metadata: authors: 0: author: McLure, Charles E., Jr.
docna: 0: docna: A consumption-based direct tax for countries
            in transition from socialism
docty: Policy Research Working Paper
subtopic: Tax Administration,Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Tax Law,Public Sector Economics,State Owned Enterprise Reform,Tax Policy,Public Sector Administrative & Civil
            Service Reform,Inflation,Privatization,Energy Privatization,Public Finance Decentralization and
            Poverty Reduction,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Finance and Financial Sector Development
abstracts: cdata!: This paper suggests a consumption-based
            direct tax, referred to here as a simplified alternative tax
            or SAT, as an alternative to the standard income tax for
            reforming socialist economies (RSEs).  The paper consists of
            seven sections.  Section I serves as an introduction.
            Section II outlines some of the objectives of tax policy in
            RSEs and some of the constraints on the achievement of those
            objectives.  Section III provides examples of the
            overwhelming complexity of the income tax.  Section IV
            explains the basic mechanics of the SAT and contrasts the
            simplicity of the SAT with the complexity of the income tax.
            Section V describes the economic advantages of the SAT and
            section VI discusses some potential problems of the SAT.
            The final section concludes by stating that the SAT
            encourages saving and investment in a way that is
            economically neutral and avoids many of the administrative
            problems of an income tax.
repnme: repnme: A consumption-based direct tax for
            countries in transition from socialism
display_title: A consumption-based direct tax for
            countries in transition from socialism
listing_relative_url: /research/1991/08/699905/consumption-based-direct-tax-countries-transition-socialism
topicv3: Inflation m1326709 0870F4727ACED1CF8525815C00471347,Tax and Revenue Policy and Administration
            m1327008 720,Privatization m1327236 1283,Taxation m1327615 1121,Tax Policy m1327616 983
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Policy Research Department
no_of_pages: 50
model_extractions: **Policy, Research, and External Affairs**

# **Socialist Economies Reform**

WPS 751 This paper-a product of the Socialist Economics Reform Unit, Country Economics Department-is part of a larger effort in PRE to study **tie** processes of reformn in countries emerging from socialism. Copies are available .ree from theWorld Bank, 1818 H StreetNW, Washington DC 20433. PleasecontactCECSE, room N6-035, extension 37188 (44 pages).

Countries emerging from socialism must move quickly to implement tax systems that will allow them to finance the proper functions of government in a noninflationary way. Yet they are illprepared to cope with the intricacies of a standard income tax. 'They lack the accounting practices, the tax administration, and the expericncc with tax compliance to make an income tax work well. It is imponant to design tax policy with these limitations in mind, rather than simply ignoring them during the (possibly long) period when they remain significant impediments.

McLure suggests an alternative to the income tax: the simplified alternative tax, a consumption-based direct tax. The simplified alternative tax encourages savings and investment in a way that is economically neutral and avoids many of tihe administrative problems of an income tax - especially those stemming from timing issues and the need to adjust for inllation.

The simplified alternative tax is not a panacea, but McLure suggests that it deserves serious consideration.

Indeed, administrative considerations should weigh almost as heavily as economic effects in the choice of a tax system for a country emnerging from socialism.

Thc PRE Working Paper Series disseminates the findings of work under way in the Rank's lolicy, Rescarch, and External AffairsComplcx. An objective ofthescrics is to get these findings out quickly, cven ifpresentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily reprcsent official Bank policy.

**Produced** by **the** PRE Dissemination Center
# A Consumption-Based Direct<sup>Tax for Countries</sup> in Transition from Socialism

# by Charles E. McLure, Jr.

# Table of Contents

- I . Introduction II. Objectives and Constraints A. The Economic Context B. Administration and Compliance C. Distributional Considerations D. Incentives for Saving and Investment E. International Considerations

- III. Complexity of the Income Tax A. Timing Issues B. Inflation Adjustment C. Other Issues

- IV. Mechanics and Simplicity of the SAT

- A. Mechanics B. Simplicity of the SAT

V. Economic Effects of the SAT

- A. Exemption of the Return to Invested Capital B. Taxation of Extraordinary Returns C. Investment Incentives D. Parity of State and Private Enterprise E. Parity of Taxable and Tax-Exempt Sectors

VI. Potential Problem Areas

- A. Distributional Equity B. Losses C. Investment Hunger D. The Cost of Debt Capital

- E. Counter-cyclical Effects F. Accounting G. Manipulation of Transactions H. Intemational Issues I. Transition Issues J. "No One Does It" K. Relation to the VAT

1 2 2 3 5 5 6 6 7 9 11 12 12 13 14 14 15 15 16 16 17 17 17 13 18 19 19 20 20 21 22 23
|VII.<br>Concluding Remarks|24|
|---|---|
|Appendix A: Relation of SAT and Income Tax|25|
|Appendix B: Relation of SAT to VAT|28|
|Appendix C: Advantages of the SAT over the Tax on Consumed<sup>Income</sup>|31|
|Endnotes|32|
|References|41|
# A Consumption-based Direct Tax for Countries in Transition from Socialism

## _Charles E. McLare, Jr._<sup>_0_</sup>

### I. INRODUCrION

Countries in transition from socialism-reforming socialist economies (hereafter RSEs) face severe fiscal problems. The problem is not merely that most of them are running large budget deficits that threaten to fuel inflation and undermine transition, though this is, indeed, a serious problemY The basic outlines of their tax systems were set during the period of classical central planning when taxes did not play an important role in either the allocation of resources or the distribution of income.? Thus at the beginning of the transition process the systems were-and some still are-otally inappropriate for a market economy.- They contained (or stll contain) anomalies that will distort resource allocation and create inequities in the distribution of income if continued after transition. Perhaps more important, the countries lack the administrative infrastructure, the accounting practices, and the experience with tax administration and compliance needed to make a modern tax system fiimction. Thus, as privatization occurs, and revenues can no longer be taken from captive state entrprises, tax collection is likely to become more difficult and revenues are likely to fallY Nor can tax administration and compliance quicldy be improved, though every effort should be made to do so.

The general tendency has been to sugges **t** hat the RSEs adopt reformed tax systems patterned after those found in the developed countries of the West. Thus there would be a value added tax similar to those used by members of the European Community, an individual income tax, and a company income tax similar to those found in the West. As has so often been the case in developing countries, too little thought has been given (and is being given) to the features of RSEs that may make the standard prescription less than totally appropriate for these countries.y Individual income taxes would presumably have graduated rates, but efforts to use personal exemptions, itemized deductions, and other devices to "flme tune" liabilities to the individual circumstances of taxpayer **s** hould be minimized to prevent administrative and compliance problems; this issue is discussed further below. In several 'reformed" systems saving and investment is being encouraged by a variety of tax "gimmicks," including investment credits, accelerated depreciation, and tax holidays; these are reminiscent of both 1960s style interventionism in Latin America and the use of tax incentives for similar purposes in advanced countries before the worldwide tax reform movement of the 1980s.9' There are ample reasons to believe that this is not good policy.

This paper was prepared under the auspices of the Socialist Economies Reform Unit of the World Bank. I gratefiully acknowledge comments made on an earlier draft by Cheryl Gray, Janos Kornai, Stephen Langlois, John Litwack, George Zodrow (who taught me most of what I know about the SAT), and especially Richard Bird, and by participants in a seminar organized by the Fiscal Affairs Deparanent of the International Monetary Fund, including Milka Casanegra, Ved Ghandi, Leif Muten, Abdul Rahman, Vito Tanzi, and Christine Wallich.

**_1_**
_2_ The purpose of this paper is to break out of this mindset-to offer a plan for reform of direct taxation that is more closely geared to the problems of the RSEs. It addresses such concerns as weak tax administration and lack of experience with mass taxes; the special twist given to distributional issues by both the legacy of socialist indoctrination and the potentially egalitarian eff of privatization; and the desire to attract foreign investors.

The tax system proposed for consideration, a consumption-based direct tax which I call the Simplified Alternative Tax or SAT, has been proposed elsewhere, but has not been adopted by any country.Y1 To some extent this lack of action on the SAT can be explained by the novelty of the proposal; after all, no one wants to be a pioneer in a matter of this importance. I contend, however, that RSEs should at least consider the SAT, since they are being pioneers in economic matters far more important than tax policy. To some extent failure to adopt the SAT can be explained by the legitimate concerns that have been raised about the tax. I contend that many of these concerns are less important in the RSEs than in other contexts.

Sew;on II outlines some of the objectives of tax policy in RSEs and some of the constraints on the achievement of those objectives. Section HI provides examples of the overwhelming complexity of the income tax. Section IV explains the basic mechanics of the SAT and contrasts the simplicity of the SAT with the complexity of the income tax. Section V describes the economic advantages of the SAT and section VI discusses some potential problems of the SAT. The final section contains concluding remarks. Two appendixes contrast the SAT with the income tax and with two forms of VAT. A third appendix explains briefly several reasons for preferring the SAT over another form of direct consumptionbased tax. As noted in secdon V, the SAT is equivalent to exemption of the return to investmnent. In present value it is equivalent to a tax on consumption under certain circumstances. See McLure gjj., (1990) chapter 8. This last point is not emphasized in the text, since the important debate in RSEs is likely to be with advocates of a traditional income tax.

# HI. OBJECTIVES AND CONSTRAINTS

In many ways the objectives of tax policy for RSEs and the constraints on their realization resemble those found in middle-income developing countries with market economies. But they are also different in important ways. Both the similarities and the differences must be considered in framing tax policy for countries in transition from socialism. lTis section discusses some of these objectives and constraints.Q'

# A. The Ecanomic Context

The tax policy examined in this paper is being offered as potentially interesting to all the countries of Central and Eastern Europe making the transition from socialism, notably Bulgaria, Czechoslovakia, Hungary, Poland, Romania, the Soviet Union, and Yugoslavia.<sup>2</sup> ' In several cases (e.g., Czechoslovakia, the USSR, and Yugoslavia) it may be the constituent republics that would be interested, if existing unions were to dissolve.'<sup>2</sup> The paper discusses the suitability of the SAT for a generic RSE, though using examples from particular countries.

1. The nee for a sable business clima. Ideally the preferred long-run tax policy for an RSE would be put in place before the beginning of transition and would then be basically unchanged, in order to simplify transition to the new tax system and promote certainty and stability in the investment
climate.k Of course, that prescription is unrealistic, since all these countries have already undertaken some restructuring of their economies and some have already made important changes in their tax systems. A more realistic picture would find the tax system changing-perhaps repeatedly-as everything else changes. Ihis suggests a less rigorous set of guidelines for tax policy during transidon: avoidance of the "zigzag problem." By this, I mean that RSEs should decide at the outset the type of tax system they ultimately want to have and then move toward it essentially in a linear manner, avoiding reversals of policy that create uncertainty for business. An additional suggestion is to avoid introducing an individual tax that is more sophisticated and complicated than can be administered, risking either massive non-compliance or the need to rescind the policy and adopt a system that is more appropriate, given limi tations imposed by the capacity for tax administration and compliance.

2. Three tyne of busines. In all these countries state enterprises loom large in the overall economy, and are likely to continue to do so for some time, due both to rel'ctance in some countries to privatize completely and the difficulty in all of privatizing quickly. It thus seems best to thini of three general types of business.2 First are the state enterprises. Inidally these will be fbund in-or even dominate-almost all sectors of the economy (with exception **s** uch as agriculture in Poland, which was decoflectivized in 1956). Ultimately-following extensive privatization-state ownership may be found primarily in sectors characterized as public utilities in the WVest and in certain industries thought to have "special importance," such as steel and energy. In principle, it should be relatively easy for the authorities to exercise fiscal control over these enterprises, providing appropriate accounting standards are implemented. Indeed, much of the tax revenues of RSEs has traditionally come from these enterprises. Even so, the history of soft budget constraints and losses makes one less than opdmistic about collecting taxes from most such enterprises.i The second group are large enterprises that are primarily in the private sector. These include both locally and foreign-owned fis. (Whether to classify joint ventures between public and private firms with public or private enterprises is not totally clear. The answer probably depends on the breakdown of ownership, voting rights, etc. Fortunately this distinction is probably not crucial for the present discussion.) Tne primary issues for this group are a) whether such firms have accoundng records adequate for their fiscal control and b) whether they are widely or closely owned. Widely owned companies are likely to be more easily controlled by fiscal authorities than are closely held ones, because of their need to report to shareholders.

The third group consists of the burgeoning small business sector. Many "firms" in this category are closely owned (they may be proprietorships. including "mom and pop" businesses), many have quite inadequate books of account, many are not formally registered to do business, some do not even have identifiable permanent places of business, and many will not voluntarily pay the taxes they owe. In short, they are typical of the "hard-to-tax" groups found in developing countries.

# B. Administration and Compic

One legacy of central planning is the virtually complete lack of both a tax administration infrastructure and experience with tax compliance. Under classical central planning, (some if not all) profits of state enterprises were simply transferred to the state budget (and investment funds were allocated among enterprises by the planners). The transfer was simply a bookkeeping entry involving enterprise "funds' that, due to the all-inclusive nature of planning, generally could not be used for any other purpose.A In this "tellering" activity, as much attention may have been paid to allocating revenues to the appropriate budgetary fimds as to verifying the accuracy of reported profits.W While
4 there might be arguments about just how great the profits<sup>to be transferred were in particular cases, the</sup> basic fact remains that defining taxable income carefully<sup>and correctly was not high on anyone's agenda.</sup> Similary, while the interests of the planners and<sup>those of enterprise managers were not totally congruent,</sup> they were ceitainly more closely akin than are<sup>those of the typical taxpayer and fiscal authorities in a</sup> Western market economy. Tn 4i,ort, tax administration<sup>and compliance are different in kind and</sup> importance under central planning and in a market economy.

The situation is not much better in RSEs stating<sup>from the less extreme position of market</sup> socialismA What are commonly called turnover taxes<sup>are not the type of multistage cascading taxes</sup> oa gross receipts that go by that name in the West.<sup>Rather, in RSEs turnover taxes simply represent the</sup> difference between controlled retail prices (net of retail and<sup>wholesale margins) and manufacturing costs.</sup> Again tax administration and compliance are less demanding<sup>than in a market economy. Much the same</sup> can be said for the profits tax, which irn the<sup>pre-Utansition system was coliected only from state</sup> enterprises. The base of the tax is "balance sheet profits."<sup>a concept that bears little resemblance to</sup> economic ineome. (For present purposes the most important<sup>difference is the failure to allow depreciation</sup> allowances and deductions for some interest expense.) More<sup>to the point, for neither of these taxes is</sup> any real administrative effort expended.

The "supply constrained economy" that is characteristic of<sup>Communism creates behavior that will</sup> be inimical to tax compliance and administration.0' Enterprise<sup>managers have learned to barter with</sup> each other in order to circumvent the restrictions of central<sup>planning and obtain the inputs they need.</sup> They will find the skills in barter trade and the personal ties<sup>developed in this process to be valuable in</sup> avoiding tax liabilites.

Kornai (199(, pp. 118-19) has identified yet another legacy of Communist<sup>rule that compounds</sup> the problem of inadequate tax administration: disrespect for<sup>the state and its laws. He notes:</sup> people in general consider it a laudable act, rather than something<sup>to be ashamed of, if someone</sup> defrauds the state, appropriates its wealth, or shuns his own<sup>obligations. ITose who refrain from</sup> this kind of behavior are seen as dupes.... Consequently, when<sup>we contemplate budget revenues</sup> we should be prepared to face the fact that many citizens<sup>will try hard to dodge taxes.... In the</sup> Hungarian case, there is an additional factor: a considerable<sup>part of the private sector still belongs</sup> to the shadow economy, and it will voluntarily emerge from<sup>the shadow and into the light-only</sup> after some time.

Another legacy of Communism, based on experience with the<sup>secret police, is a deep-seated fear</sup> of the state. Kornai rightly fears a system in which tax collectors<sup>spy on taxpayers, keeping a constant</sup> check on 0-.ir earnings and expenditures.

Und .r Communism, earning income outside the tightly controlled<sup>state enterprise sector was</sup> disreputable, if not illegal. This mindset perneates much thinking<sup>in the RSEs. Even now, one hears</sup> complaints against "speculation"--what economists in the<sup>West might call the seeking of unexploited</sup> opportunities for profit that make the economy<sup>innovative and efficient. Thus many residents of RSEs</sup> will be reluctant to reveal their incomes to the fiscal authorities, for<sup>fear of reprisals.</sup> The upshot of this discussion-and that of the ptevious subsection-is<sup>that every effort should be</sup> made both to upgrade tax administration and compliance and<sup>(especially in the short run) to design tax</sup> policies with the constraint posed by inadequate administration<sup>and compliance firmly in mind. As</sup>
_5_ Komai (1990, pp. 120, 117) states the issue, "Hungary needs<sup>a tax system able to evade the dilemmas</sup> described above... .Taxes should be collected where they are<sup>'seizable,' giving preference to the</sup> technically simplest forms of taxation." Bird adds (in<sup>correspondence with the author), "it is a classic</sup> 'Hard-to-tax' problem from developing countries, which<sup>presumably calls for the same sorts of solutions</sup> e.g., withholding where possible, presumptive techniques, and a decent auditing<sup>and penalty system."</sup> Pending the development of improved taxpayer morale and auditing, it is important<sup>to utilize withholding</sup> to the extent possible and to design the system in such a<sup>way as to facilitate compliance and</sup> administration.

## C. Disibutinal onsiderati

In virtually all countries there is a desire to use progressive taxation to<sup>"level down" the peaks</sup> in the income distribution. This egalitarian sentiment appears to be<sup>at least as strong in RSEs as in other</sup> societies; it is almost certainly stronger there than in the United<sup>States. Up to now it has been manifested</sup> formally primarily in the compression of wages; workers in RSEs<sup>who would have high incomes in the</sup> West are simply paid less than the value of their inarginal<sup>product, rather than receiving a wage</sup> commensurate with productivity which is then subject to high marginal<sup>tax rates.</sup> The essential absence of private entrepreneurial activity (at least<sup>in legal forms) and private</sup> property has, until recently, largely eliminated the need to<sup>think seriously about progressive taxation of</sup> the income from private business and capital. Reflecting the<sup>socialist bias against private business</sup> activity, the existing taxes on business income of individuals<sup>tend to be levied at high rates-rates of 80</sup> to 85 percent-that can only be termed punitive.

The shift to a market economy will change all this. Wages<sup>will be geared more closely to</sup> marginal productivity. That plus the rise of privaw business activity<sup>and private ownership of capital will</sup> create tendencies for inequalities in the distribution of income<sup>and wealth not seen in these countries for</sup> many years.1' TMis, in turn, will likely lead to pressures for progressive<sup>taxation.</sup> On the other hand, the RSEs start from a position of relatively<sup>equal distribution of wealth.</sup> Depending on how privatization is conducted, the ownership<sup>of shares in companies may, at least for a</sup> while, be much more widespread and equal than in most<sup>Western countries.A' This is particularly</sup> significant when one thinks about whether and how to eliminate<sup>the double taxation of company income,</sup> to be considered further below. Moreover, at least some members<sup>of society in RSEs recognize the need</sup> to offer the incentives provided by the prospect of large incomes<sup>if rapid economic development is to</sup> occur. It is difficult to know how these conflicting pressures<sup>for and against progressive taxation will</sup> ultimately be resolved. One would hope, however, that progressivity<sup>will be fairly mild and that the</sup> enterprise tax rate and the top marginal rate applied to income<sup>of individuals will be relatively low-in</sup> the range of 40 to 50 percent.

# D. Incentive for-SAying and-Investment

Following a long period in which private ownership of most<sup>forms of capital was out of favor</sup> and in which there was little foreign investment, RSEs are now<sup>interested in encouraging domestic saving</sup> and investment by both their residents and foreigners. For<sup>the most part these countries are adopting</sup> what I call the "Swiss cheese" strategy of legislating tax incentives,<sup>tax holidays, and other fiscal</sup> inducements to saving and investment, many of them targeted<sup>to particular sectors, rather than adopting</sup> a comprehensive definition of income for tax purposes and relying on<sup>low tax rates and market forces</sup>
6 to stimulate saving and investment and direct funds to the right uses, as many advanced<sup>Western countries</sup> recently have done.

This strategy has several undesirable implications. First, it creates opportunities for abuse that will strain the ability of weak tax administrations. Obvious opportunities for<sup>abuse include manipulation</sup> of transfer prices on sales to and from affiliated holiday firms and<sup>the 'yo-yo problem" of residents</sup> sending money out of the country so it can return<sup>as tax-preferred foreip investment.</sup> Sxond, it implies faith in the ability of bureaucrats and politicians to pick<sup>winners and losers that</sup> is unjusdfied and reminiscent of central planning, rather than a wilrlngness to<sup>rely on the invisible hand</sup> of free markets. If the wrong sectors are chosen-or choose themselves, via abuses-economic<sup>distortions</sup> and the waste of scarce resources will occur. Third, it necessitates higher<sup>tax rates than under a</sup> comprehensive definition of taxable income. Finally, its equity is questionable, and it creates the impression of inequity. In short, it is not an appropriate policy. It would be<sup>far more appropriate to</sup> have generalized and neutral incentives that do not involve picking winners and losers,<sup>do not distort</sup> resource allocation, and do not open the door to abuses; ideally such generalized incentives<sup>would be</sup> perceived to be fair.

## E. 11irationl Considerations

After four or more decades of isolation from the West, the RSEs of Eastern Europe are<sup>suddenly</sup> painfully aware of the international implications of what they do in the<sup>fiscal arena. First, any of them</sup> with aspirations of joining the European Community (EC) are alniost certain to adopt<sup>an EC-type value</sup> added tax (VAT).A' Second, as suggested above, all RSEs are concerned with<sup>attracting foreign</sup> investment, as well as preventing cap.'al flight. This concern is reflected in<sup>the desire to have a favorable</sup> tax clime.

Traditionally it has been thought that tax effects on foreign investment would be most<sup>relevant</sup> for investors from countries employing a territorial system of taxation<sup>or from countries that allow tax</sup> sparing. In the case of countries utilizing residence-based or worldwide<sup>taxation and offering foreign tax</sup> credits (without tax sparing), the source country tax would be borne by<sup>the treasury of the home countries</sup> of investors. This view must be qualified in several respects.<sup>First, home-country tax generally is not</sup> due until profits are repatriated. If investment is financed from retained foreign<sup>earnings, rather than new</sup> equity, there may, in effect, be no additional tax in the home country.WV<sup>Recent changes in the tax</sup> systems of many countries with residence-based systems, including<sup>especially the United States, and the</sup> increasing prevalence of excess foreign tax credits that has resulted,<sup>make the host-country tax climate</sup> relevant for many potential investors from such countries.-W (Tese<sup>changes include reduction in tax</sup> rates, changes in income allocation rules, and limits on the foreign<sup>tax credit. This point is explained</sup> further in Section V below.)

# m. COMPLEXITY OF THE INCOME TAX

In order to understand why the Simplified Alternative Tax is given<sup>that name, Li is useful to</sup> examine the complexity that is either inevitable or likely under<sup>the income tax.</sup>
7 In order for an income tax to be fair and neutral, the definition of income for tax purposes must reflect real economic income fairly accurately. If this objective is not realized, income from different sources will be taxed differently. If this happens, the tax system will not be fair and it will distort economic decisions.m Designing an income tax that measures real economic income accurately involves one major problem that is inevitable, no matter what the rata of inflation, and another that arises if prices are not essentially stable. These are the issues of timing and inflation adjustment, respectively.W Thiing issues are discussed first, Ignoring issues of inflation adjustment. Then the effects of inflation are considered. Finally, a few additional issues are discussed briefly.

# A. TimingIaaes

The classic Haig-Simons definition of economic income is "consumption plus the change in net wealth." Leaving aside questions of valuing consumption and knowing exactly when consumption occurs, we see immediately that the "change in net wealth" part of this definition can be a source of considerable trouble, for it is not necessarily easy to know when this change occurs (when income "accrues") or to measure it accurately. This is perhaps most easily seen through the use of several simple examples that illustrate the difficulty of accrual taxation.

_Depreciaton_ is perhaps the best-known example of a timing problem. Strictly speaking, depreciation allowances should track the loss in the economic value of assets if taxable income is to reflect economic income.zy Of course, this pattern of loss in value is extremely difficul **t** o know, and arbitrary schedules are commonly used for tax purposes to approximate actual depreciation. The problem is that deviations of depreciation for tax purposes from economic depreciation will cause income to be mismeasured and cause inequities, economic distortions, or both. Similar problems arise in the case of amortization, depletion, etc. In some cases (e.g., advertising and research and development) the problems are so severe that it is common to allow immediate deduction of expenditures, despite the inequities and distortions this creates.

To see the importance of this timing issue, we can assume that the true pattern of depreciation of a particular asset is such that it loses 99.99 percent of its value in the second year, and nothing in years one and three.0 If the relevant interest rate used to discoun **t** ax savings is _25_ percent, immediate exr.,nsing of this asset (first-year write-oft) would give a deduction that is 25 percent greater in present value than is appropriate for the calculation of economic income. (If deduction is to be allowed in the first year, an allowance of only 79.99 would be required to equal the 99.99 properly allowed in the second year.) If, on the other hand, the deduction is postponed until the third year, it will be only 80 prcent as great as it should be. (A third-year deduction of 124.99 would be required to be equivalent in present value to the allowance of 99.99 properly deducted in the second year.) More generally, if deductions are granted too rapidly (too slowly) or the recognition of income is postponed (accelerated), income for tax purposes is understated (,- .rstated).

_C4phal gains_ should ideally be taxed on an accrual basis, that is, as changes in asset values occur. This is difficult for both adnmnistrative and political reasons. While it is relatively easy to determine the current value of securities that are widely traded on financial markets, for many assats current valuation is extremely difficult; this is true,for example, of real estate and closely owned businesses. In addition, the need to pay tax on an accrual basis could force the disposition of appreciated assets and the liquidation of family businesses. For these reasons capital gains are almost universally taxed on a realization basis, that is, at the time of disposition of assets.
Taxation at realization creates other problems. First, the taxation of capital gains is generally postponed, often for many years. This reduces the present value of tax and undermines both horizontal and vertical equity.

Second, taxpayers can chose the timing of realization of gains and losses. Thus there is a tendency to realize losses, but not gains. To prevent abuse, it is common to limit the amount of capital losses that can be offset against crdinary income. Such limitations create an impedimenw to risk-taking, which requires unlimited deduction of losses.

Third, taxation at realization reduces the mobility of capital, as investors become locked into appreciated assets.A' Fourth, if gains are taxed only at realk stion, they tend to be concentrated in a few years. Under a tax system with graduated rates, the tax liability on such gains will be greater than if the gains were taxed on an accrual basis and thus spread out more evenly over more years. (Of course, the advantage of deferral may far outweigh the effects of bunching of gains.) This problem caa be ameliorated by allowing the averaging of income received over a period of years, but this adds considerably to complexity.

An alternative approach is to tax capital gains at a preferential rate; this policy is also often proposed to further various other objectives, including stimulus to saving, investment, and risk-taking, and provision of ad hoc compensation fsr inflation. Preferential treatment of capital gains is not a satisfactory response to any of these concerns, and it considerably complicates compliance and administration, as taxpayers attempt **to** convert ordinary income to capital gains and fiscal authorities attempt to prevent them from doing so. _Original issue discount_ occurs when a bond is issued at less than its redemption value; (at least part of) the interest is implicit in the increase in the value of the bond as maturity approaches. The question is when the increase in value occurs. Clearly it is not appropriate to assume that the increase occurs only at the time of maturity and to tax it then; to do so is to give this form of income unduly favorable treatment. On the other hand, assuming interest is earned proportionately over the period from issae to maturity errs in the other direction; because of compounding, interest incomo is earned later than this straight-line assumption suggests. Interest is earned as indicated by a table of compound interest, and to assume otherwise pruduc.ts an inaccurate measure of income.22' Of course, a similar problem exists anytime an interest bearing security is not acquired at its redemption value-which is most of the time, in tne case of marketable securities.

_Ma lti-period production_ occurs when expenses are incurred currently for the subsequent production )f income. (Examples include long-term construction contracts, mine development costs, and the costs ox growing timber, coffee, and orchards.) Such expenses should be capitalized and deducted (or depreciated) at the time income is earned.m A faster schedule of deduction will be too favorable to the taxpayer.

This is only a small sampling of timing issues. A more complete list reads like a rogues' gallery of tax complexity. It would include installment sales, decommissioning of nuclear power plants, reclamation of strip mines, capitalization of the costs of inventories, and the tax treatment of property and casualty insurance. The common features of many of these issues include lack of clarity as to exactly when the change in net wealth occurs; complexity in accounting and in tax compliance and administration, even if clarity is not a problem; and distortions and inequities if the issues are not handled properly.
**_9_**

Problems arise if an income tax does not provide symmetry in the tax treatment of interest income and expense. That is, under symmetrical treatnent, interest would be deductible by the debtor and taxable to the creditor in the same year. In fact, many tax systems do not achieve symmetry. For example, if taxpayers can choose their fiscal years for tax purposes. it is fairly simple to "knit together" repeated loans between related parties (e.g., a partnership and its partners) in which interest is always deducted before it is reported as income. This results in a loss of revenue and inequity.

Problems may be compounded under certain circumstances. If deductions are sufficiendy accelerated, if the recognition of income is sufficiently postponed, or if the two sides of important wansauctions are not treated symmetrically, some taxpayers may report losses for tax purposes, even if they are making money. If business losses can be passed through to the owners of businesses and used to offset or 'shelter' income from other sources, a polidcal problem may arise, due to the perception of inequity.ul "Backstop" measures are sometimes used to prevent the unseemly spectacle of wealthy individuals and large and profitable companies paying no tax.A These can add enormously to the complexity of the system. For example, the U.S. Tax Reform Act ef 1986 contains antishelter provisions that-along with efforts to deal with timing issues-help explain why one multinational accounting firm has noted that, "Complexity is the hallmark of this legislation. "2 Timing issues are inevitable in any standard income tax. Even if the more esoteric problems can be avoided, many mundane ones such as depreciation will remain, and others (multi-year contracts, installment sales, etc.) will surface as taxpayers and the economies in which they operate become more sophisticated. If they are not handled satisfactorily, equity and neutrality will suffer.

# B. I:laioAdUa

The tax systems of most developed countries were designed for a world of price stability. That is, they use historical costs as the basis for calculating capital gains, depreciation allowances, and the cost of goods sold from inventory.1V Moreover, they make no distinction between nominal and real (inflation-adjusted) interest income and expense. As long as prices are relatively stable, such treatment is entirely appropriate; inflation adjustment is so complicated that it should not be introduced unless it is really needed. If, however, inflation reaches even relatively modest levels, it is necessary to choose between the complexity of inflation adjustment and the inequities and distortions that result from an unindexed system.

Several simple exampiles illustrate the need for inflation adjustment. Consider first the issue of capital gains. Suppose for simplicity that the price level has doubled since an asset was bought. If an asset was bought for 100 and now sells for 160, there is no real capital gain; indeed, there has been a real capital 'oss of 40 (= 160 - 100 x 2). Yet a tax system based on historical values will report a capital gain of 60 (= 160 - 100) in this case. By comparison, a system that provides inflation adjustment of the basis of assets produces the correct result.

A similar problem arises in the case of unindexed depreciation allowances and inventories. If the price level has increased significantly since a depreciable asset was acquired, it would be appropriate to base depreciation deductions on this increased value. Use of historical value understates the loss in real value and overstates taxable income. Depreciation allowances are sometimes accelerated in an effort **to** offset the effects of inflation. Of course, a given pattern of acceleration is appropriate for at most one inflation rate.
10 lie cost of goods sold from inventories can also be indexed<sup>to reflect the increase in their value</sup> since the time of acquisition. Some countries allow<sup>the use of last-in, first-out (LIFO) inventory</sup> accounting as a substitute for explicit inflation adjustment<sup>of inventories. Note, however, that while this</sup> approach may appear to be easy to implement, it is<sup>not conceptually correct, in that it confounds changes</sup> in re.ative prices of inventories and changes in price<sup>levels (the proper object of indexation).</sup> Consider finally the deduction of nominal interest<sup>expense and the taxation of nominal interest</sup> income. Suppose the real interest rate is 5 percent,<sup>the inflation rate is 20 percent, and the nominal</sup> interest rate is 25 percent.w It would be appropriate<sup>**to**allow a deduction for (and tax) only the real</sup> interest payment of _5_ percent, because the part of<sup>nominal interest rates that exceeds the real rate</sup> represent compensation for loss in the value of principle,<sup>not interest, per se.The conceptually correct</sup> way to achieve this result is to disallow a deduction<sup>for (exclude an amount of income equal to) the</sup> inflation rate times the principal amount of indebtedness.<sup>An alternative that may be somewhat simpler,</sup> but is correct only under very special circumstances,<sup>is to disallow (exclude) a pezcentage of interest</sup> equal to the fraction of the nominal interest rate represented<sup>by the inflation rate.AV In this simple</sup> example both techniques give the same result: disallowance<sup>(exclusion) of 80 percent of interest</sup> deductions (income). It is apparent from this example<sup>that adjustment for an unexpected inflation rate</sup> as low as 20 percent can have major impacts on &e equity<sup>of the tax system. (If inflation is expected,</sup> there is likely to be little effect on either equity or resiource<sup>allocation in a closed economy; distortion of</sup> resource allocation is likely to be serious only if borrowers<sup>and lenders are subject to substantially</sup> different marginal tax rates. In an open economy resource<sup>allocation may also be seriously affected by</sup> expected inflation. See also McLure La., 1990, chapter<sup>7.)</sup> These examples illustrate the need for inflation adjustment,<sup>as well as suggesting one form of</sup> adjustment, ad hoc and essentially independent adjustments<sup>of each of the four affected types of income</sup> flows (capital gains, depreciation, inventories, and interest).<sup>An alternative "integrated" approach used</sup> in Chile that is more accurate makes adjustments **to** non-monetary<sup>elements of the balance sheet and then</sup> reflects these adjustnents in the income statement.w1 The adjustment of interest is an implicit result of the process, rather than being done explicitly.

Whichever of these approaches is used, the ad hoc approach<sup>or the integrated Chilean approach,</sup> there can be no doubt that inflation adjustment is complicated.<sup>It would be a major burden for any</sup> country, and doubly so for a country with only rudimentary<sup>accounting practices, almost no tax</sup> administration, and almost no experience with taxpa.yer<sup>compliance. The problem is aggravated by the</sup> lack of reliable price indices.9' Inflation adjustment<sup>is not something the RSEs should gladly or lighty</sup> undertake.

Whether inflation adjustment is needed in RSEs is<sup>not clear. The historical experience of these</sup> countries provides no guidance, as it reveals only the<sup>artificial price stability of suppressed inflation. The</sup> transition experience of the pioneer RSEs would be<sup>of some relevance, if it were thought that tax policy</sup> in other countries could be fundamentally reformed<sup>before the beginning of transition. In Poland prices</sup> rose by 78 percent in January 1990, immediately following<sup>the administration of "shock treatment;"</sup> although inflation has slowed markedly, it has<sup>been perhaps 5 percent per month since then,-9 a rate</sup> that, if continued, would clearly justify concern about<sup>the effects of inflation on an unindexed tax system.</sup> Whether this experience is relevant depends on whether<sup>a given country ean manage transition without</sup> inflation, and if not, whether it will have undergone<sup>much of the transition mcst likely to induce inflation</sup> before tax reform can be completed, and thus avoid<sup>the need for inflation adjustment</sup>
The most relevant question is the rate of inflation that will prevail in the years imediately following tax reform. There is little on which to base an estimate of this rate, but my guess is that it may be fairly high for several years following the beginning of transition and tax reform-perhaps in the range of 10 to 20 percent per year. If this is true, reliance on an unindexed tax system would be risky.

# C. Is

The above discussion should suggest why I have given the following assessment of the U.S. Tax Reform of 1986, which addressed rizany timing issues, but did not provide for inflation adjustment: it is horribly complex-so much so that we may have shown definitively that attempting to implement a conceptually correct income tax (even one without inflation adjustment) is impractical.A

# Problems that would be encountered by an RSE go beyond those identified thus far.

1. i £. Under so-called classical systems the equity income of companies that is distributed to shareholders as dividends is subject to double taxation. That is, corporate tax i* paid on the income and then individual tax is paid on the dividends. In such systems there are strong incentives to prefer debt to equity finance and to recharacterize dividends as interest, since the interest is deductible and dividends are notA<sup>5</sup> Depending on the relationship between company tax rates and individual tax rates applied to dividends and capital gains, there may be an incentive to avoid use of the corporate form.

Most European countries allow relief from double taxation of dividends, commonly through the imputation (shareholder credit) method. That is, the corporate tax attributable to income distributed as dividends is treated as a withholding tax for which shareholders receive a tax credit. Even so, most do not allow complete dividend relief. Moreover, to the extent that dividend relief is granted in the first instance to the shareholder, rather than to the company paying dividends, there is likely to be some residual preference for debt finance, even where dividend relief is complete. This is true because business managers may respond more strongly to corporate deductions-for either interest or dividendsthan to shareholder credits. Only to the extent that dividends and interest are treated identically (taxable to the recipient and deductible to the payor) is there likely to be no such preferenceA.- (Germany combines a shareholder credit with application of a lower rate to income that is distributed; presumably the latter feature has the same effect as an equivalent deduction for dividends paid.) The dividend-paid deduction appears to be simpler to implement than the shareholder credit, since it lodges the primnary compliance problems at the enterprise level. In fact, this difference is easily overstated. If there is withholding of tax on dividends, the two are essentially equivalent from an administrative point of view.

The existence of deviations of taxable income from economic income further complicates the problem of providing dividend relief. In order to prevent giving relief for company taxes not actually paid, most countries have special provisions (e.g. the Advance Corporation Tax in the United Kingdom and the precompte in France) intended to limit relief to the amount of company taxes paid. Such provisions are inevitably complicated, and they can distort decision-making.-' inter-corporate (or inter-company) dividends create a final source of complexity. That is, it is necessary to prevent multiple taxation of such income, without granting overly generous treatment. This
**_12_**

can be especially Important in RSEs, where holding companies<sup>are likely to be established in the process</sup> of privatization, intercompany holdings are likely<sup>to be quite common, and there are likely to be many</sup> joint ventures.

In short, prevention of double taxation of dividends is complicated.<sup>Again, while necessary from</sup> an economic point of view, it is not something RSEs<sup>will soon be prepared to handle.</sup> 2. (lgh a- . Most authorities on taxation would probably agree<sup>that global taxation</sup> (taxation of all income under one rate schedule applied to aggregate<sup>income) is conceptually preferable</sup> to schedular taxation (taxation of specific types of income under<sup>separate schedules). UJnder the former</sup> approach, liability is based on the taxpayer's aggregate income<sup>from all sources, whereas under the lattr</sup> different rates are applied to different types of<sup>income. At first glance global taxation seems preferable</sup> on grounds of both equity and neutrality. In fact,<sup>schedular taxation has some appeal under certain</sup> circumstances. We have already seen one example,<sup>the avoidance of tax shelters (the offsetting of</sup> artificial tax losses against income from other sources). The second,<sup>the simplification of withholding,</sup> may be especially imporant in RSEs, since it may reduce drastically<sup>the number of taxpayers who must</sup> file returns.

3. Withholdine on interetand dividends. The taxation of<sup>interest and dividends under the</sup> income tax causes at least two types of complications related<sup>to withholding. First, recipients of interest</sup> and dividends are notorious for their reluctance<sup>to report such income and pay tax on it. Tlus</sup> withholding on such income, or at least the filing of information<sup>returns, is necessary to prevent evasion.</sup> Second, in a system with graduated rates, the marginal tax rate<sup>that should be applied to interest</sup> and dividends depends on the taxpayer's labor income. Thus it is difficult,<sup>within the context of a global</sup> income tax, to make withholding a final tax on such income. Recipients<sup>of large amounts of interest and</sup> dividend income may need to file returns, even though they would not<sup>need to do so in the absence of</sup> the progressive taxation of these income flows. By comparison,<sup>if schedular taxes are applied to interest</sup> and divdiends (or if they are tax-exempt), withholding is<sup>simplified.</sup> Where deduction is allowed for interest payments of individuals,<sup>including especially mortgage</sup> interest, further problems arise. Even the marginal tax rate to<sup>be applied to labor income depends on the</sup> amount of such deductions.

# IV. MECHANICS AND SIMPLICITY OF THE SAT

In many respects the Simplified Alternative Tax resembles the type<sup>of income taxes found in most</sup> countries. Yet it differs in important ways that<sup>have both administrative and economic implications. Ihis</sup> section de;; ribes the basic mechanics and simplification<sup>benefits of the SAT.A Three appendices</sup> compare thn tax to the income tax and two types of VAT<sup>and explain why it is simpler than another</sup> consumption-based direct tax.

# A. Mchanics

The SAT system would consist of two more or less separate<sup>taxes. One would be imposed on</sup> the wage and salary income (including pensions)<sup>received by individuals; the other on the income of</sup> businesses. Both interest and dividends would<sup>be exempt from both taxes and neither would be</sup> deductible. Borrowing and lending would have<sup>no tax implications.4' Unlike the situation under the</sup> so-called expenditure tax. Capital gains on financial assets would<sup>be exempt. Gains on non-financial</sup>
_13_ assets would be exempt from the individual tax, but would be subject<sup>to the business tax.-V Under</sup> some proposals, gifts and inheritances would be included in the base of the individual<sup>tax.</sup> The individual tax could (but need not) accommodate joint returns,<sup>perional exemptions, itemized</sup> deductions, and graduated rates; it would be collected largely through withholding<sup>at source by</sup> employers. There is much to be said for a relatively simple system<sup>with individual filing, no personal</sup> exemptions, and no itemized deductions, at least until the administrative infrastructure needed to deal with such complexities has time to develop. Such a system allows fairly accurate withholding on<sup>labor income</sup> and avoids the need for most taxpayers, especially those with only one employer,<sup>to file tax returns.a</sup> Fortunately, most of the RSEs are not hampered by a tradition of joint filing<sup>and itemized deductions.</sup> The business tax would be levied at a flat rate-presumably the<sup>top rate applied to the income of</sup> individuals-with no allowances for personal exemptions or itemized deductions. It<sup>would apply to all</sup> forms of business, whether state-owned enterprises, cooperatives, collectives,<sup>stock companies,</sup> partnerships, joint ventures, or proprietorships. Immediate expensing<sup>would be allowed for all</sup> investments, including those in depreciable assets and inventories. Owners<sup>of small businesses (including</sup> cooperatives and corporations) would be allowed to pay salaries<sup>to</sup> themselves,<sup>thereby achieving the</sup> benefits of "do-it-yourself integration." On the other hand, business losses could not be passed hough to individual owners of the business.A Owner-occupied housing poses particularly thorny questions. It would be possible, in theory,<sup>to</sup> treat owner-occupied housing as a business. This would necessitate the imputation of rental<sup>income; it</sup> is generally not recommended. Instead, most authorities agree that owner-occupied housing should be treated in the same way as financial investment. That is, the purchase<sup>and sale of a home would have</sup> no tax implications; of course, home mortgage interest would not be deductible.1L'

# B. Simplicity.o1he SAT

The SAT avoids the problems of timing and inflation adjustment that<sup>characterize the income tax,</sup> since interest payments have no tax consequences and business tax<sup>liabilities are based on cash flow,</sup> rather than accrual concepts. For example, expensing replaces both<sup>depreciation and inventory</sup> accounting; thus there is no need (for tax purposes)<sup>todetermine depreciation rates or engage in</sup> depreciation or inventory accounting and no need for inflation<sup>adjustment of depreciation allowances or</sup> inventories.9 (Of course, such issues may be addressed in financial<sup>accounting. This is discussed</sup> below.) Because of expensing, the basis of capital assets is identically<sup>zero. Thus the entire proceeds</sup> from the sale of such assets is subject to tax. There is no need to<sup>keep track of the (depreciated) basis</sup> of such assets or to index it for inflation. This feature<sup>also facilitates cross-checking the income tax</sup> reurns of buyers and sellers. Deductions for the purchase of assets and inventories are contemporaneous with the reporting of receipts, instead of being spread over<sup>time, as in the case of depreciation allowances</sup> and deductions for cost of goods sold.5' (in a growing<sup>economy, expensing also increases the</sup> prevalence of losses; this issue is discussed in section VI.) Since interest is exempt and non-deductible, such timing problems as original issue discount and inflation adjusunent of interest payments' cannot arise. With<sup>interest payments having no tax</sup> consequences, postponement of the recognition of income<sup>and the acceleration of deductions cannot</sup> undermine the neutrality or fairness of the system.
_14_ The SAT avoids the problems *.:eated by<sup>the differential treatment of debt and equity under</sup> virtually all extant income taxes. First, since<sup>both interest and dividends are treated identically for tax</sup> purposes (non-deductible and non-taxable),<sup>there is no artificial tax-induced preference for one over the</sup> other. Second, this result is achieved<sup>automatically under the SAT, without complicated provisions for</sup> integrating the company and individual taxes.Finally, since there is no incentive to recharacterize dividends as interest, the administrative<sup>burden of preventing this abuse is aroided.</sup> The problems related to withholding identified<sup>earlier are avoided under the SAT. There is no</sup> need for either withholding on interest<sup>and dividends or information returns covering such income.</sup> Perhaps more imporant, liability for<sup>the individual tax depends only on labor income (and family</sup> circumstances, as indicated by a working<sup>spouse, personal exemptions, and itemized deductions); it dies</sup> not depend on the amount of non-labor<sup>income received. Thus withholding can much more accurately</sup> reflect final tax liability than under a global<sup>income tax. This minimizes the number of individual retuns</sup> that must be filed.

The general disallowance of interest deductions<sup>would also increase the accuracy of withholding.</sup> It may also facilitate avoidance of one<sup>of the most inequitable and distortionary elements of the tax</sup> systems of some countries, the deduction<sup>of interest on home mortgages.'</sup> The schedular nature of the SAT implies that<sup>tax shelters based on pass-through of losses cannot</sup> exist; sheltering can occur only within the<sup>boundaries of a single business filing one tax return. This</sup> benefit is, of course, bought at the expense<sup>of implicitly taxing all business income (except that paid out</sup> to the owners as wages) at the business tax<sup>rate, rather than at the marginal rate applied to other income</sup> of the owners.

It is important not to claim too much for<sup>the SAT.57' The individual portion of the SAT is</sup> essentially the same as the taxation of labor<sup>income under a standard income tax; it involves no major</sup> simplification, at least relative to a sensible<sup>income tax. Perhaps the most important difference-aside for</sup> the exemption of interest and dividends-is<sup>that home mortgage interest is inherently non-deductible in</sup> the SAT framework, whereas the desirability<sup>of deductibility is more debatable in the income tax context.</sup> The SAT facilitates compliance for (and<sup>administration of the tax on) honest taxpayers who want</sup> to pay the proper amount of taxes, but<sup>have difficulty in doing so, because of complexity. It will do</sup> relatively little directly to curb certain abusive<sup>practices or to facilitate taxation of the "hard-to-tax"</sup> groups.W In this area there is no substitute<sup>for proper administrative procedures and diligent effort.</sup> But the SAT will help indirectly by freeing<sup>administrative-resources that would otherwise go into</sup> implementation of complex provisions.

## V. ECONOMIC EFFECTS OF THE SAT

# The SAT is, under certain conditions, equivalent<sup>to a tax only on income from labor; that is, to</sup> a tax that exempts the return to investment.<sup>This is most clear in the case of interest and dividends,</sup> which are explicitly exempt from the<sup>individual tax.22'</sup> A. Exe0mDtion A. of the Retur to Inve-sted _~~~~~~~~~~~~~~~~~~~~~~~~~~.Capital

What is less clear is that income from other<sup>investments is also, in effect, tax exempt.A This</sup> can be seen from a simple example.<sup>Consider the case of an equity-financed investment of $1,000 that</sup> yields $200 or 20 percent one year later.<sup>If the company tax rate is 30 percent, the company only invests</sup>
_15_ $700 of its own money, since the deduction of $1,000 results in a tax saving of $300 (assuming hie company can filly utilize the deduction of $1,000 resulting from expensing of the investment, an issue to be addressed in the next section). Tax of $360 must be paid on "taxable income" of $1,200<sup>in the</sup> second year, leaving net after-tax income of $140 ($1,200-$700-$360). or 20 percent of the inial invesunent of $700 of own company funds.4' Since the net rate of retr on company fiuds is the same as in the absence of tax, the marginal effective tax rate (METR) is zero.

Economists commonly cite the implicit exemption of the return to saving as one of the primary advantages of consumption-based taxes such as the SAT. My own view is that while this is an important advantage, the administrative advantages described above are even more important.

# B. Taxation of Extraona Returns

Even though the SAT essentially exempts the return from capital, it allows the state to share in extraordinary returns to investments. In the above example, the government also earns 20<sup>percent on its</sup> investment of $300 in forgone tax revenues; this is true even if the competitive return is only 10 percent. In a sense the fisc is a silent partner in all investments.

This feature could be very important in economies in transition from socialism, where extraordinary returns are likely to be common. To see this, consider these cases: the profits<sup>attributable</sup> to trademarks such as Coca Cola and McDonald's; the profits that will be made if state enterprises<sup>are</sup> privatized on terms that are too generous to private investors; the profits that will be made<sup>when</sup> inefficient but viable state enterprises become efficient; and the returns from<sup>the exploitation of natural</sup> resources.

# C. I_ =1

As indicated above, the return to investment is effectively exempt under the SAT.<sup>This should</sup> be a powerfil incentive for saving and investment-and one that avoids the problems<sup>of targeted</sup> incentives: the need to pick winners and losers, the risk of economic distortions,<sup>the complexity, the</sup> opportunities for abuse, and the real and perceived inequities.

It is interesting to compare risk-taking under the SAT and under a generalized system of perpetual tax holidays.A' Under both the marginal effective tax rate is zero. But, as just<sup>noted, under the SAT</sup> the government is a partner in all investments; thus it shares in the cost of investment (via expensing) and in all retums, be they extraordinary returns, normal returns, low returns, or losses. (Mhe fill<sup>validity</sup> of this statement depends on the treatment of losses, an issue to be addressed in the next<sup>section.) By</sup> comparison, in the case of holidays the government is not a partner, since<sup>it does not share in the cost</sup> of investment or in either gains or losses. (ibis is actually an optimistic assessment.<sup>It is fairly common</sup> for govermnents to allow, if not always intentionally, deductions to be taken for<sup>at</sup> least some<sup>expenses</sup> of holiday firms. This means that losses are subsidized and that the METR on profitable<sup>activities is</sup> negative.) This has several important implications. First, under an income tax regime with tax<sup>holidays,</sup> if the government wants to share in the returns to extraordinarily profitable investments it must identify the opportunities for such investments and explicitly make the investments, through state<sup>enterprises or</sup> joint ventures. This does not appear to be consistent with the sentiments for privatization<sup>running through</sup> the RSEs.-
_16_ Alternatively, the government caa abrogate the laws providing tax holidays, once it sees which sectors are unusually profitable. Ordinarily this possibility might be dismissed simply by noting the folly of such a policy for a country that needs to establish a favorable investment climate in order to attract foreign investment. But some of the RSEs are already becoming aware that their holiday provisions are much too generous and may therefore be thinking of rescinding them.

Second, the up-front revenue cost of the SAT is higher than that of tax holidays. Third, the stimulus to risk-taking is greater under the SAT than under holidays if gains and losses are treated symmetrically under the SAT; see also the discussion of losses below.

Fourth, it may be more convenient to tax some employee fringe benefits by denying business deductions for them than to attribute them to employees and subject them to tax as labor income under the individual tax. This option does not exist under holidays.

# D. Party of stat nd Drivate C enerss

It is important to achieve parity in the tax treatment of state enterprises and private firms during the period before privatization is complete.iA Interest and dividends received by the state are inherently tax-exempt. Thus interest and dividends received by private investors should also be exempt. This implies non-deductibility of interest and dividends at the enterprise level. (Otherwise, the METR will be highly negative, considering the taxes levied at both the enterprise and shareholder/bondholder levels.) In combinatio. this suggests that the SAT is needed to achieve parity.

# E. Eait of taxable and tax-exempt s

One problem found in many Western countries is the lack of parity between taxable and exempt sectors. Interest and dividends received by non-profit organizations are commonly exempt. Besides being non-neutral, this treatnent opens the door for various forms of abuse. The SAT helps to achieve parity in these and similar situations. Because all interest would be exempt, that received by non-profit organizations would enjoy no special privilege.

In some countries, business income of non-profit organizations that is not directly related to their charitable purpose is subject to taxation. (For example, in the United States, income from "unrelated business activities" is taxed.) This seems entirely appropriate, if only to prevent unfair competition<sup>with</sup> the for-profit sector. Even if business income of non-profit organizations were to be exempt,<sup>the</sup> violation of parity would be less under the SAT (which effectively exempts the marginal reurn to investment) than under the income tax.

So. -e countries make the mistake of exempting the interest paid on the debt of governmental and quasi-gover,imental agencies. In the United States, for example, interest on the debt of state and local governments is exempt from federal taxation (and generally from the state income tax of the state<sup>in</sup> question). In many countries interest on all government debt is exempt.

This is an extremely inequitable and inefficient means of subsidizing the borrowing of<sup>such</sup> entities, since the revenue cost of such exemptions depends on the marginal tax rates that<sup>would have</sup> been paid by high-income lenders, but the savings in interest costs depend on the marginal rate paid by the marginal lender. By exempting all interest income, the SAT would eliminate the differential advantage of public borrowing and the inequity and inefficiency it entails.
17

# VI. POTENTIAL PROBLEM AREAS

When offered in market economies, proposals for the SAT have run into predictable and potentially vslid objections. For the most part these objections appear to be somewhat less telling in the context of countries in transition from socialism.

# A. D o

The SAT effectively excludes the return to capital from the tax base. ITis can be appraised in two ways. First, the SAT is less progressive than is an income ,ax levied at the same rates. This is troublesome in the developed countries of the West-and even more so in LDCs-because the ownership of capital is highly concentrated.9' This might be less important in RSIEs than in market economies, despite the greater weight given to distributional considerations in the former, if the ownership of capital following privatization were much less concentrated than in the West.`' The degree of concentration will depend on exactly how privatization is achieved, that is, via vouchers distributed equally to all citizens, distribution of enterprise shares only to workers and managers of the enterprise, sale of assets, or "spontaneous privatization" (in which enterprise managers "take the enterprise private," often by means of questionable legality).

Second, a society that has been raised to believe that profits and other returns to capital are not to be tolerated may have considerable difficulty in swallowing the notion that income from capital is effectively to be exempt. This political problem may initially be ameliorated by the fact that profit appears to be taxed under the SAT, even if interest and dividends are not. Eventually-and perhaps very soon-it would become apparent that many who have large econoniic incomes were paying little or no taxes.9' nis problem of inequity-and the perception of inequity-would be especially important in the case of banks and other financial institutions. Because interest income is exempt and interest expense is non-deductible, the entire profit margin earned from financial intermediation would be tax exempt, as is the income earned from providing services of intermediation (which is commonly included in exempt interest income). It has been proposed that a special tax might be imposed on this sector.@9 Third, there is the important issue of whether it is appropriate to define equity in terms of "opportunities," instead of in terms of "outcomes." Under the income tax (and under an alternative form of consumption-based tax called the tax on consumed income), those who "strike it rich" on their investments pay high taxes (except to the extent earnings are reinvested, in the case of the tax on consumed income), whereas under the SAT all returns to investment are exempt.3'

# B. L

Another of the potentially troubling p;oblems of the SAT is that, because of expensing, tax losses would occur more frequently than under a standard income tax. New companies are especially likely to incur tax losses. Simple carry forward of losses (without interest) is not a totally satisfactory solution, for if deductions for investments cannot be utilized immediately, the economic benefits of the SAT would not be fully realized, and some of the simplicity benefits would also be lost. Moreover, there is the potential problem that the firm may never have the income necessary to absorb the losses, which are based on expensing, and not on depreciation allowances. This is especially true of rapidly growing firms.21' This prospect can be expected to dampen the theoretical incentives for investment and risktaking provided by the SAT?<sup>2</sup> '
_18_ Tbe economic benefits of the SAT could be retained if refunds equal to the product of the tax rate and the amount of losses were paid currently.' Such refunds are commonly opposed, due to the risk of fraud and the administrative burden of preventing abuse. While refunds of d.is type are paid under the VAT employed in the EC, s well as the VATs of many other countries, some countries will not make large refiunds, especiallo to new firms, without furst verifying their validity. An additional problem is the appearance of unfairness that occurs when profitable companies and wealthy individuals (operating businesses as companies) receive tax refinds.W An alternative is to allow tax losses to be carried forward with interest. While clearly superior to carry forward without interest, this adds somewhat to complexity and does not address the problem of perpetual tax losses.

It is important to place this problem in perspective. Targeted investment incentives under an income tax are likely to create similar problems of unused tax benefits. Even tax holidays can create complexity, whether or not firms are allowed to postpone deductions that are worthless during the holiday period until after the holiday has expired. Moreover, holidays create opportunities for abuse not found in the SAT.

# C. Investment Hungor

Kornai has emphasized the insatiable hunger for investment on the part of state enterprises that face a soft budget constraint.7 Some countries with socialist economies impose taxes on investment spending in the attempt to suppress this investment hunger. Some may fear that immediate expensing of capital goods under the SAT would aggravate the excessive demand for investment.

This concern can be addressed on several levels. First, including gimmicks in the tax system is no substitute for a rational system of ownership, control, and incentives for management to be concerned abcut profitability. Where private firms are concerned, there is little reason to expect expensing to lead to irrational demands for investment, as long as the tax rate is moderate and there is no expectation of state bail-outs for those who lose money. The situation is more worrisome in the case of state enterprises, which historical experience has given reasons for such expectations. This emphasizes the need for privatization to occur as rapidly as practicable and for managerial incentives to be rationalized where rapid privatization is not possible.

Beyond that, there is little reason to fear that expensing under the SAT would provide a unique spur to investment hunger, if the alternative is investment incentives, tax holidays, etc. or an income tax with negative METR for debt-financed investment under inflationary conditions. Presumably these policies would have similar effects if their benefits were equally available.

# D. The Cost of Debt capital

The inability to deduct interest might make foreign-source debt capital too expensive for enterprises operating in an RSE employing the SAT. This might necessitate the allowance of deductions for interest (and presumably for dividends, in order to maintain parity between the two types of financing). This, in turn, would call for taxation of interest received by residents (collected in large part through withholding) and perhaps withholding taxes on interest paid to foreigners."' Such a compromise has several disadvantages. First, it would destroy the parity in the tax treatment of enterprises owned by the state and those owned privately and the parity of the for-profit and
**_19_**

non-profit sectors . Second, it would Increase the prevalence of tax losses and tke problems associated with them. Third, it would reintroduce some of the complexities of the income tax (those related to timing of the recognition of interest income and the deduction of interest expense) and (unless interest deductions were indexed, at the cost of further complexity) render the tax vulnerable to the effects of inflation.

# E. CiE

One potentially important characteristic of taxation-though one that is not currently in vogue-is automatic or built-in macro-economic stabilization. Thus tax liabilities would ideally increass during cyclical periods of prosperity (full employment and the threat of inflation) and fall during periods of cyclical wealmess.

On this criterion the business portion of the SAT fares rather poorly, compared to a convenional income tax. (The individual portion of the SAT would resemble the portion of the income tax applied to labor income in this respect.) An investment boom would reduce tax liabilides under the SAT because of the effect of expensing. Conversely, tax deductions would fall with a drop in investment spending. By comparison, deductions for depreciation allowances under an income tax remain relatively stable, being determined largely by prior events, rather than current investment.

At is difficult to know how much weight to accord the lack of automatic stabilization. The traditional Keynesian view is that built-in stability is very important; extreme monetarist and radonal expectations views would discount this feature heavily.

## F.

Countries in transition from socialism commonly lack the generally accepted accounting practices (GAAP) found in the West. This hampers the development and implementation of a modern income tax, as well as the development of business more generally. In addition, many small businesses are likely to lack the ability to implement sophisticated accounting sysnms.

To some extent the SAT sidesteps both problems by providing cash-flow tax treatment of many receipts and expenditures, including investment in depreciable assets and purchase<sup>of inventories.</sup> Moreover, neither borrowing and lending nor payment and receipt of interest has any tax<sup>consequences</sup> under the SAT. This simplification advantage is (or will be) partially offset by the fact that<sup>as GAAP</sup> develops firms will need to keep dual records, one set based on GAAP and<sup>one based on the SAT</sup> conventions. By comparison, choosing the income tax model should encourage more<sup>rapid development</sup> of GAAP. (There is some risk that those responsible for the developmens of GAAP would seize on the SAT rules for financial accounting. Any such tendency should be resisted,<sup>since these rules are not</sup> appropriate for judging the financial performance of enterprises.) This problem is easily overstated, because the tax returns under the SAT would be fairly simple and would be based on much of the same information as income tax returns, but without the<sup>complexities</sup> inherent in compliance with a satisfactory income tax law-one that handles timing<sup>issues and inflation</sup> adjustment adequately. Perhaps more important, any difficulties of this<sup>type are dwarfed by the more</sup> common problem found in the United States, some other Westem countries,<sup>and many LDCs: ad hoc</sup> divergence between GAAP and the calculation of income for tax purposes. Such divergence can<sup>be</sup><sup>_traced_</sup> to failure to adopt GAAP for tax purposes in such areas as installment sales, inventory<sup>accounting, etc.</sup> and to incentives such as tax holidays and accelerated depreciation. As<sup>noted earlier, the SAT eliminates</sup>
_20_ the first set of issues and makes targeted incentives redundant and unnecessary. On balance,<sup>this does</sup> not appear to be a matter of major concern.

# G. M plati Qnofranacis'

Under the SAT some economically similar transactions would be treated<sup>very differently. For</sup> example, lease payments would be deductible and taxable, whereas interest wou!d be non-deductible and non-taxable. This opens the way for manipulation of transactions between two persons,<sup>one of whom</sup> is taxable under the business tax and the other of whom is not. (There is generally no advantage<sup>to such</sup> manipulation when both parties are either taxable ea non-taxable under the business tax.) For example, a taxpayer might simultaneously lease a building to a tax-exempt organization at below-market<sup>rent and</sup> borrow from the organization at a below-market rate of interest. Alternatively,<sup>it might make an</sup> installment sale to such an organization-or to an individual-at an understated price and<sup>an overstated rate</sup> of interest.

Solutions to this problem might involve floors and ceilings on interest rates and/or<sup>the taxation</sup> of certain business activities of tax-exempt organizations. Though this problem deserves<sup>further scrutiny,</sup> it does not appear to be important. A related and potentially more important source of problems is the overstatement of the purchase price of imported assets. (It would generally do no good to<sup>inflate the</sup> price of assets produced locally, for reasons indicated above.) Since assets can be written off in the first year, there may be an incentive to overstate their value. If substantial customs duties are<sup>applied to such</sup> imports, this abuse is unlikely; in some countries, however, such imports are duty free or<sup>subject to low</sup> tariffs. Of course, one hopes that the RSEs will employ only low and uniform tariffs.<sup>The VAT would</sup> not have much effect in preventing this practice, since it is creditable against future liabilities. It should be noted that similar abuse is possible, though in attenuated form, under a conventional<sup>income tax.</sup>

## H. Ismatin

I is unclear whether the United States would allow foreign tax credits for the company SAT. Credit is allowed only for net income taxes paid to foreign goverrunents. This restriction<sup>is intended to</sup> prevent credit being taken for gross receipts taxes, scverance taxes, royalties,<sup>etc., especially those levied</sup> by oil-rich nations. It can be argued that the SAT is not a tax on net income,<sup>because no deduction is</sup> allowed for interest expense.

If the SAT were not creditable, several concerns would arise. First, the<sup>country adopting the</sup> SAT night be giving up the opportunity to have part of its tax bill paid by the U.S. government.w' Second, a non-creditable tax might discourage investments by U.S. multinational<sup>corporations in RSEs</sup> adopting **ti** e SAT.

I b, lieve that the SAT should be creditable; of course, this line of reasoning may<sup>not be found</sup> convincing.-' First, the SAT is less burdensome than a tax on real net<sup>economic income, not more;</sup> this is indicated by the METRs under the two taxes: zero under the SAT; statutory rate under<sup>the income</sup> tax. Moreover, revenues are likely to be lower under the SAT<sup>than under an income tax levied at the</sup> same rate.0 Second, the SAT clearly has economic and administrative advantages<sup>that recommend it</sup> over the income tax; it is not just a gross receipts tax being levied to soak<sup>up foreign tax credits. Finally,</sup> fur the portion of the income tax base that is common **to** the base of the<sup>SAT, extraordinary profits, the</sup> two taxes are identical. In short, the SAT should be creditable.
_21_ lhis issue cm easily be overstated. First, creditability is an issue only for repatriated eangs. For income financed by reinvestment of retained eanings, the effec of taxion resemble those of a territorial system.2' Second, a tax with a MEM of zero, even when combined with the US tax on repatriated earnings, is unlikely to have much disincentive effect on investment in the host country.

Tbird, as a result of the rate reduction and other features in the 1986 tax reform many American multinationals have excess foreign tax credits (that is, they have paid more foreign taxes than they can credit against U.S. liability, because of statory limits on the availability of the U.S. credit).K' Excess credits can only be carried backward two years and forward five years (without interest). Because of the American use of an overall limitation on the foreign tax credit, such companies would not be able to take credit for an income tax levied by an RSE, even if the tax were, in principle, creditable. In other words, there may be little practical difference between a creditable income tax and a non-creditable SAT; neither would actually be credited.

There is, however, more to the story than this. First, not all American firms have excess foreip tax credits. Second, similar questions must be addressed for other countries employing worldwide taxation based on the residence of the taxpayer and offering foreign tax credits for source-based income taxes.

Third, any country knowingly adopting a non-creditable tax would be in a vulnerable position. If the United States were to raise its corporate income tax rates enough to restore the 'umbrella' over the tax systems of other countries, any country adopdng a non-creditable tax could be placed in a worse position than if it had adopted a creditable tax.

Fourth, the creditability of the company tax may have symbolic importance over and above the number of dollars of U.S. tax offset by the foreign tax credit. In this respect creditability may resemble the existence of a double taxation treaty. There are good reasons to question whether developing countries benefit, on balance, from treades concluded with developed countries. Much the same question can be raised about treaties between RSEs and developed Western countries. Yet the existence of a system of tax treaties may be thought to be important as providing evidence of a stable investment environment. Much the same may be said of the symbolic importance of creditability.

The hybrid system described above in the section on the cost of capital would eliminate concerns about creditability. A tax that allowed a deduction for interest expense would clearly be creditable. But, as noted there, such a system is not without its own problems.

# I. IQ S

The shift from an income tax to the SAT would pose difficult transition problems for a Western market economy. These involve primarily how to treat the undepreciated basis of assets and interest on outstanding debt, in order to avoid windfall gains and losses.W This is much less problematical in economies in transition from socialism.

First, under the system of enterprise taxation based on "balance sheet" profits, some interest is not deductible; in addition, interest rates have tended to be exceptionally low (e.g., one percent on some loans in Bulgaria). lTus shifting to a system in which interest is not deductible is not a major change.
**_22_**

In addition, since there have been no deductions for depreciation, there is no isssue of how rapidly to allow the remaining basis to be written off.

Second, if the SAT could be introduced quickly, before privatization, windfalls would be experienced largely by state-owned enterprises, rather than by individuals and privately owned companies. Under some forms of privatization windfalls would also be less troubling than in the West, even if experienced by private investors. In particular, one could hardly complain about windfalls if the SAT were introduced just after all citizens received equal shawes in all enterprises (or vouchers that entitled them to such shares) and no private investment had yet occurred. Of course, the longer introduction of the SAT-or any new direct tax system-is postponed, the more the transition issues resemble those in the West. The windfall problem could be alleviated, though at the cost of increased uncertainty, by making it clear to prospective buyers and investors that a system such as the SAT is being considered.

Third, in many countries making the transition from socialism the issue is essentially one of introducing a new tax system where a workable system has not existed, rather than substituting one workable system for another. (Again, delay will render this assessment inaccurate, since elements of Western style income taxes are being introduced.) Unlike the situation in Western countries, maintenance of the status quo is not a viable option; these countries must abandon their present flawed systems. Similar transition problems will be faced whether the shift is to the SAT or to a conventional income tax. T1he transition to the SAT may be no more difficul **t** han the transition **to** a conventional income tax.

Ihis is especially true once one considers the need to deal adequately with issues of timing and inflation adjustment described above. At high rates of inflation, most of nominal interest paymenls would be disallowed as deductions or excluded from income; disregarding all such payments may involve only a minor difference. Of course, the administrative and complianc **e** ffort needed to introduce a tax on real economic income is far greater than that needed for the SAT.

Finally, and most important, any transition problems resulting from the introduction of the SAT are likely to be swamped by the larger transition effects of moving from a command economy, with state ownership, controlled prices, etc., to market economies with private ownership of property, marketdetermined prices, etc. The presen **t** ransition period offers unparalleled freedom to choose the best and most appropriate tax system available, relatively unencumbered by past choices.19 No country in the West has wanted to be the first ta introduce the SAT.' (That international tax conventions are based on the income tax is a different issue; it is discussed above.) The argument that no one has ever tried the SAT is less telling in countries emerging from socialism, since no country has ever tried to make the transition from a command economy to free markets, either.

A slightly different reaction commonly heard in the countries of Central and Eastern Europe is that they do not want to be used as guinea pigs for an experiment Westem countries are unwilling to undertake at home. While this reaction is understandable, itreally does not seem appropriate. The thesis of this paper is that the SAT may be more appropriate ,or RSEs than is a conventional income tax, for the reasons stated. If the reasoning presented here is not found compelling, the SAT should be rejected.

in making this judgement, one should clearly be aware of the costs of being mistaken. The primary risk seems to be the up- front revenue loss resulting from expensing and the transition problems that would result from the need to switch subsequently to a system in which interest is taxable and
_23_ deductible (and the related problems involved in changing the tax treatment of dividends). Taxpayers would not object to allowing deductibility for interest on existing indebtedness (or for dividends); the primary problem would be one of revenue loss. By comparison, creditors (shareholders) would object to the taxation of interest income from existing debt (dividends on existing stock). It would, of course, be undesirable to allow interest deductions without taxing interest income. Since the marginal tax rates of most borrowers are likely to be higher than those paid by most lenders, it seems likely that borrowers and lenders could work out voluntary arrangements to restructure debt incurred under the SAT foir an income tax world.

# K. Relation tI the VAI

In his recent book, The Road to a Free Economy, Janos Kornai (1990, pp. 125-3 1.) argues that Hungary (and by implication, all economies in transition from socialism) should adopt three types of taxes as their primary sources of public revenue: a linear consumption tax such as the value added tax, a linear (non-progressive) payroll tax, and a linear (non-progressive) profit tax. He urges this approach to achieve three objectives: simplicity, economic neutrality, and non-progressivity. The SAT clearly resembles an amalgam of the last two of these (but it might well be levied at graduated rates on labor income). It is most commonly thought of as a substitute for the individual and company income taxes.

The SAT is also quite similar to the subtraction-method VAT. (This is shown in appendix B.) But, because the SAT can accommodate personal exemptions and graduated rates on income from labor, it has distributional advantages not shared by any extant VAT. It woud be fairly easy to duplicate the basic distributional effects of the SAT at the low end of the income scale through the combination of a VAT and a system of grants based on labor income and the size and composition of families; it is, however, difficult to achieve the full range of rate differentiation provided by the SAT. This raises the question of whether it makes sense for a country to have both a VAT and the SAT.d' One can imagine a system in which the SAT substitutes for both the VAT and the individual and company income taxes (and for payroll taxes).

The answer seems to depend in part on whether the country in question has aspirations of joining the European Community. If it does, there is no real alternative to adopting an EC-type VAT; in that case, the only question is whether to adopt the SAT instead of a conventional income tax. The discussion to this point has implicitly taken this question as the point of departure.

For a country not likely to be joining the EC anytime soon the question is more complicated. Administrative resources would be saved by concentrating them on one tax. But this benefit would be achieved at the risk of putting "all the revenue eggs in one basket," a serious issue in countries that a) can hardly afford serious revenue shortfalls, b) have little experience in tax administration, and c) can expect evasion to be a serious problem. If these fears can be overcome, the SAT would be the logical choice for the single revenue source, since the SAT is much simpler than the conventional income tax, and the individual component of the tax can be "personalized" to take account of the individual circumstances of taxpayers in a way that the VAT cannot be. Moreover, the individual SAT can include graduated rates.

There are, however, international issues to be addressed in this discussion. We have seen above that the SAT may be judged not to be creditable against the income tax of the United States (and perhaps those of other countries). Ironically, it is also possible that border tax adjustments (BTAs, compensating taxes on imports and rebate of tax on exports) would not be allowed for the SAT, on the grounds that it is not an indirect tax, the only type for which BTAs are allowed under the General Agreement on
_24_ Tariffs and Trade. Thus we would have the worst of both worlds-no foreign tax credit and no border tax adjustments. It seems likely, however, that the tax could be structured to avoid one of these adverse judgements.

# VII. CONCLUDING REMARKS

Countries emerging from socialism must move quickly to implement tax systems that will allow them to finance the proper functions of government in a non-inflationary manner, Yet, they are illprepared to cope with the intricacies of a standard income tax. They lack the accounting practices, the tax administration, and the experience with tax compliance **to** make an income tax work well. It is importan **t** o design tax policy with these limitations in mind, rather than simply i6-Poring them during the (possibly long) period when they remain significant impediments. Indeei, I would argue that administrative considerations should weigh almost as heavily as economic effes in the choice of a tax system for a country emerging from socialism.-W This paper suggests an alternative to the income tax, the SAT, that encourages saving and invesunent in a way that is economically neutral and avoids many of the administrative problems of an income tax, especially those stemming from timing issues and the need for inflatio1n adjustment. The SAT is not a panacea. But I believe it deserves serious consideration.