax liabilities on existing real estate 

also would rise. It is likely that, for an appropriate

phase-in period, the asset value change to existing owners 

would be small. However, tax shelters on new construction 

would be totally eliminated immediately. 

PROPOSED SOLUTIONS TO SELECTED PROBLEMS IN THE TRANSITION 
 TO THE COMPREHENSIVE ZNCOIE TAX 
 

Adoption of the comprehensive income tax would have 

significant impact on the taxation of capital gains, corporate

income, business and investment income, and personal income. 

The following discussion examines the problems that these 

changes present for transition. In most cases, possible

solutions to these problems are suggested. 
-- 

- 192 -

Capital Gains 

Under the compzehenstve income tax, no distinction will 

be made between capital gains and ordinary income, and 

lasses will be fuLLy deductible agahst income from other 

sources. The transitton mechanism proposed is to allow 

capital gains (or losses) that have accrued as of the 

general effective date of the propusal, to canrinue to 

qualify far: capital gains treatment upon a sale or other 

taxable disposition Ear I0 years following such date. This 

"capital gain account'' inherent in each asset could be 

determined in either af two ways: 

1. By actual valuation on the general ef�ective date of 

enactment of the propusal (or on an elective alternative 

valuation date to avoid temporary distortions in market 

value), or 

2. By regarding the gain (or loss) recognized on a 

sale or exchange of the asset as having accrued ratably over 

the period the seller held the asset. The portion of the 

gain (or loss) thus regarded as having accrued prior to the 

effective date would be taxed at: capital gain sates (or be 

subject t~ the limitation QKI capital Losses) provided that 

the asset continued to meet the current requirements fox 

such treatmeat. Recognition of capital gain (or loss) un 

the asset after the effective date would extinguish the 

capital gain (m lpss) potential of rhe asset. Thus, gains 

on sale or exchange of an asset purchased after the effective date would not receive any special tax treatment:. 

Both of these systems have been employed in the Tax 

Reform Act o� 1976 in connection with the sQ-called carryover batsis provisions at death the former far securities 

traded on established markets, and the latter for all other 

assets. 

A number of technical rules relating to transfers and 

subsequent adjustments to basis would have to be provided.

In general, the account should carry over to the transferee 

in certain tax-free transfers that reflect a change in the 

transferor's form of owesship of, ox interest in, the 

asset, such as contributions to a controlled corporation

(under section 351) or partnership (section 721) or a 

complete liquidation of certain controlled subsidiaries 

(section 332). In the case of a transfer of an asset to a 

controlled corporation or partnership, it may be appropriate 
- 193 -

to allow the shareholder or partner to elect to transfer the 

capital gain account of the asset to his stock or partnership interest, and have the asset lose its capital gain

character in the hands of the corporarion or partnership.

Also, in the case of a sale or exchange where the seller is 

allowed nonrecognition of gain on the transaction because he 

acquires an asset similar to the asser disposed of, the 

capital gain account should attach to the newly acquired 

asset. For example, if a taxpayer is to be allowed nonrecognition treatment on the sale of a personal residence 

where another residence is acquired within a specified time, 

the capital gain account would attach to the new residence. 

Rules also would be needed to take into account an 

increase or decrease in the basis of the property after the 

effective date. An increase in the basis of the property

generally should not decrease the capital gain account, 

since the increase in basis generally will be accompanied by 

an increase in the fair market value of the asset (for

example, where a shareholder contributes cash to a corporation); the increased fair marker value due to the increase 

in basis would, when recognized, represent a return of the 

investment increasing the basis. On the other hand, a 

decrease in basis resulting from a deduction against ordinary income should reduce the capital gain account (i-e.,

code sections 1245, 1250, and other recapture provisions

currently in the code that prevent the conversion of ordinary income into capital gain because of excess depreciation deductions or other means should continue to apply).

In general, if the taxpayer's basis in an asset is required 

to be allocated among several assets (such as is required

with respect to a nontaxable stock dividend) the capital

gain account should be allocated in a similar manner. 

Special rules also would be needed for section 1231 

property, since net gains from the sale of such assets 

qualify for capital gains treatment. 6/ Aworkable rule 

would be to apply section 1231 to assets that qualify as 

section 1231 assets in the hands of the taxpayer on the 

general effective date, and continue to so qualify as of the 

date of sale or other taxable disposition. Such property

would have a "section 1231 account" similar to the capital

gain account attaching to each asset. Similar rules relating to transfers, basis adjustments, etc., also would 

apply. 

Since an asset may be held for an indefinite period, a 

cutoff date for capital gains treatment is needed; otherwise, 
- 194 -

the complexity of the capital gains provisions in the code 

would continue for at: least a generation, (Under the 

proposal, donors and decedents would be required to recognize gain or loss on the assets transferred, subject to certain 

exceptions and, thus, the capital gain account would not 

carry over to a donee or heir.) Accordingly, at the end sf 

a specified period (say, 10 years), the capital gains

deduction and the alternative tax treatment would expire.

Admittedly, some of the equity problems resulting from 

inmediate repeal of the capital gains provisions would 

remaFn even if complete repeal were delayed 10 years. The 

ICi+year phase-out period, however, would allow gradual

market adjustments and help protect the interests of investors who purchased assets in reliance on the current 

capital gains provisions 

An alternative to the capital gain account (and section 

1231 account) procedure would be to phase out the dedactiun 

for capital gains (and the alternative tax) ratably over a 

specified number o� years, Par example, the 50-percent

deduction for capital gains could be reduced five percentage

points a year, 50 that at the end of 10 years the deduction 

would be eliminated. The simplicity of this alternative is 

the best argument for its adoption, since no valuation as of 

a particular date would be required. 

Corporate InteEration 

Under the comprehensive income tax,corporations would 

not be subject CP tax, Instead, shareholders would be 

taxable on their income, or would 

be allowed to corporate loss. 

(See the 

The most significant transitional problems involve the 

question of timing and the treatment of income, deductions,

credits, and accumulated earnings and prcdits that are 

earned or accrued before the effective date of the changeover to integration but that would be raken into account for 

tax purposes after such date. Other transition problems

related to the foreign area are discussed in chapter 3. 

Pre-eHective Date Retained Earnings. Perhaps Ehe most 

difficult transition problem posed by corporate integration

is the treatment of corporate earnings and profits that are 

undistributed as of the effective date of integration, Such 
- 195 -

earnings would have been taxed to the shareholders as 

dividends if distributed before the effective date, or taxed 

at capital gains rates if recognized by means of sale or 

exchange of the stock. Under corporate integration,

distributions made by a corporation to its shareholders 

would be tax-free to the extent of the shareholder's basis;

distributions in excess of the shareholder's basis in his 

stock would be taxable. However, corporate earnings and 

profits accumulated before the effective date but distributed 

afterward should not be accorded tax-free treatment; to do 

so would discriminate against corporations that distributed 

(rather than accumulated) their earnings and profits in preintegration taxable years. (In the case of shareholders who 

are content to leave the accumulated earnings and profits in 

corporate solution, however, the effect of corporate integration 

on the income geneiated by such accumulated earnings may

give the same result as if such earnings had been distributed 

tax-free, since such income would be taxed directly to the 

shareholders, without the interposition of corporate tax,

and would then be available to the shareholders as a taxfree dividend.) 

The problem of accumulated earnings can be addressed by

continuing to apply current law to corporate distributions 

that are made within 10 years after the effective date of 

integration and that (1) are made to persons who held the 

shares on such effective date with respect to which the 

distribution is made, and (2) are made out of earnings and 

profits accumulated before such date. Thus, a distribution 

to such shareholders out of earnings and profits accumulated 

by the corporation before the first taxable year to which 

corporate integration applies would be a dividend, taxable 

as ordinary income, unLess the distribution would qualify

for different treatment under current law. For example, a 

distribution received pursuant to a redemption of stock that 

is not essentially equivalent to a dividend under current 

law would continue to be treated as a distribution in pait 

or full payment in exchange for the stock. On the other 

hand, an attempt to bail out the pre-effective date earnings

and profits by means of a partial redemption of stock that 

would be treated as a dividend distribution under current 

law would continue to be so treated. The provisions of 
 current law relating to electing small business (subchapter

S) corporations would be helpful as a model in drafting this 

particular transition proposal. For purposes of determining

how much of a distribution that is treated as a sale or 

exchange under current law would qualify for special capital

gains treatment, the transition rules outlined above for 

changes in taxation of capital gains would apply. 
- 196 -

In general, distributions with respect to stock acquired in a taxable transaction after the effective date 

would be subject to the new rules, and would reduce basis 

and not constitute income (unless such distributions exceeded the shareholder's basis). However, in those c3ses 

where the transferee acquired the stock after the effective 

date wLthout recognition of gain by the transferor, current 

la-would continue to apply to distributions from preeffective date accmlazed earnings and profits. 

Distributions after the effective date would be deemed 

to be made first frum the shareholder's distributable share 

of the corporation's post-effective date inc~meand then 

from pre-ef�ective date earnings and profits (similar to the 

subchapter S rules). Distributions in excess of those 

amounts would be applied agatnst and reduce the shareholder's 

basis in his srock. Amounts in excess of the shareholder's 

basis generally would be considered income. 

In order to avoid indefinite retentim of such a dual 

system of taxation, the special treatment of pre-effective

date earnfngs and profits would cease after a specified

number of years following the effective date of tntegration.

Distributions received after such date, regardless of 

source, first would be applied against basis and would be 

income to the shareholder to the extent they exceed basis. 

As previously indicated, pre-integration accumulated earnings and profits remaining after this date will not escape

taxation completely at the shareholder level, since such 

earnings will be reflected in the gain recognized on a 

subsequent taxable transfer of the stock (such as a sale or 

a transfer by gift or at dearh), or may be taxed as a distribution 

in excess of basis, Before fixing the cutoff date �or this 

provision, an effort should be made to determine quantitatively

the extent of the benefit to the shareholders of the deferral 

of such taxation. 

An alternative proposal was considered in an attempt: to 

preserve the ordinary income character of distributions from 

pre-effective date earndngs. This proposal would treat a 

shareholder as receiving a "deemed 6ivLdend" (spread ratably 

over a 10-year or Longer period) in 312amount equal to the 

lesser of the excess of the fair market value of the share 

of stock a$ of rhe effective date over its adjusted basis, 

OT the share's rorata poxtian a� undistributed earnings and 

profits as of she- mis proposal was rejected because 

of its complexity and because of the likelihood of substafitial liquidity problems for certain shareholders. 
- 197 -

Carryovers and Carrybacks. The carryover or carryback

of items of income. deduction, and credit between taxable 

years to which the corporate income tax applies, and taxable 

years to which it does not, must be considered for purposes

of the transition rules, To the extent practicable, an 

attempt should be made to treat such items in a manner that 

reflects the impact of the corporate income tax as in effect 

when such items were earned or incurred. In following this 

approach, however, no attempt should be made to depart from 

the general rules requiring that an item of income or loss 

be recognized before it is taken into account in computing 

gross income. Accordingly, unrecognized appreciation or 

decline in value of corporate assets (or stock of the 

corporation) attributable to the pre-effective date period

should not be "triggered" or recognized solely because of 

the shift to full integration. 

In general, certain deductions and credits may carry

back to a preceding taxable year or carry over to a subsequent taxable year because of a limitation on the amount of 

such deduction or credit that the taxpayer may claim for the 

taxable year in which the deduction is incurred or the 

credit earned. Thus, for example, a net operating loss 

carryback or carryover arises because the taxpayer's deductions exceed his gross income. Capital loss deductions 

are limited to capital gains, deductions for charitable 

contributions are limited to a certain percentage of income,

and the investment tax credit is limited to a percentage of 

the tax due. Also, the recapture as ordinary income, after 

the effective date, of deductions allowed and other amounts 

of income upon which tax has previously been deferred in 

pre-effective date years, has the effect of shifting that 

income to post-effective date years. 

If income sheltered by a deduction (or income that 

would have been sheltered had the deduction been utilized in 

an earlier year) had been distributed as a taxable dividend,

the net after-tax effect on the shareholder of the deferral 

or acceleration of a deduction would depend on his marginal 

tax bracket. In general, if the Shareholder is in a lower 

bracket, he may realize more total after-tax income if the 

deduction is utilized in a pre-effective date year in which 

the corporate tax applies and in which the tax savings at 

the corporate level are distributed as a dividend. If the 

taxpayer is in a higher bracket, he may realize more total 

after-tax income if the deduction is utilized in computing

his distributable share of taxable income after integration.

To best approximate the net result that would occur if such 
items could be used in the year incurred or earned, unused 

deductions and medics incurred or earned in pre-effective

date years should be given an unlimited carryback to earlier 

years of the corporation. In many cases this would benefit 

the taxpayer because he would receive a tax refund from such 

carryback earlier than he would under current law. Such 

benefits could be avoided to a large extent by charging the 

taxpayer an appropriate ammt of incerest for advancement 

of the refund 

Peductions that; could not be absorbed in pre-effective 

date years would be allowed to be carried in full to posteffective date years, subject to the ltmits established on 

the number of succeeding taxable years to which the item may

be carried, In general, however, deductions carried over 

from a pre-effective date year should not flaw through to 

the shareholders, either directly or indirectly, for use in 

offsetting the shareholder's income from other fiources, but 

should be available only as deductions at the corporate

level in order to determine the shareholder's prorata share 

of corporate income. This would avoid retroactive integration

with respect to such deductions, since the deduction would 

not flow through when incurred; i.t also would avoid possible 

abuses by means of trafficking in loss corporations. Ordinary 

income upon which t'ax was deferred in pre-effective years

should continue to be subject ro recapture as ordinary

income a 

Generally, .the carryover to a post-integration year of 

a tax credit earned in a pre-effective date taxable year

would result in a windfall far the shareholder, If the 

credit had been used to offset corporate income tax in the 

year in which it was earned, the amount representing the tax 

at the corporate level. offset by the credit would have been 

taxable ta the shareholder, either when distributed as a 

dividend or when realized by means of sale of the stock. 

Accardingly, a rule should be devised by which the tax 

benefit of a credit carryovex approximates the benefit that 

would resulr if the amount of the credit first: af�set a 

hypothetical corporate tax and then was distributed to the 

shareholder as a taxable dividend (or+ perhaps, reillized as 

capital gain). 

In general, no losses tncurred or available credits 

earned in post-effecritre date years would carry back to preeffectLve date years, since such items would flow thraugh to 

the shareholders after the effective date o� integration. 
-- 

- 199 -
 

Under present law, certain taxpayers, such as regulated

investment companies, real estate investment trusts, and 

personal holding companies, receive a dividends-paid deduction for a taxable year even though the distribution is 

actually made in a subsequent year. Such distributions in 

post-effective date years should be allowed to relate back 

to the extent provided by current law for the purpose of 

determining the corporate tax liability for the appropriate

pre-effective date year. The distribution would be considered to be out of pre-effective date earnings and profits

(whether or not it exceeds the amount in such account) and 

taxable to.the shareholders as a dividend from that source. 

Rules will have to be provided to insure that, if an 

investment tax credit earned by a corporation in a preeffective date taxable year is subject to recapture because 

of an early disposition of the property, the credit also is 

recaptured, either from the corporation or the shareholders. 

This could be accomplished at the corporate level by imposing an excise tax on the transfer or other recapture 

event in an amount equal to the appropriate income tax 

recapture. 

Flow-Through of Corporate Capital Gains. During the 

phase-out period for capital gains, the net capital gain or 

net capital loss for taxable years after the effective date 

of corporate integration should be computed at the corporate

level with respect to sales or exchanges of capital assets 

or section 1231 property by the corporation. The character 

of such net capital gain or net capital loss should flow 

through to the shareholders. 

Flow-Through of Tax-Exempt Interest. If the character 

of capital gains is to flow through to shareholders, consistency wokd require that the character of any remaining

tax-exempt interest received or accrued by a corporation

after the effective date of corporate integration from any

State or municipal bonds that are grandfathered also should 

flow through as tax-exempt interest to the shareholders. 

The tax-free character of the interest to shareholders would 

be preserved by increasing reducing the shareholder's basis 

by the amount of the interest attributable to him, but not 

including such interest in taxable income. Distribution 

would be treated as under the new law as a reduction of 

basis, but not included in income. Thus, such interest, if 

distributed, would leave both taxable income and basis 

unchanged. 
- 200 -

Generally, under present lawJ State and municipal bond 

interest is received tax-free by the corporation, but is 

taxable as a divfdend when distributed to shareholders. The 

1976 Tax Reform Act, however, provides that, in certain 

cases, the character of tax-exempt interest distributed by a 

regulated investment company flow through as tax-exempt

interest to its shareholders, 7/ If i'i is detxmnined that 

the tax-exempt character of Stare and municipal bond interest 

received by all corporations should not flow through to 

shareholders, an exceptim should be made for regulated

investment companies that have relied on the flow-thruugh

provisions of the 1976 Tax Refom Act. 

Unique CoIfporate Taxpayers. The provisions of .the fax 

code relating to taxation of insurance companies and other 

unique coryorate taxpayers will have co be examined co 

determine what adjustments, if any, are required to cake 

into account the effect of corporate integration on the 

special rules applying to such taxpayers - The determination 

of appropriate transition rules will depend on the nature 

of any changes made to the basic provisions, 

Business and Investmeqt Income, Indfvidual and Corporate 

In general, the repeal of code provisions that provide 

il~incentive for certain business-related expenditures or 

investments In specific assets should be developed to minimize 

the losses to persons who made such expenditures or investments 

prior to the effective data of the new law. The principal technique to effectuate this ~QL~CY would be to grandfather

actions taken under current Saw. For example, any repeal of 

a tax credit (such as the Lnvestment tax credit) and any

requ2rement that an expenditure that is currently deductible 

(such as soil and water conservation expenditures) must be 

capitalized should be prospective only. IG/ Subject to the 

rules prescribed above for corporations, unused tax credits 

earned in pre-effective date years should be available as a 

carryover to taxable years after the effecfzive date to the 

extent allowed under current lawm The repeal of special

provisions allowing accelerated amortization or depreciation

of certain assets generally should apply only with respect 

to expenditures made or assets placed in service after a 

specif-ic cutoff date. The revised general depreciation and 

depletion rulee should apply to property placed In service 

or expendftures made after an effective date. Thus, for 

example, buildings would contFnue to be depreciable in the 

manner prescribed by current law only in the hands of their 

current owners. A taxpayer who acquires a building and 

places it in service after the effective date would be 
- 201 -

subject to the new rules. Although this could result in 

losses in asset value for the current owners, grandfathering

the asset itself could, particularly in the case of buildings,

delay the effect of the new rules for an unacceptable period. 

The deduction for Local property taxes on personal

residences should be phased out by allowing deduction of a 

declining percentage of such taxes. 

The exclusion from gross income of interest on State 

and municipal bonds and certain earnings on life insurance 

policies should continue to apply to such interest and 

earnings on bonds and insurance policies that are outstanding 

as of the effective date. 

When adoption of the comprehensive income tax results 

in ending those provisions of current law that allow the 

nonrecognition of gain (or loss) on sales or exchanges of 

particular assets, such changes should be effective immediately,

with no grandfather clause. It is unlikely that the original

decision to invest in such assets depended on an opportunity 

to make a subsequent tax-free change in investment. An 

exception may be appropriate, however, with respect to a 

repeal of the provision that excludes from gross income the 

value of a building constructed by a lessee that becomes the 

property of the lessor upon a termination of the lease. A 

grandfather clause should apply current law to the termination 

of a lease entered into before the effective date. 

The proposal would allow an adjustment to the basis of 

an asset to prevent the taxation of "gain" that is attributable to inflation and that does not reflect an increase in 

real value of the asset sold by the taxpayer. The inflation 

adjustment should be applied with respect to inflation 

occurring in taxable years after the effective date. Making

such an adjustment retroactive would result in a substantial 

unanticipated gain for many asset holders. 

Other Individual Income 
 

Under the comprehensive income tax,several kinds of 

compensation and other items previously excluded would be 

included in gross income, and deductions for a number of 

expenditures that can be considered personal in nature would 

be disallowed. 
- 202 -
 

Employee Compensation. Such items as earnings on 

pension plan reserves allocable to the employee, certain 

health and life insurance premiulns paid by the employer,

carrain disability benefits, unemployment benefits, ahd 

subsidized compensation would be included in gross income. 

It may be presumed that existing employment contracts 

were negotiated on the basis that such items (other than 

unemployment compensation) would be excluded from the 

employee’s gross income, particularly in those cases where 

the exclusion reflects a policy of encuuraging that parcicular type of compensation, In the absence of special

transition rules, the inclusion of such ttems in income 

could create cash flow prablems or other hardships for 

employees under such contracts. For example, a worker who 

is required ta incrude in income the amount of his employer’s

health insurance plan conrribution may have LO pay the tax 

on this amount from what was previously Itcake home” pay if 

he cannot renegotiate his contract. 

This problem can best be sul.ved by an effecfive date 

provision that would apply the new rules to compensation

paid in taxable years beginning after a period of time to 

allow employers and emphyees to adjust to the new rules. 

Thus, the tax-free status of itens paid by employers on the 

date of enactment would continue for a specified period,

such as 3 years. Alternatively, the inclusion of these 

items of income could be phased in over such a period,

including me-third after 1 year, two-rhirds after 2 years,

aBd the full. mount after the third year, Special rules for 

military personnel could be devised to grandfather servicemen 

through their current enlistment or term of service. Eainirtgs

05 a qualified pension plan allocable to the employee that 

are artributabh to perhds before this delayed effective 

date would not be included in the gross incame of the employee.

However, earnings attributable to periods after that date 

(as extended wfth respect to binding contracts) would be 

included in gross income as accrued. 

Generally, tmemployment compensation, which would be 

included in taxable income under the proposal, wmLd no^ 

represent a return of a tax-paid basis to the recipient, 

since the ”premiums,” or employer contributions, with respect 

to such compensation were not included in his gross income. 

Thus, the full. mount of such compensation should be included 

in taxable income immediately after rhe general. effective 

date. 
 
- 203 -

Medical and Casualty Loss Deductions. Under the 

cowrehensive - income ~~ tax. certain nonbusiness exaenditures,

such as casualty losses,'and medical and dental expenses,

would cease being deductible. Generally, the repeal of the 

deductibility of these expenses could be effective immediately

If the medical expense deduction is replaced by a catastrophic
 insurance program, or some other program to achieve the 
 same ends, repeal of the deduction should coincide with the 

effective date of the substitute program. 

Charitable Deductions. This provision should be phased

in if the deductibility of charitable Contributions is 

eliminated under the model comprehensive income tax. To the 

extent that direct public subsidies to the affected institutions 

do not replace the loss in private gifts from removal of the 

tax incentive for contributions, both employment in and 

services to beneficiaries of such institutions would decline 

greatly. A gradual phase-in would increase the extent to 

which employment losses occur through gradual attrition 

rather than layoffs and would aid in identifying the types

of charitable recipients who might require greater direct 

public assistance when the deduction is completely'ended.

One possible method of phase-in would be to allow a declining

fraction of contribution to be deductible in the first few 

years of the effective date. 

Other Items Previously Excluded. The inclusion in gross

income of scholarships, fellowships, and means-tested cash 

and in-kind government grants would not appear to present 

any transition problems because, generally, the amounts of 

these items were not bargained for by the recipient and do 

not represent a return of a tax-paid basis. 

Treatment of Retirement Benefits. Under the Comprehensive

income tax, retirement benefits, including social security

benefits and private pensions, will be included in the tax 

base, while contributions to private pension funds and to 

social security by both employees and employers will be 

exempted from any concurrent tax liability. A significant

transition problem arises from this feature of the comprehensive

income tax. In che absence of special transition rules,

currently retired persons would be required to pay tax on 

the return of private pension contributions that had 

already been taxed. While the link between contributions 

and benefits is not so direct for social security, it still 

would be unfair co incLude social security benefits in the 

taxable income of persons who have been retired as of the 

effective date, again, because these taxpayers have paid tax 
- 204 -

on the part of income represented by aployee social security

contributions throughout their working gears. Thus, persons

retired as of the effective date should not have to pay tax 

on private retirement benefits which represent a return of 

contributioh or on social security benefits. On the other 

hand, benefits paid by qualified pension plans that allowed 

deductibility of post contributions, should remain fully

taxable, as under present law. 

More complex provisions are required �0~retirement 

income of taxpayers who are in the middle of their working 

years as o� the effective date, Such taxpayers will have 

been taxed on the employee portion of retirement contriburions 

up to fhe effective date, but not afteswards. Thus, it 

seems fair that they should pay tax on a fraction of the 

retirement benefits which represent return of contribution,

fhe fraction beartng some relation to the portion CI� the 

contributions that were excluded from taxable income. The 

general rule proposed is ro include in the tax base a fraction 

of retirement income that represents return Qf contributioa 

to an employee-funded pension plan. Tbe Eraction wQuld

depend on age at the effective date, ranging from 0 for 

taxpayers age 60 or over ZCI 1 �or taxpayers age 20 or under. 

A table could be provided in the tax form relating date of 

birth to the fraction of such income that is taxable. A 

similar treatment is proposed for social security benefits. 

Treatment of GFfts and Transfers at Death as Recognition

Events. Under the proposal, gifts and transfess at death 

wmbe treated as recognition events. Thus, in general,

che excess of the fair market value of the asset transferred 

over its adjusted basis in the hands of the donor or decedent 

would be included in the gross income of the donor or decedent. 

The portion of such gains attributable to the period

before the effccEive date of any such recognition rule 

should be exempted. Pravlsions for such an exemption were 

made in the Tax Refom Act of 1976 in connection with the 

carryover basis at death rule. The gains deemed to have 

accrued after the effective date would be taxable an transfer 

at the same rates applying to other sources of income. 

TRANSITION TO A FLUW TAX SYSTEM 

This Section presents a proposal for rransftion from 

the current: system to the model cash flaw tax pronosed in 

chapter 4. The problems involved in a EransiePon-'to the 

cash flow cax wouLd be considerable, and all 05 the alternative 

methods considered have major shortcomings. Presentation of 
- 205 -

this proposal includes discussion of administrative difficulties 

and some possible distributive inequities, and an explanation

of why certain alternative plans were rejected. 

In summary, the proposed transition plan would maintain 

the present tax alongside the cash flow tax for 10 Years 

before total conversion to the cash flow tax. During the 

transition period, individuals would compute their tax 

liability under both systems and would be required to pay

the higher of the two taxes. The corporate income tax would 

be retained for the interim and would be discontinued 

immediately at the end of the 10-year period. At thar time,

unrealized capital gains earned prior to full adoption of 

the cash flow tax would be “flushed” out of the system

through a recognition date, at which point they would be 

taxed at the current capital gains rates. Paymenr of taxes 

on past capital gains could be deferred, at a low interest 

charge, to prevent forced liquidation of small businesses. 

The transition program outlined here would not fully

realize the goals of transition presented below. It would,

however, mitigate the redistribution of wealth that would 

result from immediate adoption of a cash flow tax and would 

simplify the tax system by eliminating, within a reasonable 

period of time, the need to keep the personal and business 

income tax records currently required. 

Goals of Transition 
 

The main objectives to be realized by the transition 

rules for the cash flow tax are: (1) prevention of immediate 

or long-term redistribution of economic welfare, and (2)

simplicity and administrative ease. Although some changes

in consumption opportunities would be inevitable in a tax 

change as major as the one proposed, the proper transition 

program should be able to minimize large redistributions 

among taxpayers in ability to consume immediately and in the 

future. In particular, this program should prevent heavy

additional tax liabilities (in present-value terms) for any

clearly identifiable group of taxpayers. For purposes of 

simplicity, transition rules should eliminate the present 

tax system and its recordkeeping requirements promptly and, 

to the extent possible, avoid measuring current accumulated 

wealth and any annual changes in individuals’ total wealth 

positions in the transition period, as well as afterward. 

After transition, the principal records for tax purposes 
- 206 -

would consist only of cash flow cramactions for business 

activities, net deposits and withdrawals in qualified 

accounts, the usual wage and salary data, and transfer 

payments 

Disfribution Issues 
 

*Two dtstribution issues are important in a transition 

to the cash flow tax: (1) treatment O� mtaxed income before 

the effective date and (2) changes in the distribution of 

after-tax consumption. 

Equitable treatment of incorae untaied before the 

effective date would require that an individual who had 

unrealized capizal gains at the time of adoption of the new 

system be treated in the same way as the individual who 

realized the capftal gains before the effective date. The 

practical problems involved in achieving this goal influence 

the specifics of the transition proposal discussed below. 

The treatment of past accumulated income that has been 

taxed poses a mure difficult problem of equity. Because the 

cash flow tax is, in an important sense, equivalent to 

exempting income from capital from tax, as outlined in 

chapter 4, a higher tax rate on current wages not saved 

would be required to maintain the same tax revenue, Thus, 

the short-term effect of a cash flow tax wcruld be a higher

after-tax rate of return from ownership of monetary or 

physical assets regarded as tax prepaid and a lowex aftertax wage rate. The distributive consequences of this change

could be modified if some or all of accumulated wealth were 

to be treated as if already held in qualified accu~ts; 

i.e, , subject to tax upon withdrawal �or cmrrsumptim. 

If existing wealth were to be regarded as tax-prepaid

under the new system, all �uture xeturns from such assets, 

as well as return of principal, would not be subject to tax. 

On the other hand, if existing wealth ware to be regarded as 

receipts in the first year of the cash flow tax, an equally

logical approach, consumption of principal would be taxed, 

though the present value of tax liability would not increase 

as assets earned accrued interest, as it would under an 

income tax. 
- 207 -

Table 1 illustrates the tax treatment, under a comprehensive

Lncome tax and under the two alternative methods of cransitim to the. cash flow tax, of consumption out of $100 of 

past accumulated assets for different times at which wealth 

is withdrawn for consumption. A tax rate of 50 percent is 

assumed, assessed on annual interest earnings in the case of 

an income tax. 

Table 1 
 

Potential. Consumption Out of Accumulated 
 Wealth Under Different Tax Rules 
 

Initial Wealth = $100 

Assets Accumulate at 10 Percent Per Year If Untaxed; 

5 Percent Per Year If Taxed

Years After 
 Effective Date 

0 

10 
 

20 
 

Income Tax 
 

$lOQ 
 

$163 

$265 

Cash Flow Tax; 

Asset Tax-Prepaid 

$100 

$259 

$673 

Cash Flow Tax; 

Asset in hirial 

Receipts 
 

$ 50 

$130 

$334 

Under a comprehensive income tax, the asset cauld be 

withdrawn and consumed tax-free, but future accumulation 

would be taxed. 9/’ Under the cash flow tax, with the asset 

defined as tax-prepaid, returns from the asset would be 

allowed to accumulate rax-free and could also be withdrawn 

and consumed tax-free. Under the cash flow tax, with the 

asset value initially included in the tax base, consumption

from the asset would be taxed upon withdrawalF,but the rate 

of accumulation of the asset would not be affected by the 

tax. 

A transition to a cash flow tax with assets hitially

defined as tax prepaid would increase the welfare of owners 

of assets. The after-tax consumption of these taxpayers

would increase under the new system unless they consumed all. 

af their wealth within the first year after the effective 

date, in which case consumption would be unchanged. If 

assets were initially included in the tax base, however, the 

after-tax consumption of owners of assets would decrease if 

they chose to consme a large portion of their wealth in the 

early years afrer the effective date, Inclusion of assets 
- 208 -
 

in the base would increase after-tax consumption relative to 

an income tax for asset-holders who derevred cmsmnption out 

of accumulated wealth for a long period. ­l.Oi 

As Table 1 illustrates, how past wealth is viewed would 

make a big difference in the present value of tax Liabilities. 

Inclusion of accumulated assets in the tax base would 

be unfair to older persons who are about to consume out of 

accumulated wealth during the retirement period, if the 

income from which this wealth was accmulated had been 

subject to tax during their working years. On the other 

hand, tax-prepaid designation would greatly benefit all 

owners of monetary and physical assets by redistributing

after-tax dollars from labor CCI capiral. Although returns 

from assets would in effect be nontaxable under a fully

operational cash flow tax, past accumulatfon of wealth would 

have occurred mder a different tax system, where individuals 

did not anticipate a sharp rise in the after-tax return to 

capital. Thus, tax-prepaid treatment of capital assets for 

transition purposes may be viewed as inequitable. 

7%~distribution problem caused by defining existing

capital assets as prepaid would be reduced over time. The 

increased incentive to savings provided by the cash flow tax 

should raFse the rate a� capital fomaeion, increasing the 

amount of investment and eventually luwering before-tax 

returns to capital and raising before-Cax wages. However, 

in the firsr few years after transition, higher tax rates on 

current: wages would not be matched by a corresponding increase 

in before-tax wages. 

For certain types of assers, Che appropriate rule for 

transition definition is clear. Under the present system, 

investments in owner-occupied houses and other consumer 

durables are treated very similarly to tax-prepaid investments, 

and they should be defined as prepaid assets for purposes of 

transition to a cash flow tax. The accrued value of employerfunded pension plans should be treated in the same manner as 

qualified accounts, because the contributions were exempt

from tax under the 016 system and the receipts were fully

taxable. 

Designation of pasr accumulated aesets as tax-prepaid 

assets would be the easier rransLtion to aMnLster* There 

would be no need to measure existing wealth. Tax-prepaid 

assets could be freely converted to qualified assets to 
- 209 -
 

enable the individual to average his tax base over time. An 

individual converting a tax-prepaid asset to a qualified 

asset would be able to take an immediate tax deduction, but 

would become liable for taxes upon withdrawal of principal

and subsequent earnings from the qualified account. 11/ If 

assets were defined initially to be part of an indivzual’s 

tax base, it would be necessary to valuate them on the 

effective date. Individuals would have an incentive to 

undersrate their initial wealth holdings. Assets not 

initially accounted for could be deposited in qualified 

accounts in subsequent years, enabling an individual to take 

a deduction against other receipts. 

A Preliminary Transition Proposal 

Considering the objectives of basic reform (equity,

simplicity, efficiency), it seems best to define a11 assets 

initially in transition to the cash flow tax as prepaid 

assets. For a period of 10 years, the existing tax code 

would be maintained, with taxpayers filing returns for both 

tax systems and payin the hi her of the two computed taxes.Gl

For most taxoayers, ti? e cash how tax would he higher.

However, for persons with large amounts of income from 

assets relative to wages, the current tax would be probably

higher. 
 

The corporate income tax would be retained throughout

the transition period. Theoretically, stockholders paying

the cash flow tax should receive their corporate earnings 

groas of corporate tax during the interim period. However,

without full corporate integration, whereby all earnings

would be attributed to individual stockholders, it would be 

practically impossible to determine what part of a corporation‘s earnings should be attributed to individuals paying

the consumption tax and what part, to individuals paying tax 

under the old law. It is likely that ownership of corporate

shares would be concentrated among individuals who would be 

subject to the current tax during the interim period. For 

reasons of simplicity, therefore, the corporate tax would be 

retained for the transition period and would be eliminated 

immediately afterward. 

All sales of corporate stock purchased before the 

beginning of the transition period by individuals paying

under either tax base would be subject to a capital gains 

tax at the existing favorable rates. The reason for this 
- 210 -
 

provision is that capital gains which were accrued bur not 

realized before the interim period should be taxed as if 

they were income realized at the effective dace. 131 This 

is not administratively attractive, SD for 10 yea= all 

capital gains would b~ taxed on realizarion, whfchever tax 

base the individual was using. 

A recognition date would be required at the end of the 

transition period to 'account for all remaining untaxed 

capital gains. Under the cash flow tax, with assets defined 

as prepaid and no records of current and past carpmate

earnings and profits kept, it would be impossible to distinguish

between distributions thar were divtdends ~utof current 

income and distributions that were return of accmulated 

capital, The dividends would not be subject to tax under 

the new law. Distributing past earnings would be a way of 

returning to the individual tax-free, the capital gains

which had arisen prim to the adopcfon of the cash flow tax. 

To eliminate the need for permanent corporate records to 

capture. this past income, it would be necessary to have a 

single clay of recognition for past gains ac the end of the 

transition period. 

However, it would be possible to develop a method of 

allowing the find capital gains tax assessed OR che recognition

date to be paid over a long period at a low inrerest rate, 

to avoid forced liquidation of small firms with few owners. 

The advantages of the transition proposal ouclined hare 

are the �olbwing: 

1, 	 It:would enable all of the simplifying features of 

a cash flow tax to be in full operation after 10 

years, including elimination of tax records 

required under the present code, but not under the 

cash flow Tax. 

2. 	 It:would allow consumprim out of past accumulated 

earnings to be exactly the same as it would have 

been under the current tax during the first years

after the effective date. 

3. 	 It would provide for appropriate and consistent 

taxation of income earned before the effective 

date ~ 
- 211 -
 

4. 	 By eliminating taxes on returns earned after the 

effective date from past accumulated assets only 

on a gradual basis,it would mitigate the redistribution 

of wealth to current asset owners that would occur 

after immediate full adoption the cash flow tax. 

The major disadvantages of this transition program are 

that it would require a recognition date that would impose a 

large, one-time administrative cost on the system, and it 

would require some taxpayers to fill out two sets of tax 

forms fa2 a period of TO-years,a temporary departure from 

the long-term goal of simplicity. 

Alternative Transition Plans 
 

One alternative plan would be to adopt the new tax 

system immediately, designating all assets as prepaid,

without a recognition date to flush out past capital gains.

Although this plan would be the simplest one, it would give 

too great an economic advantage to individuals with unrealized asset appreciation and would cause too large a 

transfer of future after-tax consumption to present asset 

owners. 

Another transition plan would be to adopt the cash flow 

tax immediately and designate all assets as receipts in the 

first year. This would require valuating all wealth on the 

effective date and imposing a one-time wealth tax. Such an 

approach would be harsh on older persons planning to live 

off accumulated wealth in the early years after the effective 

date, 

A complicated variation on tax-prepaid treatment of 

assets would be one under which, in exchange for the 

elimination of taxes on consumption of assets defined as 

tax-prepaid,an initial wealth tax related to an individual's 

personal circumstances would be imposed. For example, the 

initial tax could be based on age and wealth, with higher

rates for persons with more wealth and Lower rates for older 

persons. E/ Although it might provide a transition program

that approximates distributive neutrality, such a plan would 

be a significant departure from the goal of simplicity. 

A third option would allow three types of assets: taxprepaid, as defined above; qualified, as defined above; and 
- 212 -
 

a third type, which would treat assets as defined under the 

current system. In principle, ir would be desirable for 

persons to be able to consume out of the third type of 

assets tax-free and to invest in prepaid and qualified 

assets only out of savings from current income. In effect,

this plan would initiate cash flow taxation on current 

earnings only and would treat pre-effective date earnings

exactly as they are treated under the current system,

including the same treatment of post-effective date capital

accumulation from pre-effective date wealth. This plan

would be extremely difficult to administer. Not only would 

individuals have to keep books for three types of assets,

but total annual wealth changes also would have to be 

computed, in order to arrive at a measure of annual consumption. (Valuation of unsold assets would not be a 

problem because even if too high a value were imputed,

raising both measured wealth and saving, consumption would 

remain unchanged.) Treatment of corporate income under this 

system also would be complicated, because some investments 

in corporate stock would come from all three types of 

assets. 

Under this transition alternative, assets of the third 

type would be subject to a transfer tax and converted to 

prepaid assets at death. Eventually, these assets would 

disappear from the system, and the complete cash flow tax 

would be in operation. Alternatively, all assets of the 

third type could be designated prepaid after a fixed number 

of years, 

Although the three-asset plan has the advantage of 

treating owners of capital exactly as they would have been 

treated under the income tax, and would change the rules 

only for new wealth,15/ its administrative complexity

raises very severe pKblems. 
- 213 -

Footnotes 
 

The exact change in the rate of raxation on income 

earned in corporations for different taxpayers will 

depend on the fraction of corporate income currently

paid out in dividends, the current average holding

period of assets before realizing capital gains, and 

the taxpayer's rate bracket. While the current corporate

income tax does not distinguish among owners in different 

tax brackets, integration, which would attribute all 

corporate earnings to the separate owners, would tax -all earnings from corporate capital at each owner's 

marginal tax rate. 

The taxpayer could avoid this problem by selling his 
 shares before the effective date at the current lower 
 capital gains rate and then buying them back. However, 
 one other objective of transition rules, discussed in 
 the next section, should be to avoid encouraging market 
 transactions just prior to the effective date. 
 

For example, workers damaged by employment reductions 

in industries with increasing imports due to liberalized trade policies are eligible for trade adjustment 

ass istame. 

Note that is is not clear just what is meant by an 
 "existing asset" in this context. For example, a 
 building is greatly affected by maintenance and im­
 provement expenditures over time. 
 

Appropriate depreciation schedules are those that 
 conform most closely to the actual rate of decline in 
 asset values. 
 

Section 1231 property is generally certain property

used in the taxpayer's trade or business. If gains

exceed losses for a taxable yeas, the net gains from 

section 1231 property are taxed at capital gains rates;

if losses from section 1231 property exceed. gains, the 

net losses are treated as ordinary losses. 

In the case of a subchapter S corporation, the charactex 

of net capital gains flows through to the shareholder. 

The character of tax-exempt interest does not. 

Expenditures made pursuant to binding contracts entered 

into before the effective date also should be grandfathered. 
- 234 -
 

The income tax computation assumes that all returns to 

investment would be taxed as accrued at full rates. Thus,

the annual percentage ratre of after-tax interest under 

the income tax would be cut in half. Unde~the present

law, taxation 05 capital gains is deferred until, realiaation and then taxed at only one-half the regular rate. 

For exanple, if the mser is suld after 20 years,

potential after-tax consumption would be $530, which is 

computed by multiplying the lung-term capital gain of 

$573 by .75 (the taxpayer is assumed to be in the 50 

percent bracket) and adding the return of ba.sds. It 

should be noted, however, that, if the assek is corporate

stock, profits are also subject to an annual corporate 

tax. Cmbfning the effects of corporate and personal 

raxes, rhe income of the asset holders may be taxed 

under current law at either a higher or lower rate rhan 

the rate on wage and salary income, depending on assumptions

about the incidence of taxes. 

For example, if the before-tax interest sate were 10 

percent, wealzh would quadruple in 15 years, With the 

50-percent tax rate used in Table 1, wealth holders 

would be better off under the cmsumption tax, even if 

their assets were initially included in receipts Ff 

they deferred consumption out of wealth for at least 15 

years, obtaining a daducrion against receipts in the 

ffrst year by placfag he asset in a qualified account. 

-lli A wealthy person could appear to "shelter" his current

consumption by converting prepaid assets into qualified 

assets, deducting the deposits in qualified assets from 

currant wage and ather receipts, However, this 

practice would not reduce the present value of his tax 

base, because he would have to pay a cax on the principal

and accumulated interest whenever the qualified asset 

was withdrawn for ccJnsumpt5orr. 

_c 12/ It is possible that only wealthy persons shou1c.l be

required to fill out a return for the current personal

income tax. The mab reason for retaining zhe current 

tax wwuld be to tax returns from passt accumulated 

wealth for an interim period of time to mitigate the 

inequitable distribution e�fects of a transition to 
- 215 -

tax-prepaid treatment of assets. It is likely that 

only people with significant amounts of wealth would 

have a higher liability under the current tax. The 

requirement to file two income tax returns might be 

limited to taxpayers reporting an adjusted gross income 

above a certain minimum level (for example, $20,001~or 

more) in any of several years before the effective 

date. 

-13/ Technically speaking, individuals paying the cash flow 

tax during the interim period should not have to pay

capital gains tax between the first day of the interim 

period and the time as asset is sold. One way to avoid 

this would be to adjust the basis upward to conform to 

interest that would have been earned on a typical

investment after the beginning of the interim period.

By doing this, the present value of capital gains tax 

paid for assets growing at that interest rate would be 

the same as if the gain were realized on the effective 

date. 

-141 
 Because the wealth of older persons might be subject to 

the accessions tax sooner, it might not be necessary
 for reasons of equity to tax it on the effective date. 
 

115/ 
 The three-asset plan can be viewed as a sophisticated

form of "grandfathering." 

- 217 -

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