Simplification and Comprehensive Tax Reform 

Harvey Galper

Michael Kaufman 

U.S. Treasury Department 

OTA Paper 34 September 197 8 

OTA Papers are circulated so that the preliminary findings of 

tax research conducted by Staff members and others associated 

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

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

reflect 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: September 1978 
TABLE OF CONTENTS 

Page 

I. Introduction ................. 1 

11. What is Meant by Simplification ....... 6 

111. The Proposals in Blueprints ......... 17 
Simplification and Comprehensive Tax Reform 

by 

Harvey Galper and Michael Kaufman* 

I. ,Introduction 

In January 1977, the Treasury Department of the Ford 

Administration released its view of what tax reform could 

accomplish in a publication entitled Blueprints for Basic Tax 

Reform. -1/ The purpose of that study was not to propose 

directly a legislative agenda but to present and discuss the 

basic structure of a tax system predicated on a comprehensive 

measure of income. The Blueprints exercise sought to 

determine the maximum potential for broadening the base of 

the tax system, thereby allowing a greatly reduced structure 

of tax rates. Base broadening does not involve the creation 

of additional income, for income is generated only as an 

outcome of economic transactions. Instead, base broadening 

results from the consistent application of rules for 

measuring income so that the income that is really "Out 

there" can be made subject to tax. 

* Respectively, Associate Director and Economist, Office of 

Tax Analysis, U.S. Treasury Department. We would like to 

thank Amie Powell for typing assistance on this paper. We 

also benefitted from discussions with Seymour Fiekowsky. 
* 

-2-

The primary objectives of comprehensive tax reform are 

horizontal equity and efficiency. Horizontal equity, which 

requires that persons in equal economic circumstances be 

taxed the same, presupposes an accurate measurement of income 

in the first place. Efficiency which calls for keeping to a 

minimum the distorting effects of taxes on economic decisions 

also requires that income as measured for tax purposes should 

ccrrcspond to economic reality. Under such income 

measurement rules, resource allocation would be determined by 

economic rather than tax considerations. Comprehensive 

income tax reform has long been advocated as necessary to 

achieve these two important goals. 

The pur,!ose of the present paper is not to evaluate the 

extent to which comprehensive tax reform as developed in 

Blueprints would achieve tax equity and efficiency, but 

rather to consider its impact on simplicity. The question to 

be addressed here is: can a system which comprehensively 

taxes income also be a simpler tax system? This paper will 

evaluate the proposals in Blueprints in terms of the 

complexity that would be likely to result from their 

adoption. Although the basic proposals themselves will be ' 

discussed, the underlying rationale for each will only be 

mentioned briefly, as the equity and efficiency objectives 

which motivate them have already been noted. 

c 
Some preliminary observations are in order regarding the 

nature of the Blueprints etudy. First, while no claims have 

been made as to the political acceptability of any of the 

recommendations in Blueprints, considerable effort was 

directed toward developing a system that would be 

administerable and workable in practice. Thus, it was 

explicitly recognized that a tax system based on readily 

observable data will be inherently less complex. Hence, 

Blueprints specifies that "transactions should be objectively 

observable -- as in the case of the transaction of a wage 

payment. . .'Imputed' transactions, i.e.# values arrived at 

by guesses or rules of thumb --as in the case of depreciation _. 

-- should be kept to a minimum." (P. 42) Thus, realizations 

rather than accruals enter into the tax base, and 

specifically excluded are imputations for such items as the 

services provided by owner-occupied housing and in-kind 

benefits such as medical care. This cash or realization 

principle may at times come into conflict with comprehensive 

income measurement but at some gain in simplicity. 

Secondly, the Blueprints study should not be regarded as 

definitive in the sense that all of the decisions made are 

considered final decisions. In many cases, alternative 

recommendations are presented; for example, the optional Way8 

of dealing with medical or charitable deductions or the two 

transition rules suggested for the phase-out of the 
L 

-4-

preferential tax treatment for capital gains. If 

considerations of simplicity are found to be compelling, 

other alternatives could also be developed without doing 

violence to the principle of a comprehensive tax base. In 

determining whether the specific recommendations Of 

Blueprints are compatible with simplicity, one should be 

aware of the fact that modifications to better achieve this 

objective cre possible. 

Thirdly, there are some inherent limitations in 

examining Blueprints as a model tax system. Despite 

reasonably full articulation of specific proposals, many of 

the recommendations are spelled out only broadly and not in 

complete detail. The 'efore, some difficulties will 

inevitably arise in comparing the complexities of current law 

resulting from sixty years of experience with income taxation 

to a set of more generally specified proposals for which the 

full array of rulings, regulations, and court cases does not 

exist. 

Finally, one element of simplification that is often 

lost sight of in much of the discussion of complex forms and 

1

intricately structured transactions, is whether or not the 

basic structure of the tax system itself is understandable. 

One important virtue of Blueprints is that it greatly 

clarifies what an income tax system should tax. 

.' 
. 

-5-

Our discussion of Blueprints will first describe the 

overall tax structure proposed and then consider in detail 

the taxation of corporate income, capital gains, business 

income generally, and retirement income. The results of the 

base-broadening measures envisioned by Blueprint8 are 

impressive. Using data representative of the year 1976, the 

study finds that for all tax filing units comprehensive 

income, the tax base of Blueprints, would have been $1,270 

billion compared to adjusted gross income of $1,055 billion. 

under 1976 tax law -- an increase of 20 percent. -

2/ 

Furthermore, income subject to tax, after taking into account 

allowable deductions and exemptions, would rise from $669 

billion to $884 billion, an increase of about one-third. 

Thus, the potential for base broadening -- and 

correspondingly for rate reduction -- is large indeed. The 

specific proposals which would accomplish this expansion of 

the tax base are the main subject of this paper. First, 

however, it is necessary to discuss the topic of 

simplification itself. 

. 
-6 -

11. What is Meant by Simplification? 

To determine the degree of complexity inherent in 

comprehensive income taxation it is necessary to identify the 

various participants involved in the annual struggles of 

taxpayars with the tax system. These participants include 

individual tnxDayers -- both those of moderate means and 

those with hiqher incomes and more complex transactions-­

corporate tax and financial officers, tax practitioners, and 

administrators and legislators of the tax system. 

The averaqe taxpayer often experiences considerable 

difficulty not just in assembling information and performinq 

the calculations for preparing his tax return but also in 

interpreting the instructions required to fill out the forms. 

For instance, many middle income taxpayers have trouble 

determining their eligibility for the retirement income 

credit, or in the case of divorced parents the dependency 

exemption, because of the rather complicated set of 

conditions go-~crninqthe use of these 1 :ovisions. For higher 

income individuals, the nccd to know the tax consequences of 

elternative investment 2nd other transactions greatly 

complicates economic decision making. 

Y. 
-7-

As in the case of individual taxpayers, corporate 

officers making investment or financing decisions are faced 

with uncertainties about how the tax laws will apply to 

transactions they are considering. Since many business 

decisions span a considerable period of time, corporate 

officers also need to make forecasts of possible changes in 

tax policy and administration that will affect the 

profitability of these decisions. Tax administrators, 

moreover, may find it convenient to impose on corporations 

reporting requirements for annual statements of wages, 

interest, and dividends. While these statements ease the 

burdens of record-keeping for individuals and fa:ilitate the 

monitoring of tax compliance by administrators, they, at the 

same time, impose additional complexity and costs on business 

managers. 

Complexity in the tax code makes it difficult for tax 

practitioners to understand how the tax code applies to the 

problems of their clients. The disparity of tax treatments 

associated with alternative investments further complicates 

tax planning. As complexity escalates, more and more time df 

\ 

tax practitioners is spent in keeping abreast of tax 

developments and in counseling clients on the implications of 

these developments. 
-8-

For tax administrators, tax complexity creates 

difficulties in providing taxpayers with intelligible tax 

forms, interpreting the tax code, enforcing tax compliance, 

and resolving legal disputes with respect to emerging tax 

issues. Complexity also increases the administrative costs 

of all these functions. Furthermore, legislators are 

becoming increasingly concerned about complexity, both in 

response to the complaints of their constituents and in their 

capacity as drafters of legislation designed to improve the 

equity and efficiency of the tax system. The concerns of 

these various participants in the operation of a tax system 

must all be considered in evaluating the complexity of a 

proposed ntw tax structure. 

Complexity is not a static concept which applies to a 

tax system for all time, but rather it characterizes the 

development of a system over time. Thus, our current system 

not only complex, but it -

has grown complex in response to

pressures created by its basic design features. An 

evaluation of the complexity of a tax system based on the 

Blueprints design should therefore consider its likely . evolution as well as its current features. This broader 

perspective may permit a more hopeful appraisal of the 

compatibility of simplification and comprehensive income tax 

reform. Several of the Blueprints reforms are very likely to 

lead to increased first-round complexity, but they would also 

greatly reduce the scope of transactions which are relatively 
. -9-

lightly taxed. This virtual elimination of tax preferences 

in combination with a structure of lower tax rates would 

sharply diminish incentives to design transactions in order 

to receive special tax treatment. 

, Furthermore, experience has shown that tax minimizing 

behavior on the part of individuals and corporations breeds 

further reaction by tax administrators and legislators who 

try to stem the tax avoidance tide by measures which 

specifically prohibit the latest tax maneuvers. Although the 

energy of tax reformers and administrators is large, the 

rewards for developing new tax gimmicks are likewise great. .. 

Thus, unless the underlying cause of :he tension is attacked 

directly, the prohibition of old shelters leads to the 

construction of new ones and the tax system emerging from 

this sequence of events may be more complex by far than what 

one might have expected from looking at the design of the 

system initially. 

This kind of complexity may be called dynamic 

complexity. Much of the complexity in our existing code 

seems to be of the dynamic variety. The initial tension 

. created by preferential taxation stimulates new types of 

transactions as individuals seek to gain the tax benefits 

created by the preferences. This leads to reactions by 

administrators and legislators concerned with preserving the 

integrity of "legislative intent" and protecting tax 
-10-

revenues. A portion of the complexity of current tax law can 

undoubtedly bc attributed to the complexity of modern society 

and to efforts to use the tax system to serve diverse social 

purposes. But surely a significant share must be 

attributable to this dynamic process just described. This 

process in turn has its roots in the economic pressures 

created by a failure to tax all income equally in the first 

instjnce. 

Probably the leading example of the process of dynamic 

complexity is provided by the special treatment accorded to 

capital gains. The preferential tijx treatment of long-term 

capital gains has been generally recognized as one of the 

most significant sourcc?s of complexity in the code. -3/ 

However, what most observers have in mind here is the 

cxttcmely complex set of statutory rules governing the 

taxation of capital gains and losses -4/ and the definitional 

rcuuirements that must be satisfied before the statutory 

rules on capital gains are even applicable. Dynamic 

complexity does not focus on these rules and requirements, 

complex as they may be, but rather on the economics of the 

initial tension between ordinary income and capital gains. 

For example, as ProPessors Bittker and Eustice observe: 
-11-

"One of the most persistent problems in the taxation of 

corporations and their shareholders ... is the ordinary 

income-capital gain dichotomy in the field of corporate 

distributions." I/ 

The problems arise because of the relatively favorable 

taxation of retained earnings vis-a-vis dividends. 

E 

This 

distinction, Sittker and Eustice go on to state, 

a . . . is a constant inducement to the accumulation of 

business or investment income in a corporation, where it will 

be shielded from a hostile tax collector. ...[Tlhe tax 

collector has in turn been armed with statutory weapons to 

attack undistributed corporate earnings in the more blatant 

cases of tax avoidance. One weapon is the accumulated 

earninqs tax, imposed by Section 531. . . The other wtapon

is the personal holding tax imposed by Section 541 on the 

undistributed income of a "personal holding company". . .' -6/ 

This illustrates how attempts by taxpayers to reduce 

taxes by restructuring their transactions to increase 

corporate savings can provoke complex legislative responses. 

But despite these responses, "the use of the corporation as a 

temporary or permanent refuge from the graduated individual 

income tax is one of the principal landmarks of our tax 

landscape.' I/ 

Once resources have been accumulated in the corporation, 

pressure then is transmitted to the problem of how to get the 

money out. Several devices to accomplish this in a 

tax-minimizing way have been employed including: 
-12-

- achieving income splitting and reducing corporate 

taxes by paying excess compensation in salary to family 

members of a corporation's owners. This occurs mostly in the 

case of closely held corporations. 

- selling stock, which has appreciated in value where 

the appreciation is taxed at preferred rates. 

- entering into transactions that enable the shareholder 

to realize gains on corporate earnings without paying full 

taxes such as redemptions of stock and partial and complete 

liquidations. . 

In each case, of course, the transactions must be 

carefully structured, giving rise to further complexity. 

Also, at yet another stage in this dynamic process, the 

judicial system becomes involved. The preferential taxation 

of capital gains combined with the generality of the 

statutory definition of qualifying assets has forced the 

courts to decide whether various transactions qualify for 

capital gains treatment. Two examples where decades of 

decisions have failed to produce clear boundaries for capital 

gains treatment involve the taxation of payments for the 

termination of contract rights and sales of real estate by 

individuals. The ambiguity in the latter case stems from the 

fact that the capital gains asset definition excludes 
property held for sale to customers in the *ordinary" course 

of business. Thus, preferential taxes on capital gains both 

in itself and in combination with corporate income taxation 

has been the source of a considerable amount of dynamic 

complex i ty . hnother illustration of dynamic complexity is reflected 

in the continuinq efforts of tax legislators and 

administrators to control the use of tax shelters. 

Commissioner Kurtz of the Internal Revenue Service has aptly 

described this process in 3 recent address: 

"Congress substantially curtailed many of the known tax 

shelters in the Tax Reform Act of 1976. But no sooner were 

the apparent leaks in the dike plugged than new ones 

appeared. . . Thc fact that many of these transactions are 

extremely complex and present substantial adr inistrative 

problems to the Service cannot be allowed to interfere with 

the fair administration of the tax laws. New laws may call 

for new responses.... Ne are making a concerted effort to 

learn of these new schemes as quickly as they develop and 

confront them as quickly as we can." -

8/ 

After describing the work of the Service aimed at 

increasing the audits of returns showing income from tax 

shelters, Commisioner Kurtz discussed new revenue rulings 

which were about to be issued to curb the new types of tax 

shelter transactions that were "beginning to proliferate\ . in novel areas of investment." z/ In two cases, the rulings 

arose in response to taxpayers' attempts to circumvent the 

at-risk limitations of the 1976 Tax Reform Act which were 

designed to limit taxpayers' losses to the amount of the 

assets they had personally risked in various ventures. 
- -14-

The basic problem in these cases is the tax reducing 

possibility provided by sham transactions which overvalue 

assets and allow the purchaser excessive depreciation 

deductions. At risk rules could be rationalized as one means 

of preventing sham transactions. However, such rules could 

also prevent valid depreciation deductions from beinq takcn 

for. assets which were not artificially inflated in value when 

purchased. Tn practice, because accounting conventions often 

fail to measure income properly as it accrues, many 

legitimate loans might well have the appearance of sham 

transactions. 

Apparently this tendency of overdcing reform in an 

effort to restrict tax reducinq behavior has itself lead to 

further complexity in several cases. For example, Congress 

enacted the collapsible corporation provisions to prevent 

ordinary income from being taxed as capital qains in certain 

instances. But when it was realized that the collapsible 

corporation provisions had become so broad in scope that they 

were producing harsh and "unintended" results, Conqrcss tried 

to soften them by enacting the extraordinarily complicated 

Section 341 (e) to provide dispensations from the collapsible 

corporation treatment. Finding that the relief of Section 

341 (e) was insufficient, in 1964, Congress granted further 

relief in the form of Section 341 (f), for which final 

requlations have yet to be issued. 
- -1 5-

Other examples could also be cited where the failure to 

tax income equally has produced significant complexity. In 

each case, the taxpayer's initiative leads to subsequent 

reactions by administrators and legislators in a never ending 

process. Therefore, for any proposed tax change, it is 

necessary to distinguish between first-round simplification 

and subsequent-round simplification. A proposal can be quite 

simple initially, but if it establishes pressure points which 

lead to restructured transactions and patchwork legislative 

remedies, further complex transactions will result.' We might 

well be better off if we initially dealt with the problem in 

d fairly complex way but in a way which largely eliminated 

the tension. 

It is against this background, then, that the complexity 

of a comprehensive tax system must be judged. In reviewing 

the main elements of Blueprints, therefore, the following 

questions will be addressed: 

Is the proposed change a simplification or not? 

For whom is it a simplification? 

In what ways is it a simplification? 

Is it likely to be a lasting simplification? 

If there is more Complexity, is the complexity such that 

it can be regarded as avoiding even more complexity 

farther down the road? 
. 

-16-

Pinally, it must be recognized that there are inevitable 

problems of equity if major tax proposals are adopted 

immediately. Special transition rules are qenerally required 

to deal with these problems. Since these rules would 

complicate tax assessment activities, although only for the 

period of transition, they must also be considered in this 

discussion of tax complexity. Thus, a final question is: 

Is it easy to move to the new tax system, or what are the 

problems of transition? 
. -17-

111. The Proposals in Blueprints. 

This section will analyze the complexity of the tax 

system proposed in Blueprints for Basic Tax Reform. It Will 

consider first the overall structure of the model 

comprehensive income tax and then the specific suggestions 

for taxing corporate income, capital gains, and deferred 

compensation of employees, and for improving generally 

various income measurement rules. Recommendations for 

transitional rules will be reviewed for their impact on 

simplicity as well. 

Overview of the St-ucture of Blueprints: 

Exclusions, Deductions, and Rates 

The basic structure of comprehensive taxation as 

presented in Blueprints implements to a far greater degree 

than current law the principle of taxing income from whatever 

source derived. Also, and perhaps as a consequence, the 

overall logic of the model tax system would be much easieroto 

understand. The tax base would embrace virtually all sources 

of income including many items not now subject to the 

individual income tax such as state and local bond interest, 

social security benefits, public assistance benefits, 

fellowships and scholarships, the bonus value of food stamps, 
-18-

unemployment compensation, disability and workmen's 

compen: ',on, veterans' benefits, employer contributions to 

health and life insurance plans, earnings in pension fund 

reserves and corporate undistributed earnings. At the same 

time, the separate corporate tax would be abolished. 

Taxing these currently excluded items, a decision based 

mai;ily on equity considerations, need not involve significant 

issues of complexity. State and local interest income would 

be treated the same as all other interest income. Similarly, 

taxation of benefits under various transfer programs such as 

welfare or veterans' benefits would only require the addition 

of a tax reporting system to the current state or Feder,l 

information system. Potential administra- J 

tive problems which could arise from taxing in-kind benefits 

such as public housing and Medicaid are avoided by not 

attempting to include these items in the tax base. The bonus 

value of food stamps would be included because the cash 

equivalent value is readily determinable. 

The main problem in the taxation of transfer payments is 

not addressed in Blueprints and that involves implementing' a 

withholding system for such programs. If withholding is not 

instituted and recipients of such income have a final tax 

liability, they will be sorely pressed to pay at filing time. 

On the other hand, withholding can work a real hardship on 

those with very low incomes. A liberal system of filing for 
.. -19-

exemptions from tax would be required. One possible 

mitigating factor is the fact that at the levels of most 

transfer programs, the amount withheld would be quite small 

due to the low tax rates at the bottom of the scale. And, of 

course, basic benefit levels can also be adjusted to 

compensate for their taxability. 

The taxation of private and social security disability 

pay and unemployment compensation benefits gives rise to no 

additional complications. In these cases, Blueprints 

recommends that employer contributions would continue to be 

deductible as under current law. However, employee contributions to disability insurance would also be deductible and 

the benefits of such wograms would be taxable. 

Health and casualty insurance in contrast would be 

treated somewhat differently by Blueprints. In these cases, 

employer contributions would be treated the same way as 

private purchases of health insurance, with premiums paid out 

of after-tax dollars and proceeds not subject to tax. 

According to this logic, employer contributions to health and 

casualty insurance plans would be taken into taxable income 

by the employee. Similarly, payments for life insurance 

provided by the employer would be taken into income but not 

any proceeds paid under such policies. The calculations here 

would be straightforward and could readily be provided by the 

employer as part of the annual wage statement to the 

c 
. 

-20-

employee. The only further complication occurs with respect 

to3*wholelife insurance where the interest build-up in the 

insurance policy would also be subject to tax. A calculation 

of this interest could be easily made by life insurance 

companies which currently compute the cash surrender value of 

outstanding policies. 

The exclusions from income under current law arising 

from retirement plans (including social security) and 

corporate retained earnings are discussed in more detail in 

other sections of this paper. 

One implication of these proposals to tax current 

exclusions is that more individuals would be required to file 

tax returns than under current law. In fact, if 

simplification is measured by the number of returns filed or 

the number of taxable returns, comprehensive income taxation 

may be regarded as a step backward. Under current law, of 

the roughly 109 million filing units in 1976, only 87 million 

were required to file a tax return, and of this number, only 

66 million had a positive tax liability. lO/ In contrast, 

the tax proposals in Blueprints would increase the number of 

taxable returns from 66 million to 81 million returns. On 

the surface, this seems like a retrogression -- on both 

equity and simplicity grounds. And yet Blueprints claims to 

replicate the current distribution of tax burdens. How can 

this be true? 
- -21-

The answer is that many returns now classified as 

non-taxable do in fact pay taxes but they pay them in an 

implicit rather than an explicit form. The best example is 

the corporate income tax, the burden of which may be 

allocated to all shareholders if not to all owners of capital 

assets. If this tax is allocated to either shareholders or 

all capital income (the latter being the assumption used in 

Blueprints) then many "non-taxable" and even non-filing 

returns are seen to be paying taxes, and often at very high 

rates relative to their incomes. In fact, if filing units 

with such implicit taxes are counted, the total number of 

"taxable" filing units under current law is 93 million even 

though 22 mirlion of these units file no tax returns. 

Thus, comprehensive income taxation in which the 

corporate income tax is formally abolished in favor of taxing 

corporate income directly to individuals may make such 

returns explicitly rather than implicitly taxable. This 

policy will not only achieve substantial gains in horizontal 

equity, but equally important, it will facilitate an 

understanding of the idea that all income flows should be 

directly taxed to the individuals benefitting from them. 

Comprehensive income taxation as defined in Blueprints is 

more directed to obtaining an income tax code that really 
-22-

taxes income than to decreasing the number of tax returns 

actually filed. Of course, any increase in the number of 

returns filed implies greater work loads and more resources 

devoted to tax administra'tion. 

Blueprints also permits a limited number of deductions 

in the determination of taxable income. Again, there may be 

a conflict between the more conventional view of simplicity 

and the Blueprints design. The conventional view holds that 

simplification results from fewer taxpayers itemizing 

deductions rather than taking the standard deduction. The 

structure in Blueprints provides no such choice between 

itemized and standard deductions. There is no standard 

deduction in Blueprints, but for purposes of income 

measurement five deductions are allowed. These deductions 

are for employee business expenses, non-business interest 

expenses, =/ state and local income taxes, alimony paid, and 

child care expenses subject to certain limitations. The 

child care deduction would be equal to one-half of actual 

child care expenses up to the lesser of $5,000 or the taxable 

earnings of the lesser earning spouse. In the case of 

employee business expenses, Blueprints also proposes a 

simplification option which would allow only those deductions 

in excess of a specified minimum amount. =/ 
-23-

. 

While these deductions would generally be available to 

all taxpayers, many categories of deductions allowed under 

current law would be disallowed such as state and local sales 

and gasoline taxes, property taxes for owner-occupied 

housing, charitable contributions, medical expenses, and 

casualty losses. Even moving expenses, now an 'above the 

line' deduction, would be disallowed on the grounds that they 

like commuting expenses, are more in the nature of 

consumption outlays which reflect locational preferences than 

job-related expenses. -13/ Such changes would simplify

individual record-keeping and tax administration. 

Nonetheless, given the lack of a standard deduction choice, 

trirtually every tax return filed would be an "itemizer.' 

Thus, Blueprints from this perspective may appear to 

represent a net increase in complexity. 

In other respects, the recommendations in Blueprints 

would provide simplifcation by anyone's measure. Included 

here would be the abolition of the minimum tax, the maximum 

tax, and the whole range of credits now available under 

current law including the investment tax credit, the work, 

incentive credit, the credit for contributions to candidates 

for public office, the general tax credit (which in itself 

involves a choice between two credits), the earned income 

credit, the child care credit, and now the jobs tax credit. 
-24-

The basic structure of rates and exemptions 'would also 

be simplified in Blueprints. As under current law, there 

would continue to be separate rate schedules for joint 

returns, single returns, and heads of households. However, 

the relationships among these schedules would be very much 

changed. For example, the "marriage penalty" which defines 

the excess taxes that a joint return pays over two single 

returns with the same income would generally, but not in 

every case, be reduced. The two factors contributing to this 

result are the structure of tax rates and the fact that a 

portion of the earnings of a second worker in the houehold 

would be excluded from the tax base. The exclusion would 

amount to 25 percent of the secondary worker's income up to a 

maxjwm exclusion of $2,500. Also, for secondary workers, a 

child care deduction as already noted would be allowed rather 

than the current child care credit. These measures to 

improve equity among various types of taxpayers do not 

significantly complicate the tax code. 

. 

The schedule of tax rates would also be much simpler in 

Blueprints. For each schedule, there would be only three tax 

brackets. For the joint return, taxable income of less than' 

$4,600 would be taxed at an eight percent marginal rate, 

taxable income from $4,600 to $40,000 at a 

25 percent marginal rate, and income over $40,000 at a 

38 percent marginal rate. These rates, along with the 
. 

* 

-25-

structure of per-return and per-taxpayer exemptions, would 

yield about the same distribution 0,' 'b.ax burdens by income 

class as does the combination of the personal and corporate 

income tax under current law. 

However, the simplified nature of this exemption and 

rate structure stands in sharp contrast to current law, and 

this goes well beyond the issue of tax computation. Under 

the proposed tax structure, most taxpayers would remain in a 

single marginal tax rate over most of their lives. Thus, the 

new rate schedule could be described as a flat rate tax of 

25 percent plus a positive surtax for high-income taxpayers 

and a negative surtax at the very low end. That this 

structure of rates comes quite close to the distribution of 

tax burdens under current law is due to the fact that under 

the model income tax in Blueprints relatively more income is 

included at the upper end of the income distribution. For 

example, whereas taxable income in the aggregate would be 

increased by 32 percent, taxable income in classes over 

$50,000 would increase by almost 100 percent. 

Moreover, with such a revised rate structure, calcula-• 

tions based on changes in marginal tax rates need not enter 

into individual financial planning. For example, the form in 
. -26-

which to hold investments in retirement years as opposed to 

working years or whether to realize capital gains in one year 

as opposed to another would not be important considerations. 

This in turn means that income averaging becomes less 

important since the effects of volatility in income would 

not, in general, change the marginal rates at which income 

would be taxed. The proposed structure of tax rates could 

thus make a major contribution to a reduction in dynamic 

zomplexity. 

1 . 

. 

. 
-- 

- -2 7-

Corporate Tax Reform 

Gene r a 1 Pr opa sa 1 

Blueprints recommends an end to the separate taxation of 

corpcration income for reasons of equity and efficiency. On 

equity grounds, the rationale given is as follows: 

"Strictly speaking, the uses concept of income -- consumption plus change in net worth is an attribute of 

individuals or families, not of business organizations.

Corporations do not consume, nor do they have a standard of 

living. The term corporate income is shorthand for the 

contribution of the corporate entity to the income of its 

stockholders."(p. 68) 

The separate corporate tax may also have the undesirable 

economic effects of inhibiting the flow of saving to the 

corporate sector and discouraging the use of equity relative 

to debt finance. Blueprints would deal with the problems of 

both equity and efficiency by a form of partnership 

treatment in which the income of corporate entities is 

directly attributed to the owners of the corporation and 

directly taxed under the personal income tax. 

This proposal for complete integration of corporate and 

personal taxes consists of five basic rules. (1) The owner 

of each share of stock on the first day of the corportion's 

accounting year would be designated the shareholder of 
L 

-20-

record. (2) Each shareholder of record would add his share 

of the corporation's income to his own taxable income -- or 

deduct his share of the loss. (3) Each shareholder annually 

would increase his stock basis by his share of corporate 

income, or reduce it by his share of corporate loss. (4) 

The shareholder's stock basis would be reduced by the amount 

of dividends he received each year. Once a shareholder's 

stock basis ha5 been reduced to zero, the value of any 

further distributions would be included in income. (5) Any 

difference between a shareholder's stock basis (adjusted for 

inflation as discussed below as well as for retained 

earnings) and the sales price he received for his stock would 

be added to his income and fully taxed when realized. The 

implications for simp1 city of the transitional phase-in 

rules for integration are considered below. 

While these rules address many of the technical problems 

inherent in integration, they are silent on others. The main 

advantage of these rules is that they approximate taxing to 

the shareholder corporate income as it accrues. Consider a 

shareholder who holds stock for an entire year during which 

time his share of corporate income is $100. Under the 

1 

proposal, he would simply add the $100 to his taxable income. 

Dividends would have no current effect on his taxable income 

but would merely reduce his basis. 

8 
- -29-

What about the shareholder who owns the stock lees than 

a full year? Assume the shareholder of record sells his 

stock which has a basis of $1000 halfway through the year and 

corporate income accrues equally over the year. In this 

case, he will have to add the entire $100 of corporate income 

to his taxable income although only $50 of income accrued 

while he held the stock. The $50 of earnings will make the 

market value of his stock worth $50 more than his original 

basis. Under these conditions, at the middle of the year he 

could receive $1,050 for his stock. However, as a result of 

the income attributable to him, his basis will rise to 

$1,100. The sale, therefore, results in a $50 loss which 

would be fully deductible. His taxable income at the end of 

the year would be $100 + $1,050 - $1,100 or $50, exactly what 

the corporation had earned as of the date of the sale. This 

is the identical result that would obtain if the shareholder 

reported as his income the difference between his original 

basis and the sale price of his stock, an alternative 

calculation which Blueprints would also allow. In fact, this 

alternative treatment is probably preferable for part-year 

shareholders in that the corporation's income does not have 

to be known in order for the individual to calculate his tax. 

-14/ 
-30-

The rharcholder of record designation is an important 

simplification of the integration proposal for public 

companies with large numbers of shareholders. This 

designation avoids the necessity of keeping records of 

precisely when the stock is sold during the year. Also, this 

designation in connection with the rules for basis adjustment 

accurately measure the income of part-year shareholders as 

indicated. The choice of the first day of the corporate year 

as the record date is needed to protect against trafficking 

in the stock of corporations which had incurred losses. If 

the final day of the corporate tax year were used as the 

record date, there would be a tendency for the stocks of 

corporations with losses to bt transferred late in the year 

to higher income individuals for whom the losses would be 

worth more for tax purposes. Rules that encourage such 

be'havior are undesirable in any tax system. 

Integration would require corporations to report to all 

shareholders of record their share of corporate earnings. 

Shareholders would then add these earnings to their other 

income and would make three basis adjustments to their stodk. 

The first is an upward adjustment for corporate income 

attributed to them: the second is a downward adjustment for 

dividends received; the third is an upward adjustment for 

inflation. Shareholders would thus be faced with the not 

inconsequential problem of keeping track of the adjusted 
-31-

bases of their stocks over time. While the information for 

making all of these adjustments could be provided by the 

corporation, these calculations would be required of all 

taxpayers receiving dividend income. 

Audit adjustments under integration would be handled 

the same as under current law. All dealings would occur 

between the coporation and the IRS. The shareholders of 

record Eor the corporation's tax year in question would not 

be required to make up any tax deficiency, but the higher 

taxable income and tax liability would be associated with the 

stockholders of record in the year the audit adjustments are 

settled. Similarly, under present law, an increqse in 

corporate liability for any underpaid taxes affects the stock 

values of current stockholders. However, also as under 

current law;if an understatement of income is anticipated, 

the expected value of the tax deficiency would be reflected 

in the price that the affected shareholder paid for his stock 

in the first instance. 

It might also be objected that the Blueprints system 

could place an undue hardship on low-income persons holding. 

stock in companies that currently pay out few dividends. 

Such individuals could be forced to sell their stock to pay 

their taxes. This liquidity problem could be solved by 

imposing a withholding tax on corporations and granting a 

corresponding tax credit to shareholders of record for their 
- -32-

share of the corporate withholding tax. However, the 

imposition of a withholding tax would mean that a partial 

year shareholder would continue to have an interest in the 

corporation even after he sold his stock because the tax 

credit would not be transferable to the purchaser of the 

stock. In principle, the market should be able to handle 

this problem. While the new buyer cannot purchase the 

credit, the seller would be willing to sell the stock for 

iess if he expected a tax credit to be forthcoming. 

Another set of issues raised by the integration proposal 

is the treatment of foreign source income and taxes and 

foreign shareholders of domestic corporations. Concerning 

the taxation of international income, E-ueprints would favor 

the residence principle under which all income wherever 

earned would be taxed according to the rules of the 

taxpayer's country of residence. 

This, however, is regarded as a long-run objective. As 

an interim solution, Blueprints would continue to allow a 

foreign tax credit on foreign source income. The foreign tax 

credit would be computed at the corporate level and would be 

limited to 30 percent with the remainder of foreign taxes 

allowed as a deduction. Foreign source income of U.S. 

corporations would flow through directly to the parent 

corporations and their owners whether or not distributed by 

the subsidiary or the parent. E/ It has been alleged that 

. 

P 

. 
- -33-

eliminating deferral would be a major source of complexity, 

but the earnings and profits of foreign subsidiaries must 

already be calculated according to U.S. tax accounting rules 

in order to determine the deemed paid foreign tax credit. E/ 

It may be that the most important administrative 

consideration would be the need for an expanded auditing and 

enforcement effort by the Internal Revenue Service to monitor 

at ar. scceptable level the calculation of foreign source 

income. 

Blueprints thus deals with many problems associated 

with integrating the corporate and personal taxes. Other 

problems for which Blueprints offers n.3 ready solutions might 

also be mentioned. There are, for example, income assessment 

problems stemming from interlocking corporate stock ownership 

and stock issues or redemptions after the record date. The 

rules enunciated by Blueprints would have to be extended to 

these situations before a workable integration plan could be 

achieved. 

The problem with interlocking corporate stock ownership 

runs as follows. For two corporations owning stock in each 

other, the income of each must be determined simultaneously, 

because one corporation can not determine its income unless 

the other corporation's income is determined and vice versa. 

A completely accurate determination of the income of 
-34-

interlocking corporations requires the solution of a set of 

simultaneous equations. Any possible remedy for this problem 

is likely to represent a compromise between accurate income 

measurement and administrative feasibility. 

Another problem on which Blueprints is silent but which 

may nonetheless have a bearing on simplicity is the question 

of how income would be attributed to stock newly issued 

during the year. To attribute all of income to original 

record date shareholders would be unfair to them since part 

of the corporation's income clearly has accrued to the new 

shareholders. A related issue is how withholding tax credits 

would be divided amorg new and old shareholders. Additional 

rules for allocating corporate source income would be 

required with obvious implications for complexity. The rules 

would also have to specify how income and withholding would 

be allocated to stockholders in the event of redemptions of 

stock by corporations. 

Income tax analysts have expressed concern that 

integration could not readily deal with the problem of 

allocating investment tax credits and foreign tax credits io 

millions of shareholders. E/ This issue would not 

materialize under the Blueprints proposal. All credits 

except for the foreign tax credit would be eliminated, and 

the computation of the foreign tax credit would involve only 

the corporation and not its shareholders. 
-3 5-

In general, full integration would unquestionably 

generate Considerable complexity, although more for 

corporate management than for individual taxpayers. 

Approximately 15 million returns in the aggregate would be 

affected, with 55 percent in comprehensive income classes 

below $20,000. Even these figures do not reflect the effects 

of a possible increase in the ownership of corporate shares 

-.?sultir.g from integration of corporate and personal taxes. 

Furthermore, some 2 million corporations would be required to 

change their accounting practices and procedures. Tax 

administrators as a consequence, would have to step up their 

efforts to ensure that corpor3te source income and basis 

adjustments were correctly reported. On the other hand, by 

generally ending the advantage of preferred capital gains 

treatment for corporate retained earnings, the integration 

proposal would greatly reduce pressures to convert corporate 

income into capital gains. Full integration could thus have 

a favorable effect on dynamic complexity. 
-36-

Transition Considerations 

Perhaps the major transition issue in connection with 

the integration proposal i8 the taxation of undistributed 

income accumulated in corporations but not paid out prior to 

the effective date of integration. The other major 

transition consideration having a bearing on integration 

concerns how unused losses, deductions, and credits earned in 

Fricr years but not yet utilized because of limitations of 

one type or another would be taxed under the integration 

proposal. 

As an operating principlc, Blueprints states that "to 

the maximum extent practicable, an attempt should be made to 

treat such items in a manner that reflects the impact of the 

corporate tax as in effect when the items were incurred or 

earned." (P.197) Rules to accomplish this objective would 

definitely complicate corporate taxtion during the transition 

period as well as decisions of managers and financial 

investors, since the existence and possibly changed status of 

the credits would alter the after-tax returns that could be 

expected from owning the stock of some corporations. 
Capital Gains Tax Reforms 

General Proposal 

'Blueprints. The basic recommendations for capital gains 

an3 Losses are easily summarized. Gains from the sale of 

%.-aFit=lzssets -19/ would be fully taxed upon realization at 

ordinary rates after (1) adjustments to basis for corporate 

stock (as explained in the integration proposal) and (2) an 

adjustment to basis for general price inflation. Losses, .. 

after similiar basis adjustments had been made, would be 

fully deductible. However losses would be limited to the 

adjusted basis of the shareholder. At time of death, capital 

gains would also be taxed as if fully realized. Blueprints 

would continue to allow rollover in certain situations 

including business reorganizations and sales of principle 

residences. 

The adjustment for inflation would be accomplished by 

multiplying the original basis of the asset (or the basis at 

the beginning of the taxable year in the case of corporate 

equity) by the ratio of the consumer price index in the year 

of purchase (or beginning of the taxable year) to the same 

index in the year of sale (or the end of the taxable year). 
-

-38-

The ratios to apply would be provided in the form of a table 

accompanying the capital gains tax schedule. No inflation 

adjustments would be provided for intra-year sales and 

purchases. 

Blueprints recommends the above treatment on the grounds 

of equity, since changes in capital values which merely 

reflect inflation are not real income. It considers but 

rejects (1) the full taxation of accrued capital gains on the 

grounds of difficulties of valuation and (2) an interest 

charge on the deferral of taxes resulting from the 

postponement of realizations on the grounds that such an 

approach would engender considerable com2lexity with only 

small gains in more accurate income measurement. 

Adjusting for inflation would in itself complicate the 

calculation of income but would not be expected to produce 

insuperable difficulties for tax practitioners, 

administrators, or accountants. Furthermore, these rules for 

taxing capital gains must be compared with the complexities 

of existing law. For example, under Blueprints there would 

be no need for recapture rules to prevent ordinary income 

created by excess depreciation deductions from being taxed as 

capital gains. Not only would better income measurement 

rules limit deferral but recapture would occur automatically 

since all gains would be taxed in full. 
-

-39-

Moreover, taxpqyers would be spared the need to 

undertake the present complicated netting procedures whereby 

gains and losses are divided into short- and long-term 

accounts, the net gain or loss in each account is determined 

separately, the resulting net figures in each account are 

netted against each other, and any net losses are subject to 

an income limitation but with an unlimited carryover. Also 

leaving the tax code would be the alternative tax of 25 

percent on the first $50,000 of long-term gains, the capital 

gains provisions in the minimum tax and the maximum tax, and 

the special capital gains treatment accorded timber, 

livestock, coal, and iron ore. Taxing capital gains in full 

at death would also be far less complex than the carryover of 

bases rules provided in the 1976 Tax Reform Act. -20/ 

Removing the tendency of inflation to increase taxes on 

capital income would also reduce the continual pressures to 

effect relief through legislation -- often with uncertain or 

unintended side effects. This would not only contribute to a 

more stable tax environment for economic decision-making, but 

would also give investors less reason to be concerned about , 

restructuring transactions to compensate for both inflation 

and a tax base defined in nominal terms. Thus, reducing the 

distinction between ordinary income and capital gains would 

abate the legislative and economic pressures toward dynamic 

complexity. The advantages of deferral, of course, would 

continue to be a factor in tax planning, but the range of 
. 

-40-

assets to which deferral would apply would be severely 

restricted. This would be particularly true since returns on 

corporate stock would be taxed largely on an accrual basis 

and improvements in the measurement of the income from other 

assets, as indicated below, would remove that soufce of 

capital gains under current law. 

While the information for making inflation adjustments 

can be readily provided, additional computations would be 

required of many taxpayers. In 1976, some 7 1/2 million 

returns actually realized net long-term capital gains or 

losses but this figure presumably understates the number of 

taxpayers holding assets for which basis adjustmants would be 

needed. Moreover, if the pattern of realizations is 

indicative of the pattern of holdings, about one-half of the 

tax returns affected would be in comprehensive income classes 

below $2O,OOO. 

Transition Considerations 

As is the case with other proposals, Blueprints . reconunendk transition rules for gains and losses that have 

accrued prior to the effective date of the new rules. These 

transition rules would deal with the equity problems which 

would otherwise arise from an immediate application of the 

new capital gains procedures. 
Holders of existing capital assets would be allowed a 

10-year period over which the old rules would phase out. The 

phase-out could take one of two forms. Under one procedure, 

the inclusion rates would increase over the 10-year period 

from 50 percent to 100 percent. An alternative transition 

procedure which would probably be less disruptive of capital 

markets would allow investors to treat realized gains or 

losses as accruing proportionately over the interval the 

asset was held, with the portion of the gain attributable to 

the pre-effective.date period taxed according to the old 

rcles and the remainder according to the new rules. These 

transition rules would lead to increased computational 

difficulties. 

. 
. 

-4 2-

New Income Measurement Rules 

General Proposals 

Blueprints argues that new income measurement rules are 

needed to calculate more accurately income from capital, Or 

vhat is more commonly termed business incone. Of major 

importance, in this connection, is the need for allowances 

for depreciation and depletion to correspond more closely to 

the real decline in economic value of the depreciable and 

depletable assets. Blueprints also formulates new rules for 

measuring income in the case of self-constructed assets. All 

of these rules would significantly affect the simplicity of 

the proposed tax system. 

Deprec iat ion 

for calculating capital consumption allowances for 

machinery and equipment, Blueprints advocates a system not 

dissimilar to the current ADR procedures. The system would 

involve the following elements: (1) the classification of 

all assets by types; (2) the mandatory maintenance of a 

system of vintage accounts: (3) the use of a guideline 

annual repair allowance for each asset: (4) the application 

of a specified annual depreciation rate to the undepreciated 
. 

-43-

balance in each vintage account together with a date on which 

any remaining balance may be deducted; (5) the computation 

of annual adjustments of basis in each account by a measure 

of the change in general price levels during the year. 

Similar depreciation rules would be applied to 

structures except that depreciation rates could vary over the 

life of the structure to reflect the fact that asset values 

may decline less smoothly. However, in no case would total 

depreciation after adjustments for inflation be allowed to 

exceed the original basis. Gains and losses would be 

recognized when exchanges or demolitions occurred. 

Depreciation and repair allowances would always be determined 

by the age of the structure, not by the time in the hands of 

the new owner. Expenditures for structural additions and 

modifications beyond guidelines would be treated as new 

investment which would increase the asset's depreciable base. 

Under the recommended procedures, all rules for 

estimating guideline depreciation rates and repair allowances 

would be "subject to continuous revision to reflect new 

evidence bn actual experience and changing technology." 

(p. 65). It is imperative in this system that information be 

kept current while at the same time arbitrary reporting 

requirements are kept to a minimum. Survey techniques 

modeled on current procedures of the Office of Industrial 
-44-

Economics of the Treasury Department may be used, but the 

type of information needed -- maintenance outlays and rates 

of depreciation in addition to asset lives -- would be more 

extensive. 

In addition, a large educational effort would be 

requ'ired, at least initially, to familiarize taxpayers and 

practitioners with these new rules. The IRS would have the 

particularly important task of promulgating this information 

in a form that would be enforceable and understandable, 

particularly to small businesses. However, any rule for 

depreciation requires monitoring and enforcement, and once 

understood, the particular rules in Blueprints need not be 

any more onerous than existing depreciation procedures. 

These rules would, moreover, have the effect of reducing 

the differential tax advantages of alternate investments. 

Since excess depreciation is perhaps the most common 

ingredient in tax shelters, the establishment of a system of 

depreciation allowances more congruent with economic reality 

would diminish if not eliminate the incentives of taxpayers 

to seek out such shelters. The tendency towards dynamic 

complexity, which as noted earlier is particularly important 

in the case of tax shelters, would be greatly abridged. 
. 

-45-

Also, as indicated in connection with capital gains 

taxation, the adjustment of depreciation allowances for 

inflation would reduce the need for legislative solutions to 

offset the effects of Inflation on the taxation of income 

from capital. Legislative solutions, moreover, while often 

sufficient in the aggregate albeit with a lag, are seldom the 

apropriate correction for individual industries. As a 

result, the tax environment for particular investments in an 

inflationary world is marked by a high degree of uncertainty. 

Depletion 

Blueprints also restructures the rules governing the 

taxation of mineral deposits. The problem here is that the 

economic value of a mineral deposit becomes fully known only 

after the deposit has been completely exploited, whereas an 

annual depletion schedule must be estimated from the onset of 

production from the deposit. Uncertainty about extraction 

and marketing costs and mineral prices in the future as well 

as the extent of the discovery itself, makes the task of 

valuation particularly difficult. 

Economic competition among suppliers of minerals tends 

to ensure that the costs of seeking mineral deposits at least 

in an expected value sense are equal to the returns from this 

activity. On this basis, Blueprints argues that the best 
. 

-46-

objective measurement of the market value of the mineral 

deposit prior to production is the total expenditures made 

for discovery and development of the deposit. Blueprints 

would, therefore, require the capitalization of all 

preproduction expenditures (other than for depreciable 

capital which would be separately depreciated under the rules 

already discussed) . Depletion deductions for tax purposes 

would then be based on initial production rates combined with 

guideline decline rates derived from average experience. Over 

time -- Blueprints recommends 5 years -- these rates would be 

adjusted for each property to reflect individual experience. 

But in no case would total depletion deductions exceed cost 

(after adjustment for inflation). 

Under these tules, tax administrators would be compelled 

to develop average guideline rates and workable procedures 

for periodically revising them in the case of particular 

deposits, and taxpayers would have to learn how to comply 

with these accounting procedures. On the other hand, 

investments in mineral deposits would lose their appeal as 

tax shelter devices with favorable implications for reducing 

dynamic complexity. The net result in this case would 

undoubtedly be an increase in complexity, but the extent of 

the complexity would depend upon the workability of the 

guideline procedures. 
Self-Constructed Assets 

Finally, current law accords favored treatment to 

capital assets constructed by a firm for its own use relative 

to assets purchased from other firms. For self-constructed 

assets, income accruing to suppliers of equity during the 

period of construction is not currently recognized because 

there is no sale of the completed structure. =/ TO 

equalize the tax treatment of self-constructed and other 

assets, Blueprints would require all costs of constructing an 

asset for a firm's own use (except interest paid) to be 

maintained in a separate account. "During the construction 

period a guideline rate of return would be imputed to the 

average value of this account and added to the tax base of 

the builder and also to the depreciable basis of the owner." 

(p. 67). The assets in service would be depreciated under 

the rules already discussed. Since the guideline return is 

imputed to the portion of the structure financed by debt as 

well as equity, interest costs are already included in the 

procedure and need not be separately added. 

The rationale for this treatment is that capital tied up 

in such assets must pay a rate of return at least eaual to 

what the capital could earn in alternative uses or else the 

investment would not have been undertaken. The imputation of 
. 

-48-

income is therefore necessary to equate the tax treatment of 

such assets with other assets. This imputed return is added 

to the depreciable basis of the property to avoid taxing 

capital . 

These rules to reduce the favored tax treatment of 

self-constructed assets need not involve much additional 

complexity since essentially the same rules are already in 

use for rate-making purposes in the case of utilities, the 

major industry which constructs its own assets. 

Transit ion Consider at ions 

Slueprints recommends that assets already in place when 

the new income measurement rules take effect continue to 

enjoy the old tax treatment as long as they remain in the 

hands of their initial owners. The additional complexity 

here would be the need to follow two separate sets of 

accounting rules -- one for new and one for old capital 

assets. The transition period would continue until all 

existing assets had either been retired or had changed hands. 

A Possible modification is to switch to the new rules with 

* 

respect to the undepreciated or undepleted basis of existing 

assets at some future date, say in,10 years. 
-49-

. 

The Tsxation of Retirement Tncome 

General Proposals 

Blueprints also deals with the difficult issue of the 

taxation of accruing rights to receive future income such as 

pension and social security benefits. Consistent with the 

concept of a comprehensive tax base, -Blueprints would 

establish rules that would approximate accrual tzxation of 

the value of such pension rights by combininq the full 

texation of pension bcnefits when received with the taxation 

of pension-fund carninqs. Furthermore, neither employer nor 

employee contributions would be taxed when made. This method 

is based on the idea that accrual taxation is generally 

equivalent to the full tsxation of realized benefits plus a 

deferral charge. The tax on pension-fund carninqs under the 

3lueprinE proposal represents the deferral change. 

To see how the system under Rlueprints would approximate 

accrual taxation, suppose that a taxpayer has the same 

marginal tax rate of 20 percent in his workinq years and in 

his retirement years. Let an employer contribute $100 to a 

pension fund for the last working year to be available to the 

taxpayer as retirement income next year. Suppose also that 

the money in the fund can earn 10 percent. 

7 
-50-

If a full accrual system were in effect, the taxpayer 

would pay a tax in year 1 of $20 on the $100 contribution at 

the beginning of the period leaving $80 in the fund and also 

an additional tax of $1.60 equal to 20 percent on the $8 of 

earnings of the fund durinq the year (10 percent of $80). At 

the end of the yecr he would have prepaid taxes of $21.60 on 

his retirement pension of $86.40 = $80 + 8 - 1.60 resulting 

from the transaction. Since taxes were prepaid on the amount 

in the fund, he would be allowed to receive a distribution of 

$86.40 from the pension fund tax free. 

Under the system recommended by Blueprints, both 

employer mi employee contributions to pension funds would be 

tax deductible. In this case there would be no tax liability 

for the taxpayer on the $100 employer contribution during his 

working year. However, there would be a $2 tax on his $10 of 

accruing interest income during this year. Tn addition, the 

distribution of $108 in the fund to the taxpayer would be 

fully taxed at a 20 percent rste (equsls $21.60) leaving him 

$108 - $21.60 = $86.40 in his retirement year, exactly the 

same as in the accrual taxation case. 

Thus, in the case of a taxpayer who stays in the same 

marginal tax bracket and receives fully all the retirement 

income accumulated on his behalf, an accrual taxation system 

can be approximated by taxing pension fund earninqs as they 

accrue and fully taxing benefits. 
-51-

In contrast, the current taxation of ret;-.r?mentbenefits 

is a mixture of several elements. Employer contributions are 

generally excluded from income, but not all employee 

contributions are currently deductible. Also, while benefits 

in excess of tax prepaid contributions are generally fully 

taxed when received, there is no deferral charge for the 

postponement of tax. In addition, contributions to 

retirement plans by the self-employed (or by employees who 

have no employer-sponsored plans) and earnings of retirement 

plans are exempt from tax. Since most pension plans, with 

the exception of qovernment plans, require no employee P 

contributions the current system can be characterized as 

largely on a realization basis, whereas the Blueprints system 

is an attempt at approximating an accrual basis. 

In fact, because of problems created by vesting rights 

and uncertainty about the length of life, the treatment in 

qlueprints would be fairer in an -ex post sense than would cn 

accrual system. Persons who lived shorter than normal lives 

would pay less tax than under a pure accrual system since 

Blueprints would tax benefits when received rather than 

contributions when made. Conversely, for those who lived 

longer and therefore had more benefits, Blueprints would 

subject relatively more income to taxation. In the case of 

pensions that had not become fully vested, earnings would be 

taxed to the employer. If the employer were in a higher 
- -s2-

marginal tax rate than the employee as could be the case, the 

attractiveness of this kind of deferred compensation 

arrangement would be diminished. Rowever, there would 

continue to be a tax advantage to pensions under the 

Blueprints scheme to the extent that a person's tax rate is 

higher in his working years (when his contribution is 

deductible) than in his retirement years (when his benefit is 

taxable), The advantage of this treatment would be less 

under a comprehensive income tax system than under present 

law bocause of the smaller differences in marqinal tax rates 

and the wider tax brackets. 

The overall impact of the reforms outlined in 

Blueprints would be to diminish the economic attractiveness 

and the use of pension plans as vehicles for providing 

-retirement income. With the possible exception of the qain 

in simplicity from a decreased use of pension plans, little 

would be achieved in reducing complexity relative to current 

law for those pension plans which remain in existence. For 

individual taxpayers, who would receive notices of 

pension-fund earnings along with their annual W-2 statements, 

no addit4onal complexity is involved, But pension funds 

would have the additional requirement of calculatinq and 

reporting to employees (and employers �or not fully vested 

plans) their share of the taxable earnings of pension funds. 

This would be in addition to all other reporting and 

financial responsibilities under which pension plans would 
continue to operate. On the other hand, since all benefits 

would be taxed, no computation would be needed to determint? 

which portion of pension benefits are a return of tax-paid 

contributions and which are taxable income. Inasmuch as thc! 

current rules are quite complex, this could represent a 

substantial simplification. 

Some 44 million tax returns, or about 52 percent of 

those receiving wages and salaries, would include in income 

pension-fund earnings. As noted, this information would be 

made available on W-2 forms received from their employers. 

hnothcr 11 million returns would also have pension benefits 

subject to t.ax as under current law. 

In addition to private pensions, a major sourcc of 

reticement incomr! for many people today is social security. 

For example, in 197G the Social Security system paid out ovcr 

$6 of retirement income for each dollar paid out by private 

pension plans. -22/ Under current law, social security 

benefits are not taxable but only employer contributions arc 

excluded from income. It is possible to view social security 

as a pension plan under which the benefits actually receivbd 

result in some -ex post rate-of-return on employer and 

employer contributions. However, it is virtually impossiblh 

to calculate such a return annually. This is because future 

benefits depend upon the changing conditions of a worker's 

marital status, number of dependents, earnings rccord, and 

the spouse's earnings record. 
-54-

Consequently, Blueprints does not attempt to tax the 

implicit rate of return on employee and employer 

contributions to social insurance funds, and thus does not 

implement the same accrual principle for social security as 

for private pensions. However, as in the case of pension 

funds, contributions to the fund, by employer and employee 

would be deductible and benefits would be fully taxable. 

About 72 million tax returns would bc affected by the 

deductibility of employee social security contributions from 

taxable income, although, as in the case of pensions, their 

receipt of this _ .information would be handled through the 

uslal W-2 forms. Another 23 million returns would be 

required to report social security benefits. Over 10 million 

of these returns receive comprehensive income of $5,000 or 

less, and a large proportion of these as a result would not 

be expected to be taxable. 

The treatment of social security benefits would thus be 

somewhat more lenient as well as a good deal simpler than 

pension income. Compared to current law, however, social 

security would be more heavily taxed. The full taxation of 

benefits would outweigh the deductibility of employee 

Contributions which are not allowed under current law. 

Nonetheless, the harsher tax treatment of pensions than 

social security under Blueprints could lead to pressures for 
- -55-

increasing the size of the social security program relative 

to private pensions. While in a sense such a developmcnt 

could be regarded as advancing the cause of overall 

simplicity, equity may not nccessarily be improved because 

the implicit returns earned on social security contributions 

would not be taxed. 

Transition Considerations 

Complexity is also likely to be created in moving to the 

new System of taxing retirement income. For reasons of 

eauity, it would be undesirable to immediately tax all 

retirement benefits in full. Indeed any benefits paid out of 

past accruals have a claim for being treated under the 

current rules. In response to this, Blueprints would allow 

people currently retired to bc taxed under the old rules and 

people with current retirement accounts to be taxed partially 

under the old rules. Obviously developing regulations and 

forms and monitoring compliance during the transition period 

could impose burdensome chores on toxpnycrs and 

administrators. Moreover, the transition period in this case 

would 1P st a full qenerntion. 
. 

-56-

Summary 

For most proposals presented in Blueprints, the burden 

of recordkeeping, as in the case of wages currently, would be 

assumed by the disbursing organization. Information on the 

W-2 form provided by the employer would include not Only 

wages but various adjustments �or pension plans, social 

Security, and employer fringe benefits. Thus, to the extent 

that simplification is of more concern for individuals than 

institutions, Blueprints would not pose serious difficulties. 

However, because a comprehensive income tax limits _. 

exclusions, lore taxpayers would have to file tax returns. 

Filing would be an added burden for the currently nonfiling 

population. The taxpayer assistance industry could count on 

new business and the Internal Revenue Service would have a 

larger workload to process. 

The elimination of the standard deduction is certain to 

have an adverse effect on tax simplicity for the low to 

average income taxpayer. Elimination of the standard 

deduction would increase the number of itcmizers as 

Blueprints would continue to allow deductions for five 

categories of deductions. This would necessitate additional 

record-keapinq and calculations on the part of taxpayers who 
- -57-

now take the standard deduction as well as those who do not 

8 

1 

have to file. Also IRS would have to scrutinize the 

expenditures of the new itemizers. However, since many 

deductions of current law would be disallowed by Blueprints, 

currently itemizing taxpayers would no longer have to keep 

records of expenditures that had lost their tax-deductible 

status. 

Proposals in Blueprints that would complicate an 

individual's calculation of tax liability are the basis 

adjustments for returns with capital gains and with corporate 

source income. On the other hand, Blueprints would simplify 

the decision-making process for investors since most of the 

tensions responsible for dynamic complexity would be 

eliminated. By equalizing the tax treatment of different 

investments, Blueprints would decrease the necessity for 

investors to research the tax laws -- or have this done �or 

them. Thus, while tax practitioners may spend more time 

assisting taxpayers with calculations of tax liabilities, 

they would spend less time counselling them on tax planning. 

Dlueprints would impose additional reporting 

requirements on income dispensing institutions. Examples 

include the share of corporate income and adjustments for 

chsnges in basis that would have to be reported to 

shareholders by corporate management. Pension funds, in 
-58-

addition to the normal reporting requirements, would have to 

report the share of pension fund earninqs accruing to 

individuals, or employers if the benefits had not been 

vested. 

Business accounting staffs would have to learn the new 

accounting rules for measuring capital income, but once these 

were digested they would not seem to pose any difficulties 

beyond those of current law. Finally, and perhaps most 

importantly, the lower structure of tax rates would reduce 

pressures on legislators to enact the special tax treatments 

that give rise to dynamic complexity in the first place. .. 
L 

-59-

Po0 tno tes 

A 

-1/ Rlueprints for Basic Tax Reform, Department of the 

Treasury, Washington, D.C. (January 1977). This work will be 

subsequently referred to as Blueprints. Page numbers fat all 

direct quotations from Blueprints will be shown in 

parenthesis immediately after the quotations in the text. 

Actually two model tax systems were developed in Blueprints, 

one based on a more comprehensive definition of income and 

one based on personal consumption, but for the purposes of 

this paper only the income tax model will be considered. 

-21 Comprehensive income equals iross wages minus employee 

contributions to retirement plans and to old age and 

disability insurance plus fringe benefits in the form of 

employer contributions for life and health insurance 

(including mcdicsre) plus earnings in life insurance reserves 

and pension plan reserves plus self-employment income plus 

all dividends, interest rents, and royalties, plus inflationadjusted realized capital gains plus undistributed corporate 

income plus unemployment compensation, retirement benefits, 

workmen's compensation, social security payments (excluding 

* medicare), veterans benefits, scholarships and fellowships, 

welfare payments, the bonus value of foodstamps, and black 

lung payments plus alimony reccivcd minus employee business 

expenses, alimony paid, state and local income taxes, and 

I 
-60-

nonbusiness interest expenses. Child care expenses, up to a 

limit are deductible in determining taxable income, but not 

in defining comprehensive income. 

-3/ See, for example, Bittker, S. Tax Reform and Tax 

Simplification, 29, University of Miami Law Review I, 11 

(1974) and Surrey, S. Complexity and the Management of Tax 

Detail, 34 Law and Contemporary Problems, pgs. 673 - 691. 

-4/ Issues in Simplification of the Income Tax Laws, Joint 

Committee on Taxsrtion issued September 19, 1977, Washington, 

D.C. (1977), PqS. 69 - 75. 

-5/ Bittker, B. and Eustice, J. Federal Taxation of 

Corporations and Shareholders, Warren, Gorham, and Lamont, 

Boston (19711, p.5 

6/ Ibid p. 10 - .I 

-81 Remarks of Jerome Kurtz, Commissioner of the Internal 

Revenue Code at the 30th Annual Federal Tax Conference, The 

University of Chicago Law School, October 26, 1977, Chicago, 

Illinois, issued by the Department of the Treasury, Public 

Affairs Division, Washinqton, D.C. (1977) pgs. 1 - 4. 

c 
. -61-

9/ Ibid., e. 5. -

I10/ Another 3-1/2 million returns received payments under the 

earned income credit provisions. 

-11/ "Nonbusiness interest" includes home mortgage and 

consumer loan interest. Some economists have argued that 

such interest deductions should be disallowed in order to tax 

indirectly the implicit income derived from the ownership of 

consumer durables or housing that these loans are used to 

finance. However, disallowance of these interest deductions 

is not only a crude means of taxing this implicit income but 

it also discriminates against those taxpayers that finance 

the purchase of homes and consumer durables by )orrowing as 

opposed to those who liquidate financial assets to make such 

purchases. In addition, dissllowance of non-business 

interest would create artifical incentives to substitute 

business debt for consumer debt. For these reasons 

Blueprints would continuo to allow non-business interest 

deductions. also, while recognizing the existance of 

implicit income from owner-occupied housing and consumer 

durables, Blueprints would not attempt to tax this income . 

primarily because of the adverse effect on simplicity of such 

a policy. 
-12/ In the short run this simplification option could be 

inequitable to employees for whom legitimate costs of earning 

income are no longer deductible. However, over time either 

wages would tend to rise relatively in those industries or 

employers would bear a larger share of the costs of @arninq 

income for their employees. 

-131 Arguments could be made about the merits of allowing 

most of these deductions. For example, some economists 

consider children a consumption good and allowing the child 

care deduction could be viewed as lowering the costs of 

having children just as the current moving expense deduction 

reduces the costs of moves that are pr;marily under taken for 

"consumption' rather than "busincss' purposes. Blueprints 

(see page 7) recognizes, however, that the distinction 

between consumer and business expenses is not easy to make. 

-l4/ An example may be helpful in explaining the equivalence 

between the two sets of rules for taxing corporate income to 

shareholders even when corporate income as measured at the 

corporate level differs from market valuations of that 

income. Using the example of the text, suppose that the 

. market values the corporate income halfway through the year 

at only $30, rather than $50. The shareholder's income by 
-

E 

-6 3-

the alternative method in the text would be $30 = $1,030 -

$1,000. By the �irst method his income would be exactly the 

same except this time the calculation would be $30 = $100 + 

$1,030 - $1,100 (adjusted basis). 

-15/ Foreign source income of corporations controlled by 

foreign shareholders would flow through to U.S. corporations 

and citizens only when dividend distributions were made. 

-16/ The deemed paid foreign tax credit for corporations is 

calculated by multiplying the ratio of dividends from foreign 

subsidies and earnings and profits of foreign subsidies by 

foreign taxes paid. 

-171 For example, Charles McLure has raised this issue in 

discussions at a Brookings Institution Conference on 

Integration in October, 1977. 

-18/ Forhexample, a net operating loss carryback or carryover 

arises because the taxpayer's deductions exceed his gross 

income. Capital loss deductions are limited to capital 

gains, deductions for charitable contributions are 1imited.to 

a certain percentage of income, and the investment tax credit 

is generally limited to fifty percent of the tax otherwise 

due . 

1 
- -64-

-19/ Debt would not receive an inflationary basis adjustment 

because of an important distinction between capital income in 

the form of contractual interest and income generated by 

other assets. In the latter case, inflation reduces the 

value of nominal depreciation deductions and capital qains 

and therefore results in a transfer of resources from private 

individuals to the government. While inflstion can also 

reduce the value of nominal interest payments, this causes a 

transfer of resources from creditors to debtors, rather than 

between creditors and the government. That is, the debtor's 

gain is the creditor's loss. Furthermore, if allowed to 

adjust, interest rates may increase in a way that can allow 

both parties to the loan transaction to offset the effects of 

inflation which reduce the value of principal regayments. 

-20/ The current carryover provisions cause great complexity 

for estate planninq. For example, to minimize taxes 

low-basis assets should be given to low-income heirs or 

:harities and high-basis assets to high-income heirs. Full 

taxation of capital gains at death would also put a limit on 

the deferral of taxation on these gains. It may be objected 

that the proposals in Blueprints would allow gains to go 

unrecoqniked currently whereas capital losses would bc 

deductible when realized. Given the other income measurement 

rules and the integrztion proposal, the possibilities for 

manipulation do not loom sufficiently important that they 

could not be corrected. 

. 
. -65-

-21/ Prior to 1976, certain construction costs, such as 

preproduction interest and taxes and fees paid to local 

governments, could be deducted as current expenses. The Tax 

Reform Act restricted the amount of such expenditures that 

could be expensed somewhat by requiring, for taxpayers other 

, than cofportions, that real property construction period 

interest and tax expenditures be capitalized and amortized 

over a lO-year period. 

-22/ Social Security Bulletin, January 1977, Table 9, 

Department of Health, Education and Welfare, Washington, 

Dace, p.17.