"The Cash Flow Version of An Expenditure Tax" 

Peter Mieszkowski 

University of Houston 

OTA Paper 26 August 1977 

OTA Papers are circulated so that the preliminary findings of 

tax research conducted by Staff members and other associated 

with the Office of Tax Analysis may reach a wider audience,

The views expressed are those of the author, and do not 

rcflect Treasury policy. Comments are invited, but OTA 

Papers should not be quoted without permission from the 

authors. Managing editors are Michael Kaufman and Gary

Robbins. 

Office of Tax Analysis

U.S. Treasury Department, Room 1104 

Washington, D.C. 20220 

Issued: August 1977 
TABLE OF CONTENTS 

I. Introduction ................ 

11. General Nature of Integrated Proposal.... I11. A Cash Flow Tax As An Approximation TO An 

Expenditure Tax ............... IV. A Comprehensive Cash Flow Tax Base ..... 

V . A . Some Special Aspects of a Cash Flow Tax 

System ................. B. Averaging ................ C . Treatment of International Transactions . 

D. Treatment of Taxpayers With Overseas 

Connections or Interests ........ VI . The Accessions Tax ............. VI1 . Approaches To Transition. Or Phase-in Of the 

Expenditure Tax ............... 

Page 

2 

9 

16 

28 

40 

46 

48 

51 

59 

69 
I. INTRODUCTION 

In this paper a comprehensive plan for the introduction 

of a progressive consumption, or expenditure tax, is 

presented. AS a first step various arguments that favor the 

use of consumption, rather than income, as the personal tax 

base are reviewed. Since many of these arguments are based 

on the shortcomings of the existing income tax system, they 

depend on the nature of the income tax system an expenditure 

tax will replace. However, they also depend on value 

judgments regarding trade-offs among various social 

objectives. In addition, the advantages of a consumption tax 

base hinge on factual issues, such as what will happen to 

savings and growth under an expenditure tax system. 

Fundamental criteria or principles of taxation which 

form the basis of any evaluation of a tax system are 

considerations of efficiency, or optimality, and the 

principles of horizontal and vertical equity. Considerations 

of equity require judgements on what observable economic 

quantity is the best measure of ability-to-pay and what 

measure is the best index of equality between households. 

Economists have become increasingly aware that income 

and consumption, as measured in the marketplace are only 

imperfectly related to a person's ability to pay taxes or his 

overall endowment. This is becaues a person's taxpaying 

capacity depends not only on the amount of goods he can 

consume but also on the amount of time he can devote to 
consumption type activities, like sailing and golf. HOWEIVEIK, 

it is not administratively feasible to tax the value of a 

person's endowment of time that he allocates between leisure, 

work effort in the marketplace, and household production. 

One key reason for this is that it is difficult to determine 

the appropriate value for evaluating an individual's 

endowment of time. For example, money wages are not 

necessarily a good measure because professions may differ in 

nonpecuniary income. 

AS a result of such considerations, any observable, 

measureable quantity, such as market income or COnSUmptiOn, 

is likely to be imperfect as a basis of taxation. However, 

with a more restricted definition of endowment in a world Of 

certainty, the present value of a person's endowment could be 

calculated by discounting the stream of his life-time wages 

and salary income plus the bequests and gifts that he 

receives. The number so calculated might then be used as the 

basis of an endowment tax. However, as a practical matter, 

the tax could not be imposed on such a measure of endowment 

as this magnitude would be uncertain at any given time. A 

tax could, however, be imposed on consumption and if the 

present value of a person's lifetime consumption is equal to 

the present value of his endowment (his bequests are zero), 

the basis of an expenditure tax would be equivalent to the 

basis of an endowment tax. 

Consequently, from a life-cycle perspective, neglecting 

bequests, leisure, household production, and so forth, using 
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consumption as the tax base appears to be the best means of 

extablishing horizontal and vertical tax equity. The problem 

of bequests could be handled by means of an accessions tax. 

Under such a tax, a person who received a gift or bequest 

would pay a separate tax on this component of his endowment 

regardless of whethe he used it for consumption or not. TO 

the extent that the nheritance was subsequently used for 

consumption it would be subject to double taxation, first 

under the accessions tax and then under the expenditure tax. 

Although an accession tax would alter a person's savings 

behavior, the effect would be small in relation to the impact 

of an income tax where profit and interest income are subject 

to a double tax. This is because profit and interest income, 

which had been generated by savings subject to tax in the 

past, also would be taxed in the current period under an 

income tax. 

As an expenditure tax base does not impose a double tax 

on profits, people would consume more in later stages of life 

under such a tax since the price of future consumption 

relative to current consumption will be lowered. Of course, 

current consumption would be lowered and the capital stock 

would increase.l/ - Thus the substitution of an expenditure

tax for an income tax, of equal yield, is likely to increase 

the amount of savings and lead to capital formation and 

higher overall consumption possibilities in the long run. 

While the employment effects of an expenditure tax are 

somewhat less clear, it is important to recognize that the 
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apparent increase in tax on earnings implied by an 

expenditure tax is really only a tax increase on the share of 

earnings used for current consumption. The expenditure tax 

corrects the bias against future consumption (saving) 

inherent in an accretion type income tax. Given the current 

state of our knowledge, this paper adopts an agnostic stance 

on possible favorable effects of an expenditure tax relative 

to a equal yield income tax on the lifetime allocation of 

time between work effort and consumption. It seems likely, 

however, that future analysis will show that an expenditure 

tax reduces work effort less than an income tax of equal 

yield, and that it would lead to higher levels of social 

welfare. 

This speculation is supported by the fact that 

individuals are more productive in the first thirty years Of 

their adult lives (as evidenced by age-earnings data) than in 

last twenty or thirty years. Thus, under an expenditure tax 

(in contrast to an income tax) a person will tend to work 

more when he is young and has a comparative advantage in 

producing income. Leisure activities; travel, cultural 

appreciation, golf, will be more likely to be postponed until 

the semi-retirement period. an expenditure tax would 

facilitate and stimulate more work during the early 

productive period as it would increase future consumption 

possibilities by exempting profit and interest income. 

A further aspect of the incentive argument is that an 

expenditure tax would create new incentives for the 
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accumulation of new fortunes by exceptionally productive 

yotinq men and women. While the preservation of older 

fort-uneswould also be facilitated under this system, it 

would impose r7 penalty in addition to the accessions tax on 

consumption out of inherited wealth. 

Another set of arguments favoring the consumption base 

\?rc the shortcomings of income as a measure of a person's 

t.ixable capacity -- "spending power" or endowment. For 

ex;lmplc, it seems inequitable to impose the same rate of tax 

on an additional $5,0dU of wage income and on $5,000 earnings 

on SlO0,i)C)O of wealth, since the person with the capital 

incom? will have more time to devote to non market 

activities. For these reasons a person's endowment or 

overall wealth is imperfectly measured by income and, in our 

view, consumption will typically be more closely related to 

overall endowment or ability to pay than income. 

Closely related to this issue are various difficulties 

in correctly measuring capital income. First, inflation can 

distort accounting measures of income since depreciation and 

some interest rates are set in nominal terms, and capital 

gains ate fictitious to the extent that they reflect 

inflationary appreciations. Although equity problems caused 

by inflation will not totally disappear under an expenditure 

tax unless the tax system is indexed, they will be much less 

pronounced than under an income tax, because the tax base 

will be less susceptible to measurement errors. 

The taxation of capital gains represents a key problem 

under the current income tax. For administrative reasons, 
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capital gains are not taxed on an accrual basis and as a 

result many wealthy persons are able to postpone their taxes 

indefinitely and to reduce their income tax liability by 

converting income to capital gains. Thus, persons with the 

same amount of wealth or spending power often pay very 

different taxes under the income tax. 

Another reason why horizontal and vertical equity are 

often severly compromised under the current income tax is 

that the combination of capital gains, borrowing, and various 

tax shelters in housing, oil drilling, equipment leasing, and 

agricultural investments, decreases effective tax rates on 

wealthy persons. In fact, most such devices for reducing 

income tax liabilities are available and attractive only to 

those taxpayers with substantial amounts of wealth. 

While many of these loopholes might be closed under more 

comprehensive income tax, such a reform is likely to be very 

difficult and incomplete. Administrative difficulties are 

apt to prevent the taxation of capital gains on an accrual 

basis. This consideration is reinforced by the equity 

argument that the lower tax rate on capital gains provides 

some adjustment for the impact of inflation on tax 

liabilities. 

We believe that many, if not most, of the reforms often 

discussed under income tax reform will come about naturally 

through the introduction of an expenditure tax. Under the 

expenditure tax of the type outlined below there is no basis 
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for the tax preferences granted to homeowners, and no tax 

advantages to recipients of capital gains income, and 

municipal bond interest. Income tax reform has made little 

progress in the past and we believe that the public and 

Congress are more likely to adopt significant reforms in the 

context of a complete fundamental reform of the Federal tax 

system. 

The elimination of capital gains taxation and other 

taxes on capital income would greatly simplify the 

administration of the Federal tax system. Although the 

expenditure tax is sometimes regarded as too difficult to 

administer, strong arguments can be made that the 

administrative complexities introduced by the expenditure tax 

are quite manageable and small relative to gains of 

simplicity that will come about from the elimination of 

complicated provisions on capital gains taxation, 

depreciation, depletion, and the tax treatment of corporate 

earnings. 

One of the principal attractions of an expenditure tax 

is also one of the principal criticisms of the tax. This is 

that wealth is not subject to taxation under this tax system. 

Some writers, beginning with Thomas Hobbes, have placed 

emphasis on the social value or social externalities 

associated with savings and the accumulation of capital. 

Consumption has been characterized as representing a 

withdrawal form the common pool, while net savings are 

represented as additions to the common pool. Although many 
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people will have trouble with the notion of withdrawal from 

the common pool in a system of private property rights where 

individual effort is viewed as the basis of income and 

consumption, nonetheless this concept is useful in that it 

dramatizes the social value of additional capital in 

improving the productive capacity of society. 

Under a consumption basis, wealth is not subject to tax 

unless it is consumed, although it represents ability to pay. 

One justification of this exemption is the common pool 

concept of the social value of wealth. Another justification 

is that for most persons accumulated wealth represents 

deferred consumption that will be subject to tax at Some 

later point in their lives. 

If taxes are based on consumption the problem of wealth 

left as bequests or gifts can be solved by taxing this 

accumulated wealth under an accessions tax. Also, there are 

various advantages, including efficiency, equity, and 

administration, which seem to favor a consumption base over 

an income base for the tax system. 

11. GENERAL NATURE OF INTEGRATED PROPOSAL 

The main recommendation of this paper is to replace the 

personal income tax imposed on households and individuals 

with a progressive expenditure tax. In addition, the paper 

recommends the elimination of the corporate profits tax and 
the replacement of the current gift and estate tax by an 

accessions tax. Under an accessions tax, tax liability would 

depend on the amount of inheritances received by donees, 

rather than the amount of estates left by donors. Together 

these proposals represent a very comprehensive reform of the 

Federal tax system. Of course, id making these 

recommendations it is recognized that they both bear on the 

parameters (standard deductions, rates, etc.) of the system. 

The general guideline we suggest for setting these parameters 

is that the existing vertical burdens of the tax system be 

maintained as nearly as possible. The vertical pattern of 

burdens is, of course, a separable issue. 

The main objectives of an accessions tax and an estate 

and gift tax are quite similar. Both stem from the broad 

political concensus that the tax system should be used to 

lessen the concentration of wealth and the widely held view 

that a special tax should be paid by those who are fortunate 

enough to inherit physical and financial wealth. In a world 

where there are no substantial income and wealth differences 

among various households, and inheritances are modest, the 

treatment of gifts and inheritances would be quite simple 

under an expenditure tax. Gifts and bequests would be 

deducted by the donor but would be counted as receipts 

(income) by the donee. However, as there are marked 

differences in the earning capacities of indifferent 

households and in their wealth positions a separate tax 

should undoubtedly be imposed on inter-generation transfers 

of wealth. 
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It might be argued that if an individual does not 

consume his total endowment over his lifetime that his 

bequest should be treated as consumption. After all, the 

donor has the option of consuming his wealth or leaving it to 

his heirs. As the margin, it is reasonable to assume that a 

donor values money left to his heirs as much as a dollar used 

for current consumption. This is an argument in favor of an 

estate tax. However, an accessions tax, by reducing the 

consumption possibilities of a donor's heirs, would also 

effectively impose a tax on the consumption value of donor's 

bequests. Indeed, overriding considerations seem to favor an 

accession or inheritance tax imposed on the donee rather than 

the donor. Although in a sense the burden of an estate tax 

does fall on the donee, as it decreases the size of the 

estate, there is reason for making this burden more explicit. 

For, if a tax is to imposed on inhe ited wealth so as to 

lessen the concentration of wealth, the tax should depend on 

whether an estate is left to one he r or to twenty. 

Also, society may deem certain organizations and 

institutions more deserving of inheritance than heirs who are 

individuals and it would be simpler to express this 

preference in the form of differential taxes on the donee 

rather than through deductions for charitable donations under 

the estate tax. 

Under the accession tax, as elaborated upon in a later 

section of the proposal, the tax treatment of gifts and 

bequests would be integrated. Also, the tax would be on 
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lifetime accessions rather than on annual accessions. The 

principle here is that the tax should depend upon the 

accumulated sum of the good fortune rather than on the size 

of the receipient bequest. One weakness of the separate 

accession tax is that it is not based on the total 

circumstances of the individual but only on lifelong 

accessions. Part of this difficulty could be handled by 

allowing a sizable exemption. 

The accessions tax proposal is really a new way of 

addressing the objectives now implicit in estate and gift 

taxation. In addition to simplifying some aspects of 

transfer taxation, it seems better suited to attain the 

objectives of estate and gift taxation. As explained later, 

all of the issues of deferral which are associated with the 

taxing of trusts under an accretion tax are easily solved 

with an accessions tax. Also, under the expenditure tax, we 

propose to treat transfers as deductible from the cash flow 

base of the donor and includable in base of the donee so the 

accessions tax also "corresponds" with this feature of our 

proposed system. 

However, the replacement of the gift and estate tax by 

an accession tax is not basic to the adoption of an 

expenditure tax and there is no obvious reason why the 

existing estate and gift tax system could not be 

super-imposed on this structure. 

The same general point also applies to the corporate 

profits tax. The expenditure tax could be introduced without 
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any change at all in the corporate income tax. Yet, it is 

our view that the benefits of the proposal would be 

significantly reduced if the corporate tax is not eliminated, 

as this tax makes even less sense under an expenditure tax 

than under the present tax system, since the corporation tax 

would represent a tax on savings used to invest in corporate 

equities. 

Also, the elimination of the corporate tax would 

considerably simplify the Federal tax system. Provisions On 

depreciation, depletion, capital gains, inventory 

evaluations, as well as tax rates and tax credits could be 

eliminated from the tax code. Stockholders would merely 

report dividends as part of their cash flow under the 

expenditure tax and realized capital gains would be included 

in the tax base, and thus would be taxed if they were not 

saved. The reporting of profits, gross and net, would not be 

required for tax purposes. A discussion of the advantages of 

eliminating the corporate tax follows. 

First, corporate profits would not be subject to tax arid 

this would stimulate savings. As corporate equity would no 

longer be subject to tax, the tax distortion between 

corporate and noncorporate investment would be eliminated. 

The tax incentive to retain earnings and to invest them 

within the firm, rather than in higher yielding investments 

elsewhere, would also be eliminated. Because of this, 

misallocation of capital within the corporate sector would be 

eliminated. Also, the current bias toward using debt 

financing would be eliminated. 
Under the present tax system, the distortionary effects 

of the tax on corporate equity are in large measure offset by 

the deferral of tax on capital gains under the realization 

procedure. For example, in the extreme case a taxpayer in 

the 50% tax bracket will effectively pay very little, if any, 

tax on current earnings if earnings are retained and the 

accrued capital gains are not realized for many years 

hence.2/ - If the corporate tax is 50%, then for this special

case the high bracket taxpayer will pay approximately the 

same effective tax on investments in corporate equity and 

corporate debt and in non-corporate investments. Of course, 

the offsetting tendencies of the current system are only 

approximate and integration of the corporate and the personal 

income taxes would be more neutral with respect to the 

allocation of savings. 

Under an expenditure tax, capital gains and dividends 

would be taxed at the same rate and would be taxed only when 

the proceeds are consumed. Consequently, in contrast to the 

present system where there is a tax penalty for paying our 

dividends as earnings, with an expenditure cum corporate tax 

system corporations will have a very strong tax incentive to 

change their financial structure by paying our most, if not 

all, of the earnings as dividends and relying much more on 

debt finance. The share of corporate equity in the financial 

structure of corporations would be reduced to a minimal 

amount and it is for this reason that we consider the 

corporate tax as out of place, if not inconsistent with an 

expenditure tax system. 
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The other main disavantage of retaining the corporate 

tax is that complicated accounting problems associated with 

the measurement of corporate income would continue and the 

prinicpal administrative advantage of an expenditure tax 

would be eroded. One of the main advantages of a cash flow 

expenditure tax is that it would no longer be necessary to 

measure net profit income, for tax purposes. Of course to 

determine business income it would be necessary to measure 

the costs of doing business; i.e., wages and other expenses. 

On the other hand, depreciation, depletion, and inventory 

evaluations would no longer have to be measured __- for tax 

purposes. 

To summarize this section, we propose that along with 

the introduction of a cash flow expenditure tax, the present 

gift and estate tax be replaced by an accession tax, which is 

described more fully in a later section of this paper, and 

the corporation profits tax be eliminated. We view the 

elimination of the corporate tax as being quite fundamental 

to the success of this proposal. The accession tax is less 

fundamental, but would represent a significant improvement 

over a gift and estate tax system which could also be 

superimposed on an expenditure tax system. 
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111. A CASH FLOW TAX AS AN APPROXIMATION TO AN EXPENDITURE 

TAX 

If we adopt consumption rather than income as the basis 

of taxation, a choice has to be made between direct and 

indirect forms of taxation. The direct form of taxation, 

where the tax liability is imposed directly on households and 

tax burdens can be tailored with more precision to the 

specific circumstances of the taxpapers and made directly 

progressive seems preferable to the indirect form of taxation 

on transactions. A consumption tax system with a progressive 

rate schedule is known as an expenditure tax. 

The individual household’s flow of consumption services 

can be determined using annual cash flow information. It is 

for this reason that we refer to this reform as a cash flow 

tax (CFT henceforth). 

It is important for administrative considerations that 

the CFT be based on current market flow information to avoid 

the need of keeping information over long periods of time on 

assets, consumption, and so forth, and not require 

complicated balance sheet information on changes in net 

worth. 

It was first recognized by Irving Fisher that the flow 

of annual consumption and savings can be calculated by means 

of current cash flow information without a complicated 

tallying of every consumption expenditure. The general 
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nature of this calculation consists of two basic steps. The 

first is to calculate all cash receipts over the tax period 

(year). In these receipts the taxpayer would report: 

(a) wages and salaries, 

(b) interest and dividends, 

(c) gross receipts of personal business enterprises 

minus expenses (cost of doing business), proceeds 

from 

(d) the sale of all assets, (except consumer durables) 

stocks, bonds, real capital, land, producer 

durables, and so forth, and 

(e) all retirement income, social security, company 

pension, annuity income, and so forth. 

These receipts items are meant to illustrate and are not 

to be fully comprehensive since more complicated items under 

receipts are disucssed in the next section. But the general 

principle is straightforward; all receipts whether income 

or from the sale of assets would be included in rec@ipts. 

In order to calculate or to arrive at consumption, the 

taxpayer will be allowed to deduct: 

(al) purchases of all income-earning assets: real 

capital, stocks, bonds, savings accounts (net 

change in value), checking accounts, cash (other 

than petty cash), land, and inventories: 
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(bl) all costs of acquiring income, whether wage or 

capital: 

(cl) various deductions currently allowed under the 

income tax, such as charitable deductions, state 

and local taxes as discussed in the next section of 

the proposal. 

In essence, the consumption or expenditure base would be 

arrived at by adding together all receipts and deducting from 

this figure the current (annual) purchases of all income 

producing assets. 

For example, if an asset is sold and the receipts are 

used to purchase another asset of equal value there would be 

no tax consequences (regardless of the existence or not of 

"capital gains" as now defined). If the receipts are not 

reinvested, but are used for purchasing consumption services, 

the tax levied would be based on the total consumption. 

Similarly, wage income that is not consumed and shows up in 

an increase in savings account would not be taxed as 

consumption, as the increase in the value of the savings 

account would be deductable. 

Wh le the basic Fisher cash flow approach to calculating 

current consumption is reasonably straightforward, there are 

several of conceptual issues associated with the tax 

treatment of consumer durables and the purchase of assets, 

financial and otherwise. One main issue is, that there are 

two alternative ways, ____I more or less equivalent, of treating

saving and dissaving under a cash flow tax. 
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One approach would be to allow a deduction for savings 

and include all receipts from the savings in the calculation 

of expenditures in subsequent years. The second possibility 

would be to tax savings as they are made (not allow a 

deduction for savings) and then to exempt future consumption 

made possible by receipts produced from the savings. Also, 

there are two almost equivalent ways of handing consumer 

durables. One is to tax the purchase value of the durable at 

the time of purchase. The second is to tax the future value 

of the services of the durable over the life of the durable. 

Similarly, we will see later that there are two equivalent 

ways of treating consumer durables. The choice between the 

alternative approaches will be determined by administrative 

and compliance costs and by averaging considerations. As we 

shall explain below by allowing the taxpayer to opt for, or 

chose the type of tax treatment, tax assessment on the basis 

of lifetime consumption would be automatically provided and 

the need of direct averaging provisions in the tax code would 

be eliminated. The averaging provisions in the present law 

are quite complex and rather haphazard in their use. For 

example, there is now only up-side averaging. 

For expositional convenience we shall begin with a 

restrictive special case. Consider a situation in which the 

tax system consists of a single proportional tax rate, where 

there is one asset and where all individuals can borow and 

lend at the same rate of interest. 

Then, in order to exempt savings from taxation, the 

ordinary or standard way of dealing with savings would be to 
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allow a taxpayer a deduction for purchases of capital assets. 

So, if a taxpayer’s receipts are $10,000 and he buys $1,000 

of capital assets, his tax (consumption) base will be $9,000. 

On the other hand, if the taxpayer sells the capital 

asset, he must report the receipts from the transaction as 

current receipts. In the more gerieral case where there are 

several assets, sales and purchases of different assets would 

tend to cancel out, yielding the level of net saving or 

dissaving. 

The alternative way of dealing with savings is to allow 

the taxpayer to prepay tax on savings that will ultimately be 

consumed, by not allowing a deduction when an income earning 

asset is purchased, but by exempting consumption financed by 

receipts from this account (asset) when it occurs. This tax 

treatment we shall refer to as the equivalent approach, in 

contrast with the standard -or ordinary approach. 

Tt is a straightforward matter to 5ee that for a 

proportional tax schedule the present value of taxes under 

both schemes are the same. Consider $1.00 of savings under 

the standard approach. No tax is paid when the asset is 

purchased and interest accumulates at a rate of r% a year. 

When the accumulated wealth is sold t years hence and the 

proceeds are consumed, a tax equal to l(l+r)t(te) is levied 

on the 1 . te which is exactly equal to the tax that would 

have been paid if the asset had not been deductible from 

current receipts. So, without rate progressivity the 

taxpayer would be indifferent between paying tax on the 
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purchase of an asset or paying tax on the sale of the asset 

plus accumulated interest (consumption) in the future. 

Another way of seeing through this equivalence is to note 

that if the tax is paid at the time of purchase, the 

government can invest the tax proceeds at the same rate r and 

end up with the same amount of real resouLces it collects 011 

the larger tax base in the future when the assets are sold 

for consumption. 

The same general equivalence applies in the case of 

loans. Under the standard or ordinary approach, loan 

proceeds would be included in current receipts and the 

repayments of interest and principal would be deductible. On 

the alternative or equivalent approach, the taxpayer would 

not include the proceeds of the loan in receipts, but would 

not be allowed to deduct interest and priricipal repayments. 

When the oan was made for investment purposes, there would 

be no tax consequences associated with the equivalent 

approach. No taxes are collected on the transaction, and the 

loan of $ .00 at a rate r to purchase an asset which yields r 

does not increase the taxpayer's net worth. Under the 

ordinary approach, if the taxpayer in the 50% tax bracket 

borrows $1.00 he will pay a tax of $.50 and then have $.SO to 

invest at a rate of interest of say 10%. So, he ends up with 

investment proceeds of $.55 and then is able to deduct $1.10 

from tax liabilities next year. This tax deduction is worth 

$.55. So, he ends up with $1.10 from the transaction in the 

next period which is exactly what he owes the bank. 
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The equivalence between the two alternative ways of 

treating loans is of special interest for the treatment of 

consumer durable loans. Before discussing the equivalence in 

this context, we consider two equivalent ways of dealing with 

consumer durables. 

One way of taxing consumer durables would be to impute 

an annual rental value to the durable. For example, consider 

an extreme case where a durable has a useful service life of 

1 year and costs $1,000: then if the investor's cost is to be 

covered the rental value is depreciation ($1,000) + interest 

(10% of $1,000) = $1,100. SO, if the tax was assessed on the 

rental value at the end of the year and the taxpayer were in 

the 50% tax bracket, he would pay $550 in tax at the end of 

the year. The alternative approach is to tax the asset when 

it is purchased. On that approach the tax liability would be 

$500 which is equal, in present value, to $550 at the end of 

the year. 

The general principle that this example illustrates is 

that the capital value or the purchase price of the durable 

is equal to the present value of the services the purchaser 

expects to reap from the asset. In principle, if the 

depreciation or useful life of the asset were known, a tax 

which taxed the services as they accrued would be equivalent 

in terms of present value to a tax on the original value of 

the asset. The difference between the sum of the rental 

values and the initial cost of the durable in each period is 

the value of the interest cost paid for the capital tied up 
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in the durable. So, the nominal tax collected is larger for 

the rental approach, but since the payment is postponed by 

spreading out tax liabilities over the life of the asset, the 

tax liabilities in terms of present value will be the same 

under both the rent imputation method and the approach where 

the tax is levied on the purchase price of the consumer 

durable. 

While the two approaches to the taxation of consumer 

durables are equivalent in present value of tax receipts, 

strong practical considerations point to using the full 

inclusion of durables in the tax base at the time of 

purchase. This strategy avoids the necessity of determining 

the rental value of consumer durables and measuring 

depreciation. Also, taxpapers would not have to keep 

complicated records. 

Some durables also have an investment aspect associated 

with them. For administrative and record keeping simplicity, 

we propose that as investment goods consumer durables be 

always treated as if tax was prepaid on the asset when it was 

purchased. 

Thus, the following rules would apply to consumer 

durables: 

(1) Purchases of durables are not deductable under the 

expenditure tax. 

(2) Any rent on durables,such as the temporary rental 

of a beach cottage, is not included in receipts. 
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(3) The revenue from the sale of any durable including 

any appreciation on the durable, such as valuable 

paintings, are excluded from receipts. The 

principle which applies here is that the tax was 

prepaid at the time of purchase and that any income 

earned on the asset is exempt from tax. 

When loans are made for consumption purposes, they can 

be treated by the standard approach where the proceeds are 

included in current receipts and the interest and repayments 

of principal are deducted. As noted in the disucussion 

above, a loan does not change the net worth or the tax 

liability of the taxpayer. It is the use of the proceeds for 

consumption that leads to an increase in tax payments if the 

loan results in an increase in the present value of 

consumption. 

Alternatively and typically, a consumer loan will merely 

change the temporal pattern of consumption, leaving the 

present value of average consumption spending and consumption 

taxes unchanged. 

An equivalent treatment of consumer loans would be to 

exempt loan proceeds from receipts and not to allow 

deductions for amortization of the loan. Suppose for 

simplicity that a person buys a $50,000 house and finances it 

completely with debt. If the loans proceeds are excluded 

from receipts, the expenditure tax would not be paid at the 

time of purchase. But, as monthly mortgage payments are 
-25-

paid, they would be counted as current consumption and 

expenditure tax would be paid on the interest and loan 

amortization. This is as it should be, as the tax on the 

interest payments can be viewed as a tax on the rental value 

of the house or as a price for postponing the payment of tax. 

Give the equivalence between the ordinary or standard 

way of treating assets and loans, and the alternative or 

equivalent treatments, the question arises whether the 

taxpayer should have the right to elect the tax treatment or 

whether administrative simplicity implies the choice of one, 

and only one, tax treatment. 

Administrative simplicity dictates that savings or the 

purchases of assets be treated by the ordinary or standard 

approach since under this approach, the taxpayer would 

include the sale of investment assets (in contrast to 

consumer durables), in rsceipts and deduct the purchase of 

investment assets. In contrast, loans could be treated in 

the standard or alternative way. Thus, taxpayers would keep 

separate accounts on loans which have not been included in 

receipts (income) when they are made and those which have 

been included. However, in the absence of averaging 

considerations, there are good reasons for treating loans in 

what we have called the equivalent or alternative way. Under 

this approach, loans would not be counted as current receipts 

and the repayment of loans and interest charged would not be 

deductible. Record keeping and other problems of taxpayer 

compliance would be simplified with only one tax treatment 
-26-

for loans. As many loans are made to finance consumer 

durable purchases, the taxation of amortization and interest 

will approximate the value of services derived from the 

durable. 

Another main advantage of the exemption of loan 

proceeds, and the taxation of interest and repayments Of 

principal, relates to a consideration we have abstracted from 

up to this point; namely progressivity of the rate structure 

and its implications �or averaging. For example, if a 

household purchases a $50,000 house, its tax liability would 

go up very substantially because of the magnitude of the 

purchase and because of rate progressivity. If the household 

borrows to pay for the house and the proceeds are not taxed, 

the household would not face a current liquidity problem of 

having to pay a very substantial tax, and, as it would be 

taxed on the mortgage payments, an automatic averaging or 

smoothing of its tax liability would occur. 

Considerations of averaging also suggest that the saver 

be given the option, perhaps restricted in some respects as 

discussed in a later section on averaging, of buying some 

assets or accounts on which tax has been prepaid. Thus, we 

propose that in addition to ordinary or standard assets which 

are deductible when purchased and includable in receipts when 

sold, the taxpayer would be able to open up savings accounts 

that would not be deductible when acquired or added to. 

However, withdrawals from these accounts would not be 

included in receipts and so consumption financed with these 
assets would not be subject to consumption tax. In effect, 

the tax is prepaid and is taxed at the marginal tax rate the 

household is subject to at the time the account is built up. 

It is not the intention of this proposal to restrict the 

type of assets that would qualify for this alternative tax 

treatment A. Thus, taxpayers would be able to designate 

stocks, bonds, savings accounts, either as assets (standard 

assets) or as A assets. The basic rationale for the 

provision for both types of accounts (assets) is averaging 

and allowing the taxpayer considerable flexibility in the 

timing of his tax liabilities. 

For example, consider an elaborate wedding planned ten 

years in advance. If the wedding is financed by means of 

standard or ordinary savings, the household will incur a 

large tax liability because of the lumpy nature of the 

expeniture and the progressivity of the tax structure. To 

avoid the "lump" in tax liabilities, esentially to average 

tax liabilities, the household can purchase A type assets and 

prepay the tax liability on the wedding. 

More generally, the availability of two types of 

accounts which vary in terms of their tax treatment; one 

which is taxable upon purchase the second which is deductible 

upon purchase provides the taxpayer considerable flexibility 

in the timing of tax payments over his life cycle. As the 

oxample of the wedding brings out, large lump expenditures 

and tax payments can often be anticipated and handled by the 

taxpayer through appropriate accumulation of tax prepaid 
-2aaccounts (A-assets). Also, if large consumption expenditures 

cannot be fully anticipated, the taxpayer, by holding A-type 

assets, can protect himself against large increases in his 

marginal tax bracket. Furthermore, even in the absence of 

such assets taxpayers could generally decrease tax liability 

by borrowing and not taking current loan proceeds into 

receipts and paying the tax in later periods when they are 

not able to deduct principal and interest repayments on the 

loan. 

Related portfolio adjustments also provide for downside 

averaging. If a person expects consumption expenditures to 

drop in the future, he can borrow without paying taxes 

currently and pay taxes as he repays what he owes. To 

provide maximum flexibility in adjusting portfolios to 

achieve both upside and downside averaging, both types Of 

loans should be available as well as standard assets and 

alternative assets. Of course, the introduction of full 

flexibility for averaging introduces complexity into tax 

administration and complicates record keeping and tax 

compliance for the taxpayer. 

In any case, averaging provisions are not essential to 

this proposal. As we have explained above investors will be 

able to use a combination of loans and asset purchases to 

achieve a kind of averaging. We regard this as a great 

virtue rather than a limitation since it enables the 

taxpayer, in effect, to have his tax assessed on the basis of 

lifetime consumption, rather than on the basis of any 
-29-

particular reporting period's consumption. An aspect of this 

is that the averaging problem is dealt with, at least in an 

EX ante sense. However, while these automatic averaging 

features obviate the need for complex averaging proposals, 

there still might be a need for expost averaging. For 

example, a person who does not correctly anticipate a change 

in income and consumption will suffer "too high" a tax 

burden. It is difficult to anticipate how serious the sort 

of problem is. We will discuss this problem in more detail 

in a later section of this paper. 

IV. A COMPREHENSIVE CASH FLOW TAX BASE 

In this section a more detailed discussion of the items 

which are included in a comprehensive cash flow tax is 

presented. It is important to recognize that for certain 

items, such as pension receipts and payments and insurance 

benefits two apparently very different tax treatments of 

items are possible and are equivalent to each other. These 

two treatments correspond to the standard and equivalent 

treatments of saving discussed above. Either the premimums 

could be deductible and the receipts taxable or the premimums 

would be not tax deductible and the receipts would be 

taxable. So the choice of approach for certain items depends 

on averaging considerations and on social attitudes rather 

than on considerations of equity. 
-730-

Under a comprehensive expenditure tax the tax paying 

unit will include the following receipts on a current flow 

basis. 

(a) Wages, salaries, and bonuses. 

(b) Imputations should be made for various fringe 

benefits, such as company cars, vacations and trips 

provided at company expense, various discounts of 

merchandise, company housing and meals, education 

provided to children, country club memberships, 

child care facilities, and so forth. In addition, 

an imputation should be made for food grown and 

consumed on farms by farm operators and their 

families. 

(c) All inheritance and gifts, subject to the 

qualifications in the discussion on intra-family 

transfers, 2re to be included as current receipts 

by the donee. The donor, if he is to deduct a 

gift, must report the social security number of the 

donee. Also, all child support payments from a 

separated or divorced parent would be included in 

the receipts of the household in which the child 

resides. 

(a)' All receipts from means-tested cash and in-kind 

government transfers would also be entered. These 

include AFDC payments, veterans compensation, food 

stamps (bonus value), and public housing (subsidy 
-31-

value). Payments received from private charities 

would also be included under current receipts. 

Also, all scholarships arid fellowships (with the 

possible exception of tuition scholarships) would 

be included. 

(e) All interest, dividends, and rent income: rent will 

be net of normal business expenses, but not of 

depreciation of capital. State and local taxes on 

business income and property and rental housing 

would be deductible in the calculation of net 

business income. Also, all net cash flow from 

individual proprietorships and partnerships would 

be included in receipts. 

(f) Receipts from the sale of all income earning 

assets; stocks, bonds, real capital, land, and SO 

forth, subject to the qualification that these 

items were fully taxed at time of purchase are 

excluded from the tax base. 

(g) Receipts from the sale of consumer durables; 

houses, cars, jewelry, art objects, and so forth, 

subject to the qualifications that these items were 

not taxed initially are included in the tax base. 

(h) Receipts from liability insurance, whether or not 

they result from successful law suits are included. 

Deductions for the recovery of medical expenses and 

for pain and suffering in these suits might be 

allowed. 
-32-

(i) The receipts from flood insurance, fire insurance, 

and homeowners protection are excluded from 

receipts. Premiums for these policies are not 

deducted in the deduction column and are taxed as 

current consumption. The rationale of this 

provision is that the insurance protects assets 

which generate consumption services and the 

premiums should be taxes as current consumption. 

flowever, losses (self-insurance) are not 

deductible. 

(j) We view life insurance and disability insurance as 

an investment made to protect a family's 

consumption level. Life insurance might be treated 

in one of two more or less equivalent ways. The 

premiums could be taxed as current consumption. On 

this approach,life insurance is treated as a tax 

prepaid asset. On the standard asset approach the 

premiums would be deductible and the proceeds would 

be included in current receipts. We prefer the 

approach where the premiums for life and disability 

insurance would not be deductible but proceeds 

would be excluded from the receipts of person(s) 

who benefit from the insurance. The justification 

for this treatment is based on averaging 

considerations. If people are not allowed to 

average consumption over their lifetimes the 

inclusion of premia in the tax base and the 
-33-

exclusion of the benefits will tend to mean 

taxation of the expected value of the benefits at 

relatively high marginal rates. 

(k) Essentially for the same sort of averaging reasons 

we recommend that medical insurance be treated 

asl'prepaid medical services." Insurance premiums 

would be taxed as cutrent consumption, and employer 

contributions to medical insurance would be 

included as current receipts. Proceeds from 

medical insurance would be excluded from receipts. 

Any social insurance scheme would be treated on a 

par with private insurance. Taxes collected to 

finance medicare or an extended social medical 

insurance plan would be taxed as current receipts 

of the household. The basic advantage of this 

treatment for medical insurance is that averaging 

problems will be minimized. 

At present, the tax code provides for a medical 

deduction if medical expenses exceed 3% of adjusted gross 

income. The present system offers a rather haphazard 

insurance program for high medical expenses, if not 

catastrophic insurance. If a person does not have medical 

insurance, unusually high medical expense can be deducted 

from income and the tax saving will equal the amount deducted 
-34-

times the marginal tax rate of the individual. Treasury 

analysis of the use of the medical deduction shows that the 

tax benefits are concentrated in low adjusted gross income 

units. This probably reflects an age effect, hut we 

recommend that a provision be made for catastrophic insurance 

programs that could be made need-related. In the absence of 

such a program, the present deduction should probably be 

retained. 

(1) WE propose to treat unemployment compensation the 

same as all other forms of compensation such as 

life insurance and medical insurance policies. 

Unemployment insurance has the same element of pure 

redistribution. Also, one of the current 

criticisms of the unemployment compensation system 

is that the non-taxability of receipts promotes 

more voluntary unemployment than is socially 

desirable. Although, with this insurance there 

would be general or approximate equivalence under 

the two possible alternative tax treatments, we 

propose to exempt (deduct) contributions to 

unemployment compensation from income (receipts) 

but to include the benefits (proceeds) in full. 

(m) For this proposal all contributions to social __. 

security and private pensions are excluded from 

receipts and all retirement income, social 

security, company pension, community income, and 
-35-

income from trusts are included. The great 

advantage of this approach is that it makes social 

security consistent with other retirement programs. 

Furthermore, if the tax payments do not match 

social security benefits, the employee is not 

regarded as having received the taxes paid as 

income. 

The following deductions will be allowed under an 

expenditure tax: 

(a) Purchases of all income-earning assets; real 

capital, stocks, bonds, savings accounts (net 

change in value), checking accounts, cash (other 

than petty cash), and land. (Consumer durables 

will not be deducted from the tax base and will be 

taxed as current consumption). 

(b) Child support and alimony payments. 

(c) All business and income related expenses; tools, 

uniforms, dues to professional associations, 

baby-sitting expenses (with a possible ceiling on 

this deduction). A standard deduction might be 

introduced to account for work-related expenses. 

But we recommend itemization of these expenses. 

(d) Tax deductions would be allowed for charitable 

contributions. We believe that there is good 

reason for promoting charities and other good works 

(universities, hospitals, and museums), through tax 

expenditures rather than direct expenditures. The 
-36-

rationale for this preference is that the tax 

expenditure is a form of matching grant. As the 

benefits of the expenditure are quite local or 

regional in their impact, there is good reason for 

preferring matching grants to untied grants on 

equity (benefit principle) grounds. Of course, the 

system could be replicated by a system of matching 

grants administered through the budgetary process. 

But, if the grants are open ended, we will have a 

system that will be equivalent to a system of tax 

credits. 

As there seems to be no strong case on a priority 

grounds for overriding the present choice of Congress on the 

matter of charitable deductions, we recomment that the 

present deduction of charitable contributions be retained. 

One possible administrative simplification would be to 

provide that only contributions in excess of some percent of 

adjusted gross cash flow would be deductible. 

(e) There is no easy solution regarding the 

deductibility of state and local taxes. On the one 

hand, if state and local taxes were used primarily 

for redistribution and, as we have proposed that 

transfer payments be included in the cash flow tax 

base of the recipient, considerations of symmetry 

dictate that state and local taxes should be 

deductible. 
-37-

On the other hand, state and local taxes do provide 

benefits to businesses and households. Firms benefit from 

police and fire protection, road maintenance, and so forth. 

Households benefit directly from these services and from 

educational outlays. Also, in a highly fragmented fiscal 

structure characteristic of the United States, households 

with above (below) average demand for certain local public 

goods and services, can group themselves in stratified 

communities and internalize the benefits and costs of locally 

provided goods and services. 

It should be noted that in such a world the current 

deduction of state and local taxes provides a substantial 

subsidy for state and local public spending the size of the 

per-unit subsidy is proportional to the marginal tax bracket 

of the taxpayer. For example, if the taxpayer is in the 50% 

tax bracket, S1,UO of public expenditure costs the taxpayer 

on $.50. SO, if state and local taxes are benefit taxes, 

they should not be deductible. The more specific proposal is 

as follows: 

(1) All state and local taxes, gasoline, income sales, 

property, and so forth paid by households would not 

be deductible. 

(2) Property taxes and other taxes paid by owners of 

rental housing would be deductible. 

(3) All business taxes, local corporate taxes, property 

taxes, licenses, and so forth, will be deducted and 

would be treated by business as a cost of doing 

business. 
The rationale of treating households and firms in 

different ways is that the benefits of local tax for business 

are small or are nil. 

On the premise that local taxes are benefit taxes, it 

follows that local property taxes should not be deductible by 

homeowners. What is not self evident is that if parity or 

equity is to be maintained between homeowners and renters, 

taxes levied on rental real estate should be deductible as a 

business expense. One general justification is that rental 

housing is just another business and that any expenses, 

private or public, will ultimately be borne by the consuming 

household, but that intermediate expense should be 

deductible. The principle is the same as the one which 

allows landlords to deduct mortgage interest, but it should 

not extend to owner occupants unless an imputation is made 

for rental income on homeowners' capital. 

Take the case where the interest rate is 10% and the 

homeowner lives in a $50,000 house. With a 2% property tax, 

the homeowner will pay an implicit rent of $6,000 a year if 

mortgage interest is not deductible, and if an imputation is 

made for the homeowners' interest costs. The rent consists 

of a 10% pure interest cost (10% of $50,000) equal to $5,000 

plus a property tax of 2% which is equal to $1,000 for a 

total of $6,000. In order for the renter to be charged the 

same rent, the landlord should be allowed the property tax 

deduction for then the landlord will make the normal return 

of 20% on the $5,000. The total rent charged the renters 
-39-

will be $6,000 which consists of $5,000 of pure capital cost 

and $1,000 benefit (property tax). Without the deduction, 

the rent will rise above $6,000 and penalize the renters 

relative to the homeowners. 

Of course, the view that state and local taxes are pure 

benefit taxes is a strong, codtroversial assumption. For 

some households, the relation between benefits and taxes is 

weak, and some redistribution takes place at the state and 

local level. However, to allow the d ductiori of state and 

local taxes without imputing benefits of local expenditures 

seems quite arbitrary, certainly more arbitrary than tti e 

alternative of not allowing deductibi ity of state and local 

taxes. 

A measure which would allow the deductibility of state 

but not local taxes also presents certain problems. Such a 

provision would represent an arbirary incentive for state 

governments to increase their share of local tax 

responsibilities; however the share of state responsibilities 

varies considerably across the nation. 

The possible distinction between general and specific 

taxes for deduction purposes would be of limited value. The 

writer of this paper favors the partial or complete 

elimination of the deduction of state and local taxes. 

However, he recognizes that the basis for the elimination of 

the deduction would introduce a highly imperfect system for 

one that, in his opinion, is even more imperfect. 

Yet, since state and local taxes are deductible under 

the current income tax law, the status quo seems advisable on 
-40-

this specific issue of taxation. The issues regarding the 

deducti,bility of state and local taxes are really no 

different under the expenditure tax than they are under the 

income tax. Consequently, it seems advisable to avoid a 

controversial provision, especially one that is not 

fundamental to the main objectives of the proposal. 

V(a). SOME SPECIAL ASPECTS OF A CASH FLOW TAX SYSTEM 

In this section we deal with a number of special aspects 

of a cash flow tax system. One of these is the nature of the 

filing unit, or the tax treatment of the family. 

The basic issue in the tax treatment of the family is 

how the income (expenditure) should be divided between 

husband and wife: whether primary household members should be 

forced to file separate returns, whether income splitting 

should be allowed, and so forth. There are a number of 

partially conflicting objectives or issues: 

The first is that families with the same mean 

i.ncome or consumption should pay the same tax. 

Thus, the total tax burden should be independent of 

the suurce of income and not depend on which family 

member (husband or wife), owns the wealth of the 

household and so forth. 

Secondly, it should be recognized that household 

production is not subject to tax. So, when there 
-41-

is only one wage earner and the family has an 

income of $20,000, it is better off than a two 

worker family with the same income. 

(c) The third objective or issue is "the secondary 

worker problem." Under joint filing or income 

splitting, the high income of one family member: 

increases the marginal tax bracket of the secondary 

worker. Thus, if a husband is in the 50% marginal 

tax bracket, a substantial tax barrier will exist 

for the wife. The obvious resolution of this 

problem is to provide for individual filing, as 

currently exists under the income tax in Canada. 

(d) The fourth objective is to minimize the tax effects 

on marriage and divorce. Other things equal, the 

tax burden of two single people should not go up 

(or down) if they get married. 

(e) Finally, the code should be as simple as possible 

with respect to intra-family wealth transfers. 

In the development of this proposal, we have considered 

a number of alternative approaches to the nature of the 

filing unit. The approach finally settled on does not 

represent a sharp departure from the current tax treatment of 

the family. The following rules would apply: 

(a) Separate tax schedules would apply to single 

taxpayers and to married taxpayers filing joint 

returns. There would also be a schedule for 
-42-

married taxpayers filing separate returns and for 

taxpayers who qualify as head of households. The 

value judgements on relative rate schedules 

embodied in the current income tax schedules would 

carry over to the expenditure tax. 

(b) Concern would be placed on the labor force 

participation of secondary workers. A partial 

deduction of tax credit will be allowed for child 

care expenses. Instead of providing for separate 

tax filing for the secondary worker, and to avoid 

various problems of figuring out how to allocate 

allowable deductions and exemptions between 

returns, we recommend that the marginal tax rate be 

decreased on secondary workers by decreasing the 

inclusion rate of their wage and salary income of 

secondary workers to rate somewhere between 50% and 

75%. The rate of inclusion would be independent of 

the amount of wage income. Under this proposal, 

the marginal tax bracket of the secondary worker 

would be somewhere between one-half to 

three-fourths of the primary rate on the joint 

return. In addition to decreasing the marginal 

rate on the income of the secondary worker, the 

lower rate of inclusion would decrease the present 

tax advantage of the single-worker family ralative 

to multiworker taxpaying units. However, the 

proposal would not be neutral on marriage formation 
-43-

and the lower inclusion rate may well promote more 

marriages and joint filing. 

(c) If a minor child has independent capital income 

from inherited wealth or from whatever source, this 

income would be reported in the primary return. 

More generally, as long as the minor child is part 

of the primary household, his capital transactions 

would be pooled with those of the person filing the 

primary return regardless of whether or not the 

person controls the wealth (trust fund). The 

capital resources of minors should be pooled with 

that of the family (the joint return of the 

husband-wife.) Otherwise there would be tax 

incentives for the parents to transfer resources to 

minor children and to finance family consumption 

out of these resources. The wage and salary income 

of a minor child would be included in the tax base 

of the family, but with a minimum exemption of 

$750. 

In general, minor children who live at home would report 

their capital income in the primary return of the family. 

However, as discussed below in the section on inheritance, 

there is good reason for allowing exceptional children Who 

have substantial wage and salary earning at an early age to 

be taxed as distinct units from their parents or guardians. 

There are not many child movie stars, musicians, models, 

athletes, and so forth; but an allowance should be made for 
-44-

such individuals. We do not have'firm ideas on the specifics 

of these clauses as they would be related in part to the 

specifics of the inheritance tax law. In general outline, 

these clauses would allow minors to file a separate primary 

return if their wage and salary income exceeds some minimum 

amount, say $2,500 a year. In the year that the primary 

return is first filed, the child (minor) would have the 

option of declaring wealth that has been inherited outright 

or in the form of a trust. After a basic exemption of say, 

$50,000, an inheritance tax would be paid on the accumulated 

wealth. The minor who meets the requirement for a minor 

return would have the option of leaving the inherited wealth 

in the "porfolio" of the family, for tax purposes, and paying 

the inheritance tax at age 18 or 21. 

However, even if the inherited wealth is not "declareci" 

for tax purposes, the minor child who earns the mi.nimum 

income to qualify for primary filing would have the assets 

accumulated from these wage earnings registered in his name 

and would report the capital transactions on these assets in 

his primary returns. 

(d) Instead of a personal exemption, this proposal 

recommends a tax credit of $250 or more a person. 

We prefer a tax credit to an exemption as tax 

relief, provided according to family size, and 

independent of the family marginal tax bracket. 

The modest tax credit may significantly understate 

the real cost of additional children by higher 
-45-

income groups. But this is consistent with the 

view that small tax differentiations for family 

size are unimportant and unnecessary at higher 

income levels. This is a common sense argument, 

but might also be justified on the grounds that 

most children born to middle and upper income 

groups in the U.S. are planned children and that 

these families have the economic means to provide a 

materially secure upbringing for their children. 

We do not appeal to the notion that will offend 

many: namely, that children are merely another form 

of consumption or indulgence. But surely in an 

affluent society there is little basis for more 

than modest tax credits based on family size for 

the well-to-do and the rich. 

(e) We leave open whether the tax credit would be 

refundable or not. For expenditure tax purposes, a 

single person is a unit: a married couple and their 

children are a unit: a widowed or divorced parent 

and her (his) children are a unit. There are more 

complicated family situations: children living 

with grandmothers and aunts, married teenagers, 

college students. 

The following persons will be eligible and required to 

file individual return: 
-46-

person over 21; 

person, whatever age, who maintains a separa e 

cile and who does not receive more than half 

support from his parent or guardian, and is not 

studying for his first college degree: and 

(3) Any married couple. 

Under this proposal there are few, if any, complicaiions 

associated with desolution of marriages. If a divorce occurs 

the property will be divided according to the laws of the 

state or residents and new tax filing units will be formed. 

The main shortcoming of proposed treatment of the family unit 

is that it is somewhat assymetric with respect to the 

treatment of capital and wage income. 

V (b). AVERAGING 

As discussed in a previous section of the proposal, by 

allowing more than one type of tax treatment for saving and 

dissaving (loans), a mechanism is made available for 

averaging tax liability over a taxpayer's life cycle. In 

particular, i.f a,taxpayercan anticipate lumpy expenditures, 

he can average the tax payments on the expenditures either by 

buying tax prepaid assets to finance them or by financing the 

expenditures by borrowing. 

One administrative restriction which probably will have 
-47-

to be imposed on the purchase of tax prepaid assets is to 

register them. Otherwise taxpayers will have an incentive to 

redesignate the accounts in their portfolios depending on the 

relative performance of the different assets or investments. 

For example, if two assets, A and E, are purchased at time t, 

each for $1,000 and tax is prepaid on one of these assets, 

then the taxpayer will have an incentive to report after the 

fact, receipts from the sale of the asset which has not risen 

in value relatively, and to designate the other asset as the 

asset on which tax has been paid. To avoid this 

reclassification, we recommend that the assets on which tax 

is prepaid be limited to assets issued by financial 

intermediaries, and the equities purchased on a prepaid tax 

base be recorded in a separate account. 

Apart from this restriction, the major issue is whether 

an additional provision should be made for averaging. For 

cxample, it would be possible to adopt the forms of averaging 

contained in the present income tax law. Alternatively, new 

averaging provisions might be developed. One argument that 

could be made in favor of an averaging provision in addition 

to the averaging urovisions inherent in the alternative tax 

treatment of assets, purchases, and loans is that large 

numbers of taxpayers whose liabilities fluctuate may find it 

difficult, or impossible, to make adjustment through 

financial transactions that will effectively average tax 

liabilities. Also, investments in family owned businesses of 

the tax prepaid variety should probably not be allowed to 
-48-

avoid the problem of the family designating its total labor 

receipts as capital income from the asset. 

V (e) TREATMENT OF INTERNATIONAL TRANSACTIONS 

This section is more tentative and more general than the 

other parts of the paper. One of the problems in dealing 

with international transactions is that it is very difficult 

to anticipate the reaction of other governments to the 

introduction of an expenditure tax in the U.S. and the 

elimination of the corporate tax here. International tax 

treaties would have to be renegotiated, and depending on the 

outcome of such negotiations, it is possible a significant 

reallocation of capital into the U.S. would occur from 

abroad. What needs to be emphasized is that the 

international implications of this proposal are rather major, 

and the issues raised are not merely technical details, or 

problems which can be resolved by technical compromise. The 

introduction of an expenditure tax in the U.S. may have wide 

reaching implications on tax systems in other major 

industrial countries, on international investment, and on 

international relations in general. 

It is possible that the uncertainties for international 

investment raised by the major tax reform in the CI. S. will 

be a serious stumbling block in the acceptance of this reform 

by certain members of Congress and by the American business 

community. 
-49-

In the present situation most major industrial countries 

impose both corporate taxes and personal income taxes. 

Dividends paid out to foreign investors are subject to a 

withholding tax by the country of origin. These withholding 

rates on dividends are subject to negotiation by a treaty and 

vary between 5% and 15%. 

There are two ways in which double taxation of foreign 

investment is avoided. One is the allowance of tax credits 

for foreign tax paid, a practice followed by the U.S. and 

other major industrial countries. The second is to exempt 

foreign earnings from domestic taxation, a practice followed 

by France and the Netherlands. 

Under the foreign tax credit system the country of 

origin collects the taxes as profit income. The U.S. is a 

larger net exporter of capital: at year end 1973 foreign 

long-term investments in the U.S. amounted to $62 billion, or 

just over 40% of U.S. longterm foreign investment abroad. 

While the U.S. as the largest capital exporter in the 

world loses net tax revenues under foreign tax credits 

negotiated with other countries, it has played a leading role 

in the development of tax policy with respect to foreign 

investment and in establishing a neutral tax system. There 

are three different senses of neutrality. One is capital 

export neutrality where a capital exporter is indifferent 

between an investment at home and abroad. Second is capital 

import neutrality where, in the host country, foreign 

investors are treated on a par (eaually) with residents. The 
-50-

third concept of neutrality is that of national neutrality 

where a country adopts tax measures that are designed to 

insure that total U.S. returns (taxes plus private returns) 

are the same whether the capital is located at home or 

abroad. 

Under present tax arrangsment, the conditions for export 

and import neutrality are satisfied, roughly, at least for 

most industrial countries. In 1968 for "Europe" [inclusive 

of Canada, Japan, Australia, South Africa and Mexico, and 

exclusive of Switzerland (17%) and Luxembourg (15%)1 

effective corporate profit rates tended to vary between 40% 

to 50%. Tax withholding on dividends, interest and royalties 

is somewhat more varied. Withholding taxes are placed on 

dividends by all countries with rates ranging from 5% to 15%; 

but many industrial countries exempt interest and royalties 

while others tax them at rates in the 5% to 15% range. 

Although it is only appraximately true that the 

international economy is characterized by export and import 

neutrality with respect to international investment, marked 

differences in tax systems (a corporate tax plus a 

withholding tax on dividends) are not observed, tax rates are 

not significantly different between countries, and there are 

not striking differences between the taxation of home 

investments and foreign investments. Certain features of the 

tax code tend to offset each other: for example, investments 

abroad gain from the advantages of deferral when foreign 

taxes are lower than U.S. taxes. On the other hand, foreign 
-51-

investments by U.S corporations do not qualify for the 

investment tax credit. 

There are a number of ways in which the corporate tax 

could be integrated with personal income tax. One is the 

split rate system which reduces the corporate tax levied on 

distributed profits. In West Germany, corporations are taxed 

at 51% on retained earnings and an effective rate of 23% on 

distributed prof its. 

Another way of providing partial integration is to 

provide a dividend credit or imputation at the stockholders' 

level. In France, corporations are taxed at 50% and 

shareholders allowed to credit 50% of the corporate tax on 

dividends. Also, the U.K. taxes corporations at 50% and 

provides a dividend credit equal to three-sevenths of the 

corporate tax on dividends. 

Under full integration of the corporate tax no 

distinction is made between retained earnings and dividends, 

and corporate earnings are grossed-up by the amount of the 

tax and reported by the stockholder with full credit of the 

corporate tax. No country used this method. 

In this proposal we are going beyond full integration, 

and in addition to eliminating the corporate tax for U.S. 

corporations investing in America, we propose to exempt all 

profits from taxation under the cash flow version of the 

expenditure tax. A key question that arises is whether 

profit taxes paid abroad would be credited under the 

expenditure tax imposed on households. There would be no 
-52-

corporate tax to credit foreign taxes against. A second 

question is whether the exemption of savings is to extend to 

foreign investors. We note that other countries who have 

adopted partial integration have not adopted consistent 

behavior. In West Germany, foreign subsidiaries have been 

taxed under the split rate system in the same way as domestic 

corporations. But branches of foreign corporations are taxed 

at the full corporate rate of 50%. France has not given the 

dividend credit to foreign parents, nor to foreign branches 

or to French investors to foreign corporations. However, 

France now does extend the dividend credit to foreign 

portfolio investors, though a withholding tax of 15% is then 

imposed on the sum of the dividend plus the 50% credit. 

In the tax treaty just negotiated with the U.K., 

American portfolio investors are given the same dividend as 

U.K. investors, subject to a 15% withholding tax on the 

total. On the other hand American subsidiaries are given 

one-half of the normal tax credit. Again the 156 withholding 

tax applies. Beyond these facts, there is no evidence that 

countries in general are reluctant to give foreigners the 

Same credits as residents. For example, the U.K. seems not 

to have preferred the split rate system because they believed 

the system would extend to foreign shareholders and that the 

[I.S. would not be willing to agree to a compensating 

withholding system that would offset the tax relief granted 

foreign investors. The Carter Commission in Canada also 

assumed that compensating withholding taxes would be 
-53-

unacceptable to the U.S. and other countries if the full 

integration proposed by the Commission was extended to 

foreigners. The Carter report proposed that the benefits of 

integration be restricted to Canadian residents, and that the 

gross-up arid credit of foreign taxes paid by Canadian 

investors be limited to a rate of 30%. In both the U.S. and 

Canada there was strong resistance to a full integration of 

foreign corporate tax with national personal income taxes. 

Should the U.S. initiate a cash flow tax and also 

eliminate the corporate tax, it would be under strong 

pressure to eliminate taxes on foreign investments in the 

U.S. One of the basic principles of international tax 

arrangements is the nondiscrimination criterion between 

residents and non-residents. The U.S. has been strongly 

committed to this principle and has used it in tax treaty 

negotiations, such as the one just concluded with the U.K. 

where the foreign country's dividend credit was partially 

extended to American investors in the U.K. 

Counteracting this discrimination criterion is the fact 

that the U.S. would lose tax revenue if foreign investment 

was exempt from tax. The U.S. might argue that if American 

taxes on foreigners were eliminated the foreign country 

should also exempt this kind of income from taxation or 

otherwise real resources will shift from the U.S. Treasury to 

the foreign treasury. 

However, initially it would be small comfort to the U.S. 

to extend complete exemption of profit income to foreigners 
-54-

if their governments continued to tax this kind of income to 

U.S. residents. 

Another consideration is that while the U.S. would be 

exempting foreigners from profits taxation, it would not 

necessarily be exempting them from tax. As there are well 

established precedents for taxing dividends paid to 

foreigners as a substitute for the payment of domestic income 

tax, the U.S. could justify a withholding tax on the earnings 

of foreign investors as a substitute for the expenditure tax. 

The basic jurisdictional rule underlying current 

international tax arrangements is the origin principle. The 

U.S. can rely on this, especially as a change to the 

residence principle is unlikely, given that the U.S. would 

gain from such a change. 

It is in the overriding self-interest of the United 

States to continue the taxation of foreign investments in the 

United States as long as other countries continue taxing U.S. 

subsidiaries and branches abroad. We propose that the United 

States simply admit that it cannot hope to adhere to the 

principle of non-discrimination if it does not tax domestic 

profits but other countries do. The United States will havs 

to impose taxes of 40% or more on the earnings of foreign 

subsidiaries and branch operations. Similar taxes will have 

to be imposed on foreign portfolio investors and substantial 

taxes will also have to be imposed on the interest income of 

foreign investors: otherwise foreign subsidiaries will have a 

strong incentive to substitute debt for equity. 
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The second part of the proposal is that foreign profits 

taxes paid abroad by American investors be passed through and 

credited to the individual stockholder under the expenditure 

tax. This is bound to be a very controversial proposal, 

especially in the Congress as it would result in a 

substantial revenue loss to the Treasury and would give 

credits to individuals for taxes paid abroad. 

Yet, despite the revenue loss the credit would not 

necessarily decrease the real income of the United States 

relative to the existing situation. At present, foreign 

governments collect taxes on American profit income earned 

abroad and they would continue to do so. The full credit Of 

foreign taxes paid abroad would weaken, even eliminate, the 

incentive of the United States citizens to repatriate their 

capital. Without the credit, relative after tax yields on 

investments abroad and at home would be changed 

significantly, and U.S. multinationals would have a strong 

incentive to liquidate their investments abroad. Such an 

event would impose severe strains on the world economy, and 

it is not certain how American business would respond to such 

a prospect. While maintaining approximate export neutrality 

for both American and foreign countries, the overall effect 

of this proposal is to increase the after-tax yield for 

American investors relative to foreign investors. This would 

place America in a distinct advantage in the accumulation of 

capital, and foreign governments would probably be under 

strong pressure to decrease profit taxes in their countries. 
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Whatever the stance taken by the United States in 

subsequent tax treaty negotiations, this proposal has far 

reaching ramifications for international finance and 

investment. Those who value harmonious international 

relations will probably resist the changes, because of the 

disruptions, and the uncertainties that may arise on account 

of the proposed tax reform. 

Others will be attracted by the international aspect of 

the tax proposal, as they will view it as an opportunity for 

a significant restructuring of taxes throughout the 

industrial world as profits taxes would be adjusted downwards 

as the result of the American reform. 

Nationalists in the U.S. and abroad may welcome the 

proposal as it is highly likely that significant amounts of 

P.merican investment abroad would be repatriated to the United 

States as the crediting of foreign taxes under the 

expenditure tax would be limited. 

V(d). TREATMENT OF TAXPAYERS WITH OVERSEAS CONNECTIONS OR 

INTERESTS 

The simplest procedure in the taxation of American 

citizens who reside abroad is to adopt the residence 

principle. American citizens who are residents of foreign 

countries would be exempt from filing an expenditure tax 

return, while foreign nationals who are permanent residents 
-56-

An alternative proposal is to exempt foreign investors 

from American taxes and not to credit foreign taxes under the 

expenditure taxes. An intermediate measure would be to 

impose modest taxes on foreign investment and to provide 

modest tax credit relief at the household level. 

The two measures generally tend to offset one another in 

their effects on the real income of the United States. The 

removal of the taxes on foreign investors will transfer 

resources (income) from the Treasury either to foreign 

governments or to foreign investors. The absence of the 

foreign tax credit under the expenditure tax will compromise 

export tax neutrality and will lead to a repatriation of 

Amer can capital from abroad. 

In the long run this repatriation will increase American 

real income, as foreign taxes previously collected on the 

repa riated capital will now accrue to American citizens. 

The most nationalistic policy would be to impose a 

substantial withholding tax on foreign capital and not to 

provide foreign tax credits under the expenditure tax. 

The policy that will be least disruptive to current 

allocations of capital throughout the world and will have the 

least effect on distribution of the gains from foreign 

investment between capital-exporting and capital-importing 

countries is the first proposal discussed. This is the 

combination of relatively high taxes on foreign investment in 

the U.S., and generous, if not complete, credits for foreign 

taxes paid under the expenditure tax. 
-59-

sales taxes, value added taxes, and so forth, that have the 

effect of a proportional income tax, would either be ignored 

or might be allowed as a deduction. 

An intermediate position would be to tax expenditures by 

American citizens on the residence principle (on a rather 

severe definition of residence), but to tax the income of 

foreigners that originates in the United States. The extreme 

version of this would be to have a separate income tax that 

would apply to American citizens residing abroad. This is 

unattractive from an administrative standpoint and such a tax 

would be minimized by owners of capital by transfer of U.S. 

resources abroad. A further possibility would be to impose a 

flat rate withholding tax on all income originating in the 

United States at a rate substantially higher than any 

possible withholding tax on foreign nationals, say 50%, and 

then allowing the American resident abroad to claim a refund 

if he so chooses by filing an expenditure tax return. 

VI. THE ACCESSIONS TAX 

In the introductory, or general sections, of this 

proposal we outlined a number of arguments justifying a 

separate estate or accessions tax. In a world where bequests 

are small and no substantial income and wealth differences 

exist there is no need for a bequest tax. In such a world 

most individuals would spend their total endowment during the 
-58-

of the United States would file an expenditure tax return. 

Of course, if a person is required to file an 

expenditure tax return, expenditures would be defined on a 

worldwide basis and purchases of foreign assets would qual fY 

for a deduction under the expenditure tax. 

The difficulty in adopting a strict residence principle 

of taxation is that residential tax havens are likely to be 

set up in the Nest Indies and elsewhere. Wealthy individuals 

will be able to set up legal foreign residence in Costa Rica 

and similar countries and jet back and forth without paying 

much in the way of tax. 

The loss of revenue is not likely to be substantial from 

this practice, but the inequities will be highly visible and 

may be politically unacceptable. One way of closing this 

loophole or at least making tax haven residence less 

attractive is to define a citizen as a non-resident only if 

he spends less than 30 to 60 days of the year in the United 

States. 

A more extreme solution would be to require every 

American citizen, regardless of residency, to file an 

expenditure tax return: to ask that each person report 

worldwide expenditures, but then to credit the foreign 

resident for direct income tax paid abroad. Thus, if I sm a 

U.S. citizen residing and working in Canada, I must file an 

expenditure tax return in addition to the Canadian income 

tax, but I would be allowed a credit for my Canadian income 

tax paid under the expenditure tax. Foreign, indirect taxes, 
-61-

tax incentive to skip his son and to leave the estate to the 

grandson. 

Under the present system an estate is often left in 

trust for the second generation (the son), and the principal 

is inherited by the third generation (the grandson). The son 

has the use of income during the life of the trust. The 

trust is set up to minimize tax burdens. For example, a 

$10,000,000 estate might pay an estate tax of $5,000,000. 

However, if left in trust the income generated is Sl,OOO,Oi)O 

a year and after paying an income tax of 50% the son has the 

means to consume $500,000. With a wealth tax of $5,000,000 

the annual consumption possibility is only $250,000 a year. 

Similarly if the aim of the family is to accumulate capital 

it will build up a stock of wealth much more rapidly if the 

estate is put in trust: 

Consider next an accession tax that is coupled with an 

expenditure tax. For simplicity we assume that all tax rates 

are 50%. When the $10,000,000 is left outright to the son he 

pays an accession tax of $5,000,000 and then can spend 

$500,0dO a year on consumption, consuming $333,000 a year. 

Assuming the principal remains untouched, the grandson will 

inherit $5,000,000 and in turn pay an accession tax of 

52,500,000 and so on. 

Suppose the $1,000,000 had been left in trust. If no 

accessions tax is paid upon the formation of the trust: but 

as the income is generated, it is subject to accessions tax, 

thus the son, if he pays the same rate of accession tax, will 
-60-

course of their life. On the other hand, a person who earns 

and saves a great deal would not be taxed on his total 

endowment under an expenditure tax. Consequently, a case can 

be made for a separate tax on the bequests. A related reason 

for taxing bequests is that the tax system should be used to 

minimize concentrations of wealth. 

The general argument favoring an accession tax over an 

estate tax is that the magnitude of the tax should depend 011 

the circumstances of the donee rather than on the donor. An 

accession tax would tend to promote bequests which are more 

widely dispersed. 

By taxing the gifts and inheritances over a person's 

lifetime we express a social preference supporting a special 

tax on the total of a person's good fortune which is 

generally not related to his own efforts. Inheritance should 

be taxed separately because it is not earned, and is 

typically not related to merit but is a good fortune of 

birth. A further rationale for an accession tax is that 

wealth confers power, security, intangible elements of 

status, and social respect. An accession tax is a very 

convenient way of taxing these benefits. 

Before turning to the specifics of the proposal, we 

consider a number of general factors that bear on the 

features of the design. The key questions are how to tax 

bequests left in trust, and whether a dual rate structure 

should be allowed so as to minimize the possible incentive of 

the accession tax to skip generations where a father has a 
-62-

havn only $500,000 a year to spend on consumption and will 

consume $333,UUU. However, when the father dies the grandson 

w i 11 i nhe r i.t $1U ,U Oil, 0 0U not $5,0 00,O 00. Conseuuen t 1y , there 

is a distinct advantzge in leaving the estate in trust. 

4nothcr way of making thc same point is to notc thzt ? family 

th,?t merely accumulates out of inheritance will he able to 

usc thc whole $lU,U0u,UOU for purposes of accumulation and 

will not pay any accession tax until thc death of the son. 

There are a numher of ways in which the advantage of the 

tax deferral for the property left in trust might be dezlt 

with. The first is to ignorc the advantage on grounds of 

administrative convenience. The second is to follow the 

sugqnstion made in the literature on an accession tax: 

namely, to levy a special estate tax on property left in 

trust. The special estate tax would then be the hasis for il 

credit against accession taxes on subsequent distributions 

from the trust. The third approach is to calculste, or 

approximate the accessions tax that would have hcfn paid if 

the estate would have been left outright to the person 

receiving the income from the trust, or to approximate this 

by considering the size of the estate on en averags rate of 

tax and then "charging" the trust interest on this amount. 

Thus, if the postponecl accession tax is $5,00O,U0d and the 

market rate of interest is 108, the interest charge would he 

$5,000,000. 

The second issue is the supposed advantage of generation 

skipping even without use of a trust. Thus, an older father 
-6 3-

who at ninety recognizes that his son, who is sixty, is in 

poor-health, will bypass the son, in favor or a healthy 

thirty-year old grandson. Otherwise, an accession tax will 

be paid twice, once when the father dies and the son inherits 

the estate, and then soon after when the sickly son dies and 

the grandson inherits the estate. Other biases favoring the 

grandson are tax advantages of trusts and lower accession tax 

rates that are presumed to apply to younger grandchildren. 

To counteract this tax bias against children, it has 

been suggested that a dual rate structure be set up that 

allow sons (immediate relations more generally) a 40% 

deduction under the accessions tax. The 40% is arrived at by 

noting that over a wide range of rates, one tax at the full 

rate has nearly the same effect as two taxes at 6US of the 

full rate. 

Some of the arguments which might be made against the 

dual rate structure are: 

(1) The code will be more complex and the definition of 

immediate relation is somewhat arbitrary. 

(2) It is very possible that tax consciousness will be 

increased by the dual rate structure, and that the 

accessions tax will have a larger, rather than 

smaller distortion. 

(3) Although most bequests are to close or immediate 

relations, it does not strike us as appropriate 

social policy to favor bequests to immediate 
-54-

relatives rather than to more distant relatives, 

friends, colleagues, employees and so forth. In 

fact, it secms arbitrary to tax gifts and bequests 

at differential rates depending on the source of 

the gift. Also, one of the objectives of the 

accession t.?x i- to uisperse ~2~1th is wicicly 2s 

possi blc. 

(4) The mzgnitude of the advantage of grandson rclativii 

to the son depends crucially on the life pattern of 

various generations. If the son is in poor health 

and dies soon after the father, then the advantsge 

is sizable. However, in a steady state where an 

eighty-year old father leaves an estate to a 

fifty-year old son who in turn lives to be eighty, 

and he leaves the estate to a fifty-year old son, 

and so forth, the tax acjvantage of generation 

skipping is much smaller. The point is simply that 

th;? present value of a dollar of accession tax paid 

thirty years from now is rather small. tlence, if 

the father leaves thc estate to the grandson the 

accession tax is x dollars. If the estate is left 

to the son the tax is x dollars and x cjollars 

thirty years from now. The present value is l.lx, 

using a discoiint rate of 8%. So while an advantage 

remains it is not nearly as dramatic BS the case 

where the deaths of the father and the son are 

close together. 
-65-

Some sort of tax relief should be given for two 

substantial accession taxes paid on the same estate over a 

relatively short time interval. One provision would be to 

allow the son the option of treating an outright bequest as 

if it were a trust. Under this treatment the accession tax 

would be paid in full (or alternatively the special estate 

tax on trusts). The donee would place the remainder in a 

special account where the withdrawals could be account& for. 

I'h'2 prepaid accessions tax would be credited with the 

accession tax on withdrawals from the "trusts", but if the 

son dies and the credits of the prepaid accessions tax have 

not been used by the son they would carry over to the 

grdndson or be returned to the trust. 

A more complicated extended provision would allow the 

gr2ndson to seek tax relief even if the son has not had the 

foresight to select the trust arrangement and/or died 

u nexpe c t ed 1y . 

Again, the objective would be to allow tb? heirs of tile 

decenderit to reconstruct the situation for tax purposes as if 

the property has been left in trust during the life of the 

decendent. Of course, this treatment would apply the special 

estate tax that would be calculated to compensate for the tax 

deferral advantages of the trust. These provisions represmznt 

adninistrative complications, but they would provide for an 

exact tax accounting that would account for varying patterns 

of death in different families. 

The more specific aspects of the accession tax proposal 

are as follows: 
-66.-

(1) All inheritances and gifts received would be taxed 

to the donee and not the donor. There would be no 

distinction between inheritances and gifts. The 

tax base would be comprehensive and would include 

the receipt of employee benefits by survivors' life 

insurance (though the exemption level might be 

rzised for this receipt.) The question of a dual 

rate structure would be left open. There are good 

reasons for believing that the magnitude of the tax 

incentive favoring grandchildren relative to 

children would be small under the provisions of the 

proposal. However, if a dual rate structure doss 

come about from a reduced inclusion rate applying 

to transfers to one's children, this writer 

recommends that the inclusion rate be no less than 

80%. 

(2) There would be an exclusion of annual per donor 

exclusions for inter-vivos gifts of up to S2,OUU 

year. The annual exclusion would be i,napplicsble 

to transfers at death and to trust distributions. 

There would be a lifetime basic exemption of 

$50,000 un6er the accession tax. 

(3) All inter-spouse gifts and bequests would be exempt 

from tax. Alternatively, a marital exemption of 

50% for inheritances could be allowed along with a 

special exemption on gifts to the spouse; perhaus 

up to half of the net worth of the donor. 

2 
-67-

(4) The inheritance and gift tax would be progressive 

and the tax would be assessed on the basis of 

lifetime inheritances and gifts. Thus, each 

individual would have an Inheritance-Gift aCCOUnt 

with the Federal government, and, each gift and 

inheritance would be added to previous gifts and 

inheritances and tax would be paid on the 

accumulated total at an increasingly higher 

aarginal rate. 

(5) No attempt would be made to tax gifts in kind thst 

children receive when they are minors. After the 

children become adults, gifts in kind such JS trips 

around the world paid for by parents should be 

reported as gifts. All transfers of durables would 

be taxed under the accessions tax as well as under 

the expenditure tax for the donee. If a parent 

gives a child a valuable painting on which tax has 

bceri paid, the parent would report this as a sale 

of a durable and would receive a tax refund. The 

child (the donee) would pay the accessions tax and 

would also report the durable as a receipt under 

the expenditure tax. 

(6) A child who leaves his family and files a primary 

return for the first time (this would occur no 

later than the age of 21) would declzre his 

accumulated wealth (inheritance from grandparents 

and deceased parents, gifts and accumulate8 
-68-

savings), and this would be taxed as an 

inheritance. This one time tax treatment of 

accumulated wealth at age 21, or earlier, when the 

person sets up an independent household, greatly 

simulifics trcatment of intra-family trznsfers of 

assets to chil.drr?nup to the age of 21. The 

difficulty with this approach is that children who 

earn wage or salary income and save it run the risk 

of having the accumulated wealth taxed as 

inheritance. For small amounts of savings, the 

basic exemption would seem to be enough. However, 

for a fixed lifetime exemption under the 

inheritance tax the young worker-sav?r may end up 

paying higher taxes on the same level of 

inheritance. In the discussion of the tax 

treatment of the family we have already made 

provision for a generous "Shirley Temple clzuse" 

which allows unusually productive young children to 

file primary returns as minors. This treatment 

might be coupled with a provision which would allow 

minor children to purchase registered alternative 

assets up to the amount of their wage and salary 

incomes, if their income does not exceed $2,500 a 

year. Once they reach this maximum, they would 

have to file a primary return. The alternative 

assets would not be taxed under the gift and 

inheritance tax. 
-69-

(7) Ideally from an administrative standpoint, the Lzw 

should not distinguish between the source of gifts 

and inheritances, and gifts from parents to 

children will be taxed in the same way as gifts 

from children to parents. 

(8) We propose that any distribution from a trust be 

taxed under an accession tax. When an estate is 

left in trust we propose that the accession tbx bc 

prepaid either through a special tax on property 

left in trust or by simply applying the regular 

accession tzx table. The prepayment will thcn be 

credited aqainst the tax levied on distributions 

from the trust. If the credits are not fully used 

before the death of the beneficiary the crxiit can 

be returned to the trust. 

VII. APPROACHES TO TRANSITION, OR PHASE-IN GF THE 

EXPENDITURE TAX 

Any change in tax structure would have differential 

distributive effects on various taxpayers and would change 

taxpayer expectations. Since the substitution of an 

expenditure tax'for an income tax represents c3 rather major 

change in tax structure, transition provisions would h3vc to 

be made. Otherwise inequities would arise and strong 

opoosition would develop againEt the introduction of the 

cx pclnd itu r c ta x . 
-70-

The most serious problem of transition relates to the 

consumption of accumulated capital in a life-cycle context. 

The easi.est way of seeing this problem is to recognize that 

in a steady state equilibrium, where wages and interest rates 

are constant, an individual entering the labor force at age 

twenty-five with no wealth would be indifferent to a flat 

rate wage tax and a flat rate consumption tax. The present 

value of the two tax payments under the alternative tax 

systems would be the same over the life cycle. Howev-r, this 

proposition is true only when there is a single tax system 

throughout a person's life. 

A person who enters the labor force under a wage tax and 

accumulates assets for retirement will suffer a loss in real 

consumption if a consumption tax is subtituted for the wagn 

tax just before the time of retirement. 

Another problem of transition is the fact that 

consumption out of social seciirity payments would not be 

subject to tax. Also, under our proposal the services of 

owner-occupied homes wou1.d be taxed at the same rate is 

rental housing. A transtion or grandfather clause would have 

to be provided to account for these structural changes. 

A related problem is that of accumulated consumer 

durables. Persons and households who have purchased durables 

just before the introduction of an expenditure tax will be at 

a distinct advantage relative to those households who 

purchase the same items shortly thereafter. 

This paper discusses the transition approach under which 

the income tax and the expenditure tax operate 
-71-

simultaneously, for some time, during the transition. This 

approach is an extension of an approach suggested by Andrews 

in connection with the taxation of high income taxpayers. 

Andrews suggested that a minimum tax be imposed by initially 

taxing consumption expenditures in excess of some specified 

minimum, say $20,000. Due to the large exemption, this 

supplemental tax would be a tax on high income groups, but 

could be the basis of the introduction of a consumption-kype 

tax as the exemption level could be lowered over time and th.5 

tax rate raised. 

In essence, this approach would involve the introduction 

of a comprehensive expenditure tax statute alongside il more 

comprehensive, reformed, income tax statute. 

Another approach would be to have every household file 

two tax returns, first the income tax and then the 

expenditure tax. Initially the tax rates under the 

expenditure tax could be very low, say 1% to 5%. Income tax 

rates could be lowered a little so as to leave total revenues 

unchanged. Then, over time, expenditure tax rates would 13% 

raised and income tax lowered still further in a series of 

steps until the income tax was phased out completely. 

Alternatively, the Andrews' version of this proposal would be 

followed where a substantial exemption would be allowed under 

the expenditure tax leaving only a small proportion of the 

total population to file under the expenditure tax. The vast 

majority of taxpayers would merely verify on their reguler 

income tax returns their consumption was less than the 
-72-

exemption of $20,000 a year. Top bracket income rates would 

be lowered initially and if the corporation income tax was 

phased out over time, the expenditure tax on the wealthier 

segment of the population could be used to recapture revenue 

lost from the corporate tax. So, the impact effect on income 

of the tax changeover would be neutralized, in large measure. 

The main advantage of this phase-in period of ten to 

fifteen years is that the full statute would be on the books, 

but only a minority of the population, say the wealthiest 25% 

would be affected. These persons would be the most 

sophisticated and able to comprehend and adjust to the 

complexities of the new law. In sense the partial 

expenditure tax would be a broadly based experiment or 

testing ground for the comprehensive expenditure tax. 

Many of the provisions of this proposal are not really 

specific to expenditure tax, and their introduction could be 

common to the continuation of the income tax and the partial 

introduction of the expenditure tax. Among these would be 

the introduction of the inheritance tax in place of the 

estate tax, the introduction of secondary work filing 

provisions and various changes in deductions and exemptions. 

It is not necessary to combine various structural 

changes that would occur under the expenditure tax to the 

reform of the income tax. Whether simultaneous reform of the 

personal income tax and the introduction of the expenditure 

tax would enhance the passage of the new tax system is 

something not speculated about here. Yet, one key provision 
-'7 3-

that would be important to introduce as quickly as possible, 

is the elimination of the deduction of mortgage interest on 

owner-occupied housing under the income tax. Otherwise the 

taxation of consumer durables during the transition period 

would be uneven. 

The numerical specifics of the phase-in need to be 

developed and analyzed in terms of their revenue 

implications. This is especially the case if the corporate 

tax is to be phased out during the transition to a full 

blooded expenditure tax. 

The choice between different transition approaches has 

to be based on intuition in large measure. The supplementary 

tax approach is especially appealing as it can be introduced 

on a partial basis and can be modified before it becomes more 

broadly based. 
-74-

FOOTNOTES 

-1/ This is because the double tax on interest type income 

reduces the return on savings. The lower return on 

savings in turn means a lower opportunity cost of using 

money for current consumption. 

-2/ For example, with continuous compounding at a 10% 

discount rate, one dollar of taxes ten years hence is 

worth only 37 cents today.