Business Tax Reform: Simplification and Increased Uniformity of Taxation Would Yield Benefits
Published: 2006-09-20T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Business income taxes, both corporate and noncorporate, are a significant portion of federal tax revenue. Businesses also play a crucial role in collecting taxes from individuals, through withholding and information reporting. However, the design of the current system of business taxation is widely seen as flawed. It distorts investment decisions, hurting the performance of the economy. Its complexity imposes planning and record keeping costs, facilitates tax shelters, and provides potential cover for those who want to cheat. Not surprisingly, business tax reform is part of the debate about overall tax reform. The debate is occurring at a time when long-range projections show that, without a policy change, the gap between spending and revenues will widen. This testimony reviews the nation's long term fiscal imbalance and what is wrong with the current system of business taxation and provides some principles that ought to guide the debate about business tax reform. This statement is based on previously published GAO work and reviews of relevant literature.
section_title: What GAO Found
paragraphs: The size of business tax revenues makes them very relevant to any plan for addressing the nation's long-term fiscal imbalance. Reexamining both federal spending and revenues, including business tax policy and compliance must be part of a multipronged approach to address the imbalance. Some features of current business taxes channel investments into tax-favored activities and away from more productive activities and, thereby, reduce the economic well-being of all Americans. Complexity in business tax laws imposes costs of its own, facilitates tax shelters, and provides potential cover for those who want to cheat. IRS's latest estimates show a business tax gap of at least $141 billion for 2001. This in turn undermines confidence in the fairness of our tax system--citizens' confidence that their friends, neighbors, and business competitors pay their fair share of taxes. Principles that should guide the business tax reform debate include: (1) The proposed system should raise sufficient revenue over time to fund our current and future expected expenditures. (2) The tax base should be as broad as possible, which helps to minimize overall tax rates. (3) The proposed system should improve compliance rates by reducing tax preferences and complexity and increasing transparency. (4) To the extent other goals, such as equity and simplicity, allow, the tax system should aim for neutrality by not favoring some business activities over others. More neutral tax policy has the potential to enhance economic growth, increase productivity and improve the competitiveness of the U.S. economy in terms of standard of living. (5) The consideration of transition rules must be an integral part of any reform proposal.

section_title: Letter
paragraphs: I appreciate this opportunity to contribute to your consideration of  business tax reform.
Businesses, both corporate and noncorporate, are a crucial pillar of our  tax system. Corporate businesses paid $278 billion in federal corporate  income taxes in fiscal year 2005. In addition, between roughly 14 and 19  percent of the income of individuals who pay federal income tax comes  from business sources. Beyond paying income taxes, businesses are also  responsible for remitting both the employer and employee shares of social  insurance taxes, which amounted to $794 billion in fiscal year 2005.  Businesses are vital to our tax system in other ways too. They collect and  remit a large fraction of individual income taxes through withholding.  They report information about individuals’ income and deductible  expenses to the Internal Revenue Service (IRS). Such withholding and  third-party information reporting greatly increases individual taxpayers’  compliance while reducing the size and intrusiveness of IRS.
Taxes are necessary because they fund a broad array of essential services  provided by the government. However, business taxes are part of our  overall fiscal system that, as the committee is aware, is currently running  large deficits and, as GAO’s long-term budget simulations illustrate, is  projected to run ever larger deficits in the future.
Beyond raising revenue, taxes affect business decision making, thereby  affecting the performance of the economy. Taxes are only one factor  affecting business decisions—others include input costs and market  conditions—but they are a key factor controlled by policymakers. Making  business decisions based on tax considerations, rather than on the  underlying economic benefits results in the channeling of some  investments into less productive activities. This, in turn, reduces the  standard of living of all Americans.
Complexity in business tax laws imposes costs of its own, facilitates tax  shelters, and provides cover for those who want to cheat. Although the  precise amount of business tax avoidance is unknown, IRS’s latest  estimates show a business tax gap of at least $141 billion for 2001. This in  turn undermines confidence in the fairness of our tax system—citizens’  confidence that their friends, neighbors, and business competitors are  paying their fair share of taxes.
Not surprisingly, there is a growing debate about reforming the tax system,  including business taxes. The debate is partly about whether to reform the  current income tax so that it has a broader base and lower rates or switch  in whole or part to some form of a consumption tax. But it is also about  other fundamental design issues such as whether to maintain different tax  treatment for corporate and noncorporate business and the extent to  which business’s foreign-source income should be taxed. The President’s  Advisory Panel on Federal Tax Reform has taken a major step in beginning  this debate. The panel suggested two alternative proposals for coordinated  reform of the individual and corporate income taxes.
My statement reviews the nation’s long-term fiscal imbalance, describes  what is wrong with our current system of business taxation, lists some of  the major strategic choices we must make about how to tax businesses in  the future, and then provides some principles that ought to guide the  debate about business tax reform. These principles are based on three  long-standing criteria typically used to evaluate tax policy—equity;  economic efficiency; and a combination of simplicity, transparency, and  administrability—which are discussed later. The principles include the  following:    The proposed system should raise sufficient revenue over time to fund  our current and future expected expenditures.
The tax base should be as broad as possible, which generally helps to  minimize tax rates, reduce complexity, lower compliance costs, lower  economic efficiency costs per dollar of revenue raised, and which may  improve equity.
The proposed system should have attributes associated with high  compliance rates—namely, taxable transactions that are transparent  and few tax preferences or complex provisions.
To the extent that other objectives, such as equity and simplicity, allow,  the tax system should aim for increased economic efficiency by  remaining as neutral as possible in its other structural features; for  example, avoiding differences in taxation based on legal form of  organization, source of financing, or type of asset. More neutral tax  policy has the potential to enhance economic growth, increase  productivity and improve the competitiveness of the U.S. economy in  terms of standard of living   Finally, the consideration of transition rules needs to be an integral  part of the design of a new system.
My statement today is drawn from previous GAO reports and testimonies  covering tax reform, alternative tax systems, and the costs of the current  system, which were done in accordance with generally accepted  government auditing standards, as well as reviews of relevant literature.  The discussions in this statement that are not based on our own work  reflect the consensus (and in some cases competing) views of economists  as summarized in studies by the Joint Committee on Taxation, the  Congressional Budget Office, the Congressional Research Service, the  Department of Treasury, and the President’s Advisory Panel on Federal  Tax Reform. (See app. I for a list of relevant studies by GAO and these  other sources.)
subsections: section_title: Background
subsections: section_title: Current Federal Taxation of Businesses
paragraphs: Most income derived from private sector business activity in the United  States is subject to federal corporate income tax, the individual income  tax, or both. The tax treatment that applies to a business depends on its  legal form of organization. Firms that are organized under the tax code as  “C” corporations (which include most large, publicly held corporations)  have their profits taxed once at the entity level under the corporate  income tax (on a form 1120) and then a second time under the individual  income tax when profits are transferred to individual shareholders in the  form of dividends or realized capital gains. Firms that are organized as  “pass-through” entities, such as partnerships, limited liability companies,  and “S” corporations are generally not taxed at the entity level; however,  their net incomes are passed through each year and taxed in the hands of  their partners or shareholders under the individual income tax (as part of  those taxpayers’ form 1040 filing). Similarly, income from businesses that  are owned by single individuals enters into the taxable incomes of those  owners under the individual income tax and is not subject to a separate  entity-level tax.
The base of the federal corporate income tax includes net income from  business operations (receipts, minus the costs of purchased goods, labor,  interest, and other expenses). It also includes net income that  corporations earn in the form of interest, dividends, rent, royalties, and  realized capital gains. The statutory rate of tax on net corporate income  ranges from 15 to 35 percent, depending on the amount of income earned.  The United States taxes the worldwide income of domestic corporations,  regardless of where the income is earned, with a foreign tax credit for  certain taxes paid to other countries. However, the timing of the tax  liability depends on several factors, including whether the income is from  a U.S. or foreign source and, if it is from a foreign source, whether it is  earned through direct operations or through a subsidiary.
The base of the individual income tax covers business-source income paid  to individuals, such as dividends, realized net capital gains on corporate  equity, and income from self-employment. The statutory rates of tax on net  taxable income range from 10 percent to 35 percent. Lower rates  (generally 5 percent and 15 percent, depending on taxable income) apply  to long-term capital gains and dividend income. Sole proprietors also pay  both the employer and employee shares of social insurance taxes on their  net business income. Generally, a U.S. citizen or resident pays tax on his  or her worldwide income, including income derived from foreign-source  dividends and capital gains subject to a credit for foreign taxes paid on  such income.
section_title: Criteria for Evaluating Business Tax Systems
paragraphs: Three long-standing criteria—economic efficiency, equity, and a  combination of simplicity, transparency and administrability—are  typically used to evaluate tax policy. These criteria are often in conflict  with each other, and as a result, there are usually trade-offs to consider  and people are likely to disagree about the relative importance of the  criteria.
Specific aspects of business taxes can be evaluated in terms of how they  support or detract from the efficiency, equity, simplicity, transparency,  and administrability of the overall tax system. To the extent that a tax  system is not simple and efficient, it imposes costs on taxpayers beyond  the payments they make to the U.S. Treasury. As shown in figure 1, the  total cost of any tax from a taxpayer’s point of view is the sum of the tax  liability, the cost of complying with the tax system, and the economic  efficiency costs that the tax imposes. In deciding on the size of  government, we balance the total cost of taxes with the benefits provided  by government programs.
A complete evaluation of the tax treatment of businesses, which is a  critical element of our overall federal tax system, cannot be made without  considering how business taxation interacts with and complements the  other elements of the overall system, such as the tax treatment of  individuals and excise taxes on selected goods and services. This  integrated approach is also appropriate for evaluating reform alternatives,  regardless of whether those alternatives take the form of a simplified  income tax system, a consumption tax system, or some combination of the  two.
section_title: Taxes on Business Income Are a Significant Source of Federal Revenue and Must Be Part of the Overall Considerations for Fiscal Reform
paragraphs: Businesses contribute significant revenues to the federal government, both  directly and indirectly. As figure 2 shows, corporate businesses paid $278  billion in corporate income tax directly to the federal government in 2005.  Individuals earn income from business investment in the form of dividends  and realized capital gains from C corporations; income allocations from  partnerships and S corporations; entrepreneurial income from their own  sole proprietorships; and rents and royalties. In recent years this business- source income, which is all taxed under the individual income tax, has  amounted to between roughly 14 percent and 19 percent of the income of  individuals who have paid individual income tax. In addition to the taxes  that are paid on business-source income, most of the remainder of federal  taxes is collected and passed on to the government by businesses.
Business tax revenues of the magnitude discussed make them very  relevant to considerations about how to address the nation’s long-term  fiscal imbalance. Over the long term, the United States faces a large and  growing structural budget deficit primarily caused by demographic trends  and rising health care costs as shown in figure 3, and exacerbated over  time by growing interest on the ever-larger federal debt.  Continuing on  this imprudent and unsustainable fiscal path will gradually erode, if not  suddenly damage, our economy, our standard of living, and ultimately our  national security.
We cannot grow our way out of this long-term fiscal challenge because the  imbalance between spending and revenue is so large. We will need to  make tough choices using a multipronged approach: (1) revise budget  processes and financial reporting requirements; (2) restructure entitlement  programs; (3) reexamine the base of discretionary spending and other  spending; and (4) review and revise tax policy, including tax expenditures,  and tax enforcement programs. Business tax policy, business tax  expenditures, and business tax enforcement need to be part of the overall  tax review because of the amount of revenue at stake.
Business tax expenditures reduce the revenue that would otherwise be  raised from businesses. As already noted, to reduce their tax liabilities,  businesses can take advantage of preferential provisions in the tax code,  such as exclusions, exemptions, deductions, credits, preferential rates,  and deferral of tax liability. Tax preferences—which are legally known as  tax expenditures—are often aimed at policy goals similar to those of  federal spending programs. For example, there are different tax  expenditures intended to encourage economic development in  disadvantaged areas and stimulate research and development, while there  are also federal spending programs that have similar purposes. Also, by  narrowing the tax base, business tax expenditures have the effect of  raising either business tax rates or the rates on other taxpayers in order to  generate a given amount of revenue.
section_title: Efficiency, Complexity, Compliance, and Equity Concerns Contribute to Calls for Business Tax Reform
paragraphs: The design of the current system of business taxation causes economic  inefficiency and is complex. The complexity provides fertile ground for  noncompliance and raises equity concerns.
subsections: section_title: Varying Effective Rates of Taxation Across Different Types of Business Investments Reduce Economic Efficiency
paragraphs: Our current system for taxing business income causes economic  inefficiency because it imposes significantly different effective rates of tax  on different types of investments. Tax treatment that is not neutral across  different types of capital investment causes significant economic  inefficiency by guiding investments to lightly taxed activities rather than  those with high pretax productivity.
However, the goal of tax policy is not to eliminate efficiency costs. The  goal is to design a tax system that produces a desired amount of revenue  and balances economic efficiency with other objectives, such as equity,  simplicity, transparency, and administrability. Every practical tax system  imposes efficiency costs.
There are some features of current business taxation that have attracted  criticism by economists and other tax experts because of efficiency costs.  My point in raising them here is not that these features need to be  changed—that is a policy judgment for Congress to make as it balances  various goals. Rather, my point is that these economic consequences of  tax policy need to be considered as we think about reform. The following  are among the most noted cases of nonneutral taxation in the federal  business tax system:  Income earned on equity-financed investments made by C corporations  is taxed twice—under both the corporate and individual income taxes,  whereas no other business income is taxed more than once. Moreover,  even noncorporate business investment is taxed more heavily than  owner-occupied housing—a form of capital investment that receives  very preferential treatment. As a result, resources have been shifted  away from higher-return business investment into owner-occupied  housing, and, within the business sector, resources have been shifted  from higher-return corporations to noncorporate businesses. Such  shifting of investment makes workers less productive than they would  be under a more neutral tax system. This results in employees receiving  lower wages because increases in employee wages are generally tied to  increases in productivity.  As noted above, such efficiency costs may  be worth paying in order to meet other policy goals. For example, many  policymakers advocate increased homeownership as a social policy  goal.
Depreciation allowances under the tax code vary considerably in  generosity across different assets causing effective tax rates to vary  and, thereby, favoring investment in certain assets over others. For  example, researchers have found that the returns on most types of  investments in equipment are taxed more favorably than are most  investments in nonresidential buildings. These biases shift resources  away from some investments in buildings that would have been more  productive than some of the equipment investments that are being  made instead.
Tax rules for corporations favor the use of debt over shareholder  equity as a source of finance for investment. The return on debt- financed investment consists of interest payments to the corporation’s  creditors, which are deductible by the corporations. Consequently, that  return is taxed only once—in the hands of the creditors. In contrast,  the return on equity-financed investment consists of dividends and  capital gains, which are not deductible by the corporation. These forms  of income that are taxed under the individual tax are paid out of  income that has already been subject to the corporate income tax. The  bias against equity finance induces corporations to have less of an  “equity cushion” against business downturns.
Capital gains on corporate equity are taxed more favorably than  dividends because that tax can be deferred until the gains are realized  (typically when shareholders sell their stock). This bias against  dividend payments likely means that more profits are retained within  corporations than otherwise would be the case and, therefore, the flow  of capital to its most productive uses is being constrained.
The complex set of rules governing U.S. taxation of the worldwide  income of domestic corporations (those incorporated in the United  States) leads to wide variations in the effective rate of tax paid on that  income, based on the nature and location of each corporation’s foreign  operations and the effort put into tax planning. In effect, the active  foreign income of some U.S. corporations is taxed more heavily than if  the United States followed the practice of many other countries and  exempted such income from tax. However, other U.S. corporations are  able to take advantage of flexibilities in the U.S. tax rules in order to  achieve treatment that is equivalent to or, in some cases, more  favorable than the so-called “territorial” tax systems that exempt  foreign-source active business income. As a consequence, some U.S.  corporations face a tax disadvantage, while others have an advantage,  relative to foreign corporations when competing in foreign countries.  Those U.S. corporations that have a disadvantage are likely to locate a  smaller share of their investment overseas than would be the case in a  tax-free world; the opposite is true for those U.S. corporations with the  tax advantage. Moreover, the tax system encourages U.S. corporations  to alter their cash-management and financing decisions (such as by  delaying the repatriation of profits) in order to reduce their taxes.
The taxation of business income is part of the broader taxation of income  from capital. The taxation of capital income in general (even when that  taxation is uniformly applied) causes another form of inefficiency beyond  the inefficiencies caused by the aforementioned cases of differential  taxation across types of investments. This additional inefficiency occurs  because taxes on capital reduce the after-tax return on savings and,  thereby, distort the choice that individuals make between current  consumption and saving for future consumption. However, although  research shows that the demand for some types of savings, such as the  demand for tax exempt bonds, is responsive to tax changes, there is  greater uncertainty about the effects of tax changes on other choices, such  as aggregate savings.
Sometimes the concerns about the negative effects of taxation on the U.S.  economy are couched in terms of “competitiveness,” where the vaguely  defined term competitiveness is often defined as the ability of U.S.  businesses to export their products to foreign markets and to compete  against foreign imports into the U.S. market. The goal of those who push  for this type of competitiveness is to improve the U.S. balance of trade.  However, economists generally agree that trying to increase the U.S.  balance of trade through targeted tax breaks for exports does not work.  Such a policy, aimed at lowering the prices of exports, would be offset by  an increase in the value of the dollar which would make U.S. exports more  expensive and imports into the Unites States less expensive, ultimately  leaving both the balance of trade and the standard of living of Americans  unchanged.
An alternative definition of competitiveness that is also sometimes used in  tax policy debates refers to the ability of U.S.-owned firms operating  abroad to compete in foreign markets. The current U.S. policy of taxing  the worldwide income of U.S. businesses places some of their foreign  operations at a disadvantage. The tradeoffs between a worldwide system  and a territorial tax system are discussed below.
section_title: Businesses Bear Significant Compliance Burdens Arising Both from the Complexity of the Tax System and from Their Multiple Roles within the System
paragraphs: Tax compliance requirements for businesses are extensive and complex.  Rules governing the computation of taxable income, expense deductions,  and tax credits of U.S. corporations that do business in multiple foreign  countries are particularly complex. But even small businesses face  multiple levels of tax requirements of varying difficulty. In addition to  computing and documenting their income, expenses, and qualifications for  various tax credits, businesses with employees are responsible for  collecting and remitting (at varying intervals) several federal taxes on the  incomes of those employees. Moreover, if the businesses choose to offer  their employees retirement plans and other fringe benefits, they can  substantially increase the number of filings they must make. Businesses  also have information-reporting responsibilities—employers send wage  statements to their employees and to IRS; banks and other financial  intermediaries send investment income statements to clients and to IRS.  Finally, a relatively small percentage of all businesses (which nevertheless  number in the hundreds of thousands) are required to participate in the  collection of various federal excise taxes levied on fuels, heavy trucks and  trailers, communications, guns, tobacco, and alcohol, among other  products.
It is difficult for researchers to accurately estimate compliance costs for  the tax system as a whole or for particular types of taxpayers because  taxpayers generally do not keep records of the time and money spent  complying with tax requirements. Studies we found that focus on the  compliance costs of businesses estimate them to be between about $40  billion and $85 billion per year. None of these estimates include the costs  to businesses of collecting and remitting income and payroll taxes for their  employees. The accuracy of these business compliance cost estimates is  uncertain due to the low rates of response to their data-collection surveys.  In addition, the range in estimates across the studies is due, among other  things, to differences in monetary values used (ranging between $25 per  hour and $37.26 per hour), differences in the business populations  covered, and differences in the tax years covered.
section_title: Business Tax Complexity Also Makes IRS’s Job of Enforcing Tax Rules Very Challenging and Can Reduce Public Confidence in the Fairness of the System
paragraphs: Although the precise amount of business tax avoidance is unknown, IRS’s  latest estimates of tax compliance show a tax gap of at least $141 billion  for tax year 2001 between the business taxes that individual and corporate  taxpayers paid and what they should have paid under the law.  Corporations contributed about $32 billion to the tax gap by  underreporting about $30 billion in taxes on tax returns and failing to pay  about $2 billion in taxes that were reported on returns. Individual  taxpayers that underreported their business income accounted for the  remaining $109 billion of the business income tax gap.
A complex tax code, complicated business transactions, and often  multinational corporate structures make determining business tax  liabilities and the extent of corporate tax avoidance a challenge. Tax  avoidance has become such a concern that some tax experts say corporate  tax departments have become “profit centers” as corporations seek to take  advantage of the tax laws in order to maximize shareholder value. Some  corporate tax avoidance is clearly legal, some falls in gray areas of the tax  code, and some is clearly noncompliance or illegal, as shown by IRS’s tax  gap estimate.
Often business tax avoidance is legal. For example, multinational  corporations can locate active trade or business operations in jurisdictions  that have lower effective tax rates than does the United States and, unless  and until they repatriate the income, defer taxation in the United States on  that income, thus reducing their effective tax rate. In addition, investors  can avoid paying the corporate income tax by putting their money into  unincorporated businesses or into real estate.
Complicating corporate tax compliance is the fact that in many cases the  law is unclear or subject to differing interpretations. In fact, some have  postulated that major corporations’ tax returns are actually just the  opening bid in an extended negotiation with IRS to determine a  corporation’s tax liability. An illustration—once again from the complex  area of international tax rules—is transfer pricing. Transfer pricing  involves setting the appropriate price for such things as goods, services, or  intangible property (such as patents, trademarks, copyrights, technology,  or “know-how”) that is transferred between the U.S.-based operations of a  multinational company and a foreign affiliate. If the price paid by the  affiliate to the U.S. operation is understated, the profits of the U.S.  operation are reduced and U.S. taxable income is inappropriately reduced  or eliminated. The standard for judging the correct price is the price that  would have been paid between independent enterprises acting at “arm’s  length.” However, it can be extremely difficult to establish what an arm’s  length price would be. Given the global economy and the number of  multinational firms with some U.S.-based operations, opportunities for  transfer pricing disputes are likely to grow.
Tax shelters are one example of how tax avoidance, including corporate  tax avoidance, can shade into the illegal. Some tax shelters are legal  though perhaps aggressive interpretations of the law, but others cross the  line. Abusive shelters often are complex transactions that manipulate  many parts of the tax code or regulations and are typically buried among  legitimate transactions reported on tax returns. Because these  transactions are often composed of many pieces located in several parts of  a complex tax return, they are essentially hidden from plain sight, which  contributes to the difficulty of determining the scope of the abusive shelter  problem. Often lacking economic substance or a business purpose other  than generating tax benefits, abusive shelters have been promoted by  some tax professionals, often in confidence, for significant fees,  sometimes with the participation of tax-indifferent parties, such as foreign  or tax-exempt entities. These shelters may involve unnecessary steps and  flow-through entities, such as partnerships, which make detection of these  transactions more difficult.
Regarding compliance with our tax laws, the success of our tax system  hinges greatly on individual and business taxpayers’ perception of its  fairness and understandability. Compliance is influenced not only by the  effectiveness of IRS’s enforcement efforts but also by Americans’ attitudes  about the tax system and their government. A recent survey indicated that  about 10 percent of respondents say it is acceptable to cheat on their  taxes. Furthermore, the complexity of, and frequent revisions to, the tax  system make it more difficult and costly for taxpayers who want to comply  to do so and for IRS to explain and enforce tax laws. The lack of  transparency also fuels disrespect for the tax system and the government.  Thus, a crucial challenge in evaluating our business tax system will be to  determine how we can best strengthen enforcement of existing laws to  give businesses owners confidence that their competitors are paying their  fair share and to give wage earners confidence that businesses in general  bear their share of taxes. One option that has been suggested as a means  of improving public confidence in the tax system’s fairness is to make the  reconciliation between book and tax income that businesses present on  schedule M-3 of their tax returns available for public review.
section_title: Business Tax Reform Entails Broad Design Choices about the Overall Tax System
paragraphs: Reform of our business tax system will necessarily mean making broad  design choices about the overall tax system and how business taxes are  coordinated with other taxes. The tax reform debate of the last several  years has focused attention on several important choices, including the  extent to which our system should be closer to the extreme of a pure  income tax or the other extreme of a pure consumption tax, the extent to  which sales by U.S. businesses outside of this country should be taxed, the  extent to which taxes should be collected from businesses or individuals,  and the extent to which taxpayers are compensated for losses or costs  they incur during the transition to any new tax system. Generally there is  no single “right” decision about these choices and the options are not  limited to selecting a system that is at one extreme or the other along the  continuum of potential systems. The choices will involve making tradeoffs  between the various goals for our tax system.
subsections: section_title: Income vs. Consumption as the Tax Base
paragraphs: The fundamental difference between income and consumption taxes lies  in their treatment of savings and investment. Income can be used for  either consumption or saving and investment. The tax base of a pure  income tax includes all income, regardless of what it is ultimately used for;  in contrast, the tax base of a consumption tax excludes income devoted to  saving and investment (until it is ultimately used for consumption). The  current tax system is a hybrid between a pure income tax and a pure  consumption tax because it effectively exempts some types of savings and  investment but taxes other types.
As noted earlier, evidence is inconclusive regarding whether a shift closer  to a consumption tax base would significantly affect the level of savings by  U.S. taxpayers. There is, however, a consensus among economists that  uneven tax treatment across different types of investment should be  avoided unless the efficiency costs resulting from preferential tax  treatment are outweighed by the social benefits generated by the tax  preference. That objective could be achieved under either a consumption  tax that exempts all new savings and investment from taxation (which  means that all business profits are exempt) or a revised income tax that  taxed all investments at the same effective rate. In comparison to the  current system, a consumption tax’s exemption of business-source income  would likely encourage U.S. businesses to increase their investment in the  United States relative to their foreign investment.
Both income and consumption taxes can be structured in a variety of  ways, as discussed in the following subsections, and the choice of a  specific design for either type of tax can have as significant implications  for efficiency, administrability, and equity as the choice between a  consumption or income base.  The exemption of saving and investment  can be accomplished in different ways, so consumption taxes can be  structured differently and yet still have the same overall tax base.
section_title: Collecting the Tax at the Business or Individual Level
paragraphs: Both income and consumption taxes can be levied on individuals or  businesses, or on a combination of the two. Whether collected from  individuals or businesses, ultimately, individuals will bear the economic  burden of any tax (as wage earners, shareholders, or consumers). The  choice of whether to collect a tax at the business level or the individual  level depends on whether it is thought to be desirable to levy different  taxes on different individuals. A business-level tax, whether levied on  income or consumption, can be collected “at source”—that is, where it is  generated—so there can be many fewer tax filers and returns to  administer. Business-level taxes cannot, however, directly tax different  individuals at different rates. Individual-level taxes can allow for  distinctions between different individuals; for example, standard  deductions or graduated rates can be used to tax individuals with low  income (or consumption) at a lower rate than individuals with greater  income (or consumption). However, individual-level taxes require more  tax returns, impose higher compliance costs, and would generally require  a larger tax administration system.
A national retail sales tax, a consumption value-added tax, and an income  value-added tax are examples of taxes that would be collected only at the  business level. A personal consumption tax and an integrated individual  income tax are examples of taxes that would be collected only at the  individual level. The “flat tax” proposed by economists Robert Hall and  Alvin Rabushka that has received attention in recent years is an example  of a tax collected at both the business and individual level. Our current  system for taxing corporate-source income involves taxation at both the  corporate and individual level in a manner that results in the double  taxation of the same income.
section_title: Territorial vs. Worldwide Taxation under an Income Tax
paragraphs: Under a pure worldwide tax system the United States would tax the  income of U.S. corporations, as it is earned, regardless of where it is  earned, and at the same time provide a foreign tax credit that ensures that  the combined rate of tax that a corporation pays to all governments on  each dollar of income is exactly equal to the U.S. corporate tax rate. Some  basic differences between the current U.S. tax system and a pure  worldwide system are that (1) in many cases the U.S. system permits  corporations to defer U.S. tax on their foreign-source income until it is  repatriated and (2) the U.S. foreign tax credit is limited to the amount of  U.S. tax that would be due on a corporation’s foreign-source income. In  cases where the rate of foreign tax on a corporation’s income exceeds the  U.S. tax rate, the corporation is left paying the higher rate of tax.
Under a pure territorial tax system the United States would simply exempt  all foreign-source income. (No major country has a pure territorial system;  they all tax mobile forms of foreign-source income, such as royalties and  income from securities.) The current U.S. tax system has some features  that result in some cases in treatment similar to what would exist under a  territorial system. First, corporations can defer U.S. tax indefinitely on  certain foreign-source income, as long as they keep it reinvested abroad.  Second, in certain cases U.S. corporations are able to use the excess  credits that they earned for taxes they paid to high-tax countries to  completely offset any U.S. tax that they would normally have to pay on  income they earned in low-tax countries. As a result, that income from  low-tax countries remains untaxed by the United States—just as it would  be under a territorial system. In fact, there are some cases where U.S.  corporations enjoy tax treatment that is more favorable than under a  territorial system. This occurs when they pay no U.S. tax on foreign-source  income yet are still able to deduct expenses allocable to that income. For  example, a U.S. parent corporation can borrow money and invest it in a  foreign subsidiary. The parent corporation generally can deduct its  interest payments from its U.S. taxes even if it defers U.S. tax on the  subsidiary’s income by leaving it overseas.
Proponents of a worldwide tax system and proponents of a territorial  system both argue that their preferred systems would provide important  forms of tax neutrality. Under a pure worldwide system all of the income  that a U.S. corporation earns abroad would be taxed at the same effective  rate that a corporation earning the same amount of income domestically  would pay. Such a tax system is neutral in the sense that it does not  influence the decision of U.S. corporations to invest abroad or at home. If  the U.S. had a pure territorial tax system all of the income that U.S.  corporations earn in a particular country would be taxed at the same rate  as corporations that are residents of that country. The pure territorial  system is neutral in the specific sense that U.S. corporations investing in a  foreign country would not be at a disadvantage relative to corporations  residing in that country or relative to other foreign corporations investing  there. In a world where each country sets its own tax rules it is  impossible to achieve both types of neutrality at the same time, so  tradeoffs are unavoidable.
A change from the current tax system to a pure territorial one is likely to  have mixed effects on tax compliance and administration. On the one  hand, a pure worldwide tax system, or even the current system, may  preserve the U.S. tax base better than a territorial system would because  U.S. taxpayers would have greater incentive under a territorial system to  shift income and investment into low-tax jurisdictions via transfer pricing.  On the other hand, a pure territorial system may be less complex for IRS  to administer and for taxpayers to comply with than the current tax  system because there would be no need for the antideferral rules or the  foreign tax credit, which are among the most complex features of the  current system.
section_title: Destination-Principle vs. Origin-Principle Consumption Tax
paragraphs: Broad-based consumption taxes can differ depending on whether they are  imposed under a destination principle, which holds that goods and  services should be taxed in the countries where they are consumed, or an  origin principle, which holds that goods and services should be taxed in  the countries where they are produced. In the long run, after markets have  adjusted, neither type of tax would have a significant effect on the U.S.  trade balance. This is true for a destination-based tax because products  consumed in the United States would be taxed at the same rate, regardless  of where they were produced. Therefore, such a tax would not influence a  consumer’s choice between buying a car produced in the United States or  one imported from Japan. And at the same time, U.S. exports of cars  would not be affected by the tax because they would be exempted. An  origin-based consumption tax would not affect the trade balance because  the tax effects that taxes have on prices would ultimately be countered by  the same price adjustment mechanism that we discussed earlier with  respect to targeted tax subsidies for exports.
A national retail sales tax limited to final consumption goods would be a  destination-principle tax; it would tax imports when sold at retail in this  country and would not tax exports. Value-added taxes can be designed as  either destination or origin-principle taxes.
A personal consumption tax, collected at the individual level, would apply  to U.S. residents or citizens and could be formulated to tax their  consumption regardless of whether it is done domestically or overseas.  Under such a system, income earned abroad would be taxable but funds  saved or invested abroad would be deductible. In that case, foreign- produced goods imported into the United States or consumed by U.S.  citizens abroad would be taxed. U.S. exports would only be taxed to the  extent that they are consumed by U.S. citizens abroad.
section_title: The Extent of Transition Provisions
paragraphs: A wide range of options exist for moving from the current business tax  system to an alternative one, and the way that any transition is formulated  could have significant effects for economic efficiency, equity, taxpayer  compliance burden, and tax administration. For example, one transition  issue involves whether tax credits and other tax benefits already earned  under the current tax would be made available under a new system.  Businesses that are deducting depreciation under the current system  would not have the opportunity to continue depreciating their capital  goods under a VAT unless special rules were included to permit it. Similar  problems could arise with businesses’ carrying forward net operating  losses and recovering unclaimed tax credits. Depending on how these and  other issues are addressed, taxpayer compliance burden and tax  administration responsibilities could be greater during the transition  period than they currently are or than they would be once the transition  ends. Transition rules could also substantially reduce the new system’s tax  base, thereby requiring higher tax rates during the transition if revenue  neutrality were to be achieved.
section_title: Criteria for a Good Tax System Provide Principles to Guide Decisions and Issues for Consideration
paragraphs: Our publication, Understanding the Tax Reform Debate: Background,  Criteria, and Questions, may be useful in guiding policymakers as they  consider tax reform proposals. It was designed to aid policymakers in  thinking about how to develop tax policy for the 21st century. The criteria  for a good tax system, which our report discusses, provide the basis for a  set of principles that should guide Congress as it considers the choices  and tradeoffs involved in tax system reform. And, as I also noted earlier,  proposals for reforming business taxation cannot be evaluated without  considering how that business taxation will interact with and complement  the other elements of our overall future tax system.
The proposed system should raise sufficient revenue over time to fund our  expected expenditures. As I mentioned earlier, we will fall woefully short  of achieving this end if current spending or revenue trends are not altered.  Although we clearly must restructure major entitlement programs and the  basis of other federal spending, it is unlikely that our long-term fiscal  challenge will be resolved solely by cutting spending.
The proposal should look to future needs. Like many spending programs,  the current tax system was developed in a profoundly different time. We  live now in a much more global economy, with highly mobile capital, and  with investment options available to ordinary citizens that were not even  imagined decades ago. We have growing concentrations of income and  wealth. More firms operate multinationally and willingly move operations  and capital around the world as they see best for their firms.
As an adjunct to looking forward when making reforms, better information  on existing commitments and promises must be coupled with estimates of  the long-term discounted net present value costs from spending and tax  commitments comprising longer-term exposures for the federal budget  beyond the existing 10-year budget projection window.
The tax base should be as broad as possible. Broad-based tax systems with  minimal exceptions have many advantages. Fewer exceptions generally  means less complexity, less compliance cost, less economic efficiency  loss, and by increasing transparency may improve equity or perceptions of  equity. This suggests that eliminating or consolidating numerous tax  expenditures must be considered. In many cases tax preferences are  simply a form of “back-door spending.” We need to be sure that the  benefits achieved from having these special provisions are worth the  associated revenue losses just as we must ensure that outlay programs— which may be attempting to achieve the same purposes as tax  expenditures—achieve outcomes commensurate with their costs. And it is  important to supplement these cost-benefit evaluations with analyses of  distributional effects—i.e., who bears the costs of the preferences and  who receives the benefits. To the extent tax expenditures are retained,  consideration should be given to whether they could be better targeted to  meet an identified need.
If we must raise revenues, doing so from a broad base and a lower rate will  help minimize economic efficiency costs. Broad-based tax systems can  yield the same revenue as more narrowly based systems at lower tax rates.  The combination of less direct intervention in the marketplace from  special tax preferences, and the lower rates possible from broad-based  systems, can have substantial benefits for economic efficiency. For  instance, one commonly cited rule of thumb regarding economic  efficiency costs of tax increases is that they rise proportionately faster  than the tax rates. In other words, a 10 percent tax increase could raise the  economic efficiency costs of a tax system by much more than 10 percent.
Aside from the base-broadening that minimizes targeted tax preferences  favoring specific types of investment or other business behavior, it is also  desirable on the grounds of economic efficiency to extend the principle of  tax neutrality to the broader structural features of a business tax system.  For example, improvements in economic efficiency can also be gained by  avoiding differences in tax treatment, such as the differences in the  current system based on legal form of organization, source of financing,  and the nature and location of foreign operations. Removing such  differences can shift resources to more productive uses, increasing  economic performance and the standard of living of Americans. Shifting  resources to more productive uses can result in a step up in the level of  economic activity which would be measured as a one-time increase in the  rate of growth. Tax changes that increase efficiency can also increase the  long-term rate of economic growth if they increase the rate of  technological change; however, not all efficiency-increasing tax changes  will do so.
Impact on the standard of living of Americans is also a useful criterion for  evaluating policies to improve U.S. competitiveness. As was discussed  earlier, narrower goals and policies, such as increasing the U.S. balance of  trade through targeted tax breaks aimed at encouraging exports, are  generally viewed as ineffective by economists. What determines the  standard of living of Americans and how it compares to the standard of  living in other countries is the productivity of American workers and  capital. That productivity is determined by factors such as education,  technological innovation, and the amount of investment in the U.S.  economy. Tax policy can contribute to American productivity in several  ways. One, discussed in this statement, is through neutral taxation of  investment alternatives. Another, which I have discussed on many  occasions, is through fiscal policy. Borrowing to finance persistent federal  deficits absorbs savings from the private sector reducing funds available  for investment. Higher saving and investment from a more balanced fiscal  policy would contribute to increased productivity and a higher standard of  living for Americans over the long term.
A reformed business tax system should have attributes associated with  high compliance rates. Because any tax system can be subject to tax gaps,  the administrability of reformed systems should be considered as part of  the debate for change. In general, a reformed system is most likely to have  a small tax gap if the system has few tax preferences or complex  provisions and taxable transactions are transparent. Transparency in the  context of tax administration is best achieved when third parties report  information both to the taxpayer and the tax administrator.
Minimizing tax code complexity has the potential to reduce  noncompliance for at least three broad reasons. First, it could help  taxpayers to comply voluntarily with more certainty, reducing inadvertent  errors by those who want to comply but are confused because of  complexity. Second, it may limit opportunities for tax evasion, reducing  intentional noncompliance by taxpayers who can misuse the complex  code provisions to hide their noncompliance or to achieve ends through  tax shelters. Third, reducing tax-code complexity could improve  taxpayers’ willingness to comply voluntarily.
Finally, the consideration of transition rules needs to be an integral part of  the design of a new system. The effects of these rules can be too  significant to leave them simply as an afterthought in the reform process.
section_title: Concluding Observations
paragraphs: The problems that I have reviewed today relating to the compliance costs,  efficiency costs, equity, and tax gap associated with the current business  tax system would seem to make a strong case for a comprehensive review  and reform of our tax policy. Further, businesses operate in a world that is  profoundly different—more competitive and more global—than when  many of the existing provisions of the tax code were adopted. Despite  numerous and repeated calls for reform, progress has been slow. I  discussed reasons for the slow progress in a previous hearing on  individual tax reform before this committee. One reason why reform is  difficult to accomplish is that the provisions of the tax code that generate  compliance costs, efficiency costs, the tax gap and inequities also benefit  many taxpayers. Reform is also difficult because, even when there is  agreement on the amount of revenue to raise, there are differing opinions  on the appropriate balance among the often conflicting objectives of  equity, efficiency, and administrability. This, in turn, leads to widely  divergent views on even the basic direction of reform.
However, I have described some basic principles that ought to guide  business tax reform. One of them is revenue sufficiency. Fiscal necessity,  prompted by the nation’s unsustainable fiscal path, will eventually force  changes to our spending and tax policies. We must fundamentally rethink  policies and everything must be on the table. Tough choices will have to  be made about the appropriate degree of emphasis on cutting back federal  programs versus increasing tax revenue.
Other principles, such as broadening the tax base and otherwise  promoting tax neutrality, could help improve economic performance.  While economic growth alone will not solve our long-term fiscal problems,  an improvement in our overall economic performance makes dealing with  those problems easier.
The recent report of the President’s Advisory Panel on Federal Tax  Reform recommended two different tax reform plans. Although each plan  is intended to improve economic efficiency and simplify the tax system,  neither of them addresses the growing imbalance between federal  spending and revenues that I have highlighted. One approach for getting  the process of comprehensive fiscal reform started would be through the  establishment of a credible, capable, and bipartisan commission, to  examine options for a combination of selected entitlement and tax reform  issues.
Mr. Chairman and Members of the Committee, this concludes my  statement. I would be pleased to answer any questions you may have at  this time.
section_title: Contact and Acknowledgments
paragraphs: For further information on this testimony, please contact James White on  (202) 512-9110 or whitej@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this testimony. Individuals making key contributions to this testimony  include Jim Wozny, Assistant Director; Donald Marples; Jeff Arkin; and  Cheryl Peterson.
section_title: Appendix I: List of Studies Reviewed
subsections: section_title: Government Accountability Office
paragraphs: Individual Income Tax Policy: Streamlining, Simplification, and  Additional Reforms Are Desirable. GAO-06-1028T. Washington, D.C.:  August 3, 2006.
Tax Compliance: Opportunities Exist to Reduce the Tax Gap Using a  Variety of Approaches. GAO-06-1000T. Washington, D.C.: July 26, 2006.
Tax Compliance: Challenges to Corporate Tax Enforcement and Options  to Improve Securities Basis Reporting. GAO-06-851T. Washington, D.C.:  June 13, 2006.
Understanding the Tax Reform Debate: Background, Criteria, &  Questions. GAO-05-1009SP. Washington, D.C.: September 2005.
Government Performance and Accountability: Tax Expenditures  Represent a Substantial Federal Commitment and Need to Be  Reexamined. GAO-05-690. Washington, D.C.: Sept. 23, 2005.
Tax Policy: Summary of Estimates of the Costs of the Federal Tax  System. GAO-05-878. Washington, D.C.: August 26, 2005.
Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal  Sustainability but Will Require a Variety of Strategies. GAO-05-527T.  Washington, D.C.: April 14, 2005.  21st Century Challenges: Reexamining the Base of the Federal  Government. GAO-05-325SP. Washington, D.C.: February 1, 2005.
Tax Administration: Potential Impact of Alternative Taxes on  Taxpayers and Administrators. GAO/GGD-98-37. Washington, D.C.:  January 14, 1998.
section_title: Congressional Budget Office
paragraphs: Corporate Income Tax Rates: International Comparisons. Washington,  D.C.: November 2005.
Taxing Capital Income: Effective Rates and Approaches to Reform.  Washington, D.C.: October 2005.
Effects of Adopting a Value-Added Tax. Washington, D.C.: February 1992.
section_title: Congressional Research Service
paragraphs: Brumbaugh, David L. Taxes and International Competitiveness. RS22445.  Washington, D.C.: May 19, 2006.
Brumbaugh, David L. Federal Business Taxation: The Current System,  Its Effects, and Options for Reform. RL33171. Washington, D.C.:  December 20, 2005.
Gravelle, Jane G.. Capital Income Tax Revisions and Effective Tax Rates.  RL32099. Washington, D.C.: January 5, 2005.
section_title: Joint Committee on Taxation
paragraphs: The Impact of International Tax Reform: Background and Selected  Issues Relating to U.S. International Tax Rules and the Competitiveness  of U.S. Businesses. JCX-22-06. Washington, D.C.: June 21, 2006.
Options to Improve Tax Compliance and Reform Tax Expenditures. JCS- 02-05. Washington, D.C.: January 27, 2005.
The U.S. International Tax Rules: Background, Data, and Selected Issues  Relating to the Competitiveness of U.S.-Based Business Operations. JCX- 67-03. Washington, D.C.: July 3, 2003.
Background Materials on Business Tax Issues Prepared for the House  Committee on Ways and Means Tax Policy Discussion Series. JCX-23-02.  Washington, D.C.: April 4, 2002.
section_title: U.S. Department of the Treasury
paragraphs: Report to The Congress on Depreciation Recovery Periods and Methods.  Washington, D.C.: July 2000.
Integration of The Individual and Corporate Tax Systems: Taxing  Business Income Once. Washington, D.C.: January 1992.
section_title: President’s Advisory Panel on Federal Tax Reform
paragraphs: Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System.  Washington, D.C.: November 2005.
section_title: Appendix II: Descriptions of Alternative Tax Systems
paragraphs: Over the past decade, several proposals for fundamental tax reform have  been put forward. These proposals would significantly change tax rates,  the tax base, and the level of tax (whether taxes are collected from  individuals, businesses, or both). Some of the proposals would replace the  federal income tax with some type of consumption tax levied only on  businesses. Consumption taxes levied only on businesses include retail  sales taxes (RST) and value-added taxes (VAT). The flat tax would also  change the tax base to consumption but include both a relatively simple  individual tax along with a business tax. A personal consumption tax, a  consumption tax levied primarily on individuals, has also been proposed.  Similar changes in the level at which taxes are collected could be made  while retaining an income tax base. This appendix provides a brief  description of several of these proposals.
subsections: section_title: National Retail Sales Tax
paragraphs: The consumption tax that Americans are most familiar with is the retail  sales tax, which in many states, is levied when goods or services are  purchased at the retail level. The RST is a consumption tax because only  goods purchased by consumers are taxed, and sales to businesses,  including sales of investment goods, are generally exempt from tax. In  contrast to an income tax, then, income that is saved is not taxed until it is  used for consumption. Under a national RST, different tax rates could be  applied to different goods, and the sale of some goods could carry a zero  tax rate (exemption). However, directly taxing different individuals at  different rates for the same good would be very difficult.
section_title: Consumption Value- Added Tax
paragraphs: A consumption VAT, which like the RST, is a business-level consumption  tax levied directly on the purchase of goods and services. The two taxes  differ in the manner in which the tax is collected and paid. In contrast to a  retail sales tax, sales of goods and services to consumers and to  businesses are taxable under a VAT. However, businesses can either  deduct the amount of their purchases of goods and services from other  businesses (under a subtraction VAT) or can claim a credit for tax paid on  purchases from other businesses (under a credit VAT). Under either  method, sales between businesses do not generate net tax liability under a  VAT because the amount included in the tax base by businesses selling  goods is equal to the amount deducted by the business purchasing goods.  The only sales that generate net revenue for the government are sales  between businesses and consumers, which is the same case as the RST.
section_title: Income Value-Added Tax
paragraphs: An income VAT would move the taxation of wage income to the business  level as well. No individual returns would be necessary, so the burden of  complying with the tax law would be eliminated for individuals. An  income VAT would not allow businesses to deduct dividends, interest, or  wages, so the income VAT remitted by businesses would include tax on  these types of income. Calculations would not have to be made for  different individuals, which would simplify tax administration and  compliance burdens but not allow for treating different individuals  differently.
section_title: Flat Tax
paragraphs: The flat tax was developed in the early 1980s by economists Robert Hall  and Alvin Rabushka. The Hall-Rabushka flat tax proposal includes both an  individual tax and a business tax. As described by Hall and Rabushka, the  flat tax is a modification of a VAT; the modifications make the tax more  progressive (less regressive) than a VAT. In particular, the business tax  base is designed to be the same as that of a VAT, except that businesses  are allowed to deduct wages and retirement income paid out as well as  purchases from other businesses. Wage and retirement income is then  taxed when received by individuals at the same rate as the business tax  rate. By including this individual-level tax as well as the business tax,  standard deductions can be made available to individuals. Individuals with  less wage and retirement income than the standard deduction amounts  would not owe any tax.
section_title: Personal Consumption Tax
paragraphs: A personal consumption tax would look much like a personal income tax.  The major difference between the two is that under the consumption tax,  taxpayers would include all income received, amounts borrowed, and cash  flows received from the sale of assets, and then deduct the amount they  saved. The remaining amount would be a measure of the taxpayer’s  consumption over the year. When funds are withdrawn from bank  accounts, or stocks or bonds are sold, both the original amount saved and  interest earned are taxable because they are available for consumption. If  withdrawn funds are reinvested in another qualified account or in stock or  bonds, the taxable amount of the withdrawal would be offset by the  deduction for the same amount that is reinvested. While the personal  consumption tax would look like a personal income tax, the tax base  would be the same as an RST. Instead of collecting tax on each sale of  consumer products at the business level, a personal consumption tax  would tax individuals annually on the sum of all their purchases of  consumption goods. Because it is an individual-level tax, different tax  rates could be applied to different individuals so that the tax could be  made more progressive, and other taxpayer characteristics, such as family  size, could be taken into account if desired.
This is a work of the U.S. government and is not subject to copyright protection in the  United States. It may be reproduced and distributed in its entirety without further  permission from GAO. However, because this work may contain copyrighted images or  other material, permission from the copyright holder may be necessary if you wish to  reproduce this material separately.