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ssment and Individual Medical Readiness (PIMR) system and its Comprehensive Immunization Tracking Application (CITA), DOD’s Defense Enrollment Eligibility Reporting System (DEERS), which is used by the Navy, and the Army Medical Surveillance Activity’s Defense Medical Surveillance System (DMSS). At the Army’s Fort Benning, we created a sampling frame (i.e., total population) of records for 606 federal civilian deployments between June 1, 2003, and September 30, 2005. Our study population was limited to DOD

federal civilians who deployed to Afghanistan or Iraq. We then drew a stratified random sample of 288 deployment records and stratified the sample to isolate potential duplicate deployment records for the same federal civilian. We found two duplicate records and removed them from both the population and sample, as shown in table 12. We also removed another 14 deployment records from our sample because those DOD federal civilians had been deployed to locations other than Afghanistan or Iraq, and were not eli

gible for the duty population. In addition, we removed another 13 deployment records that were originally selected as potential replacement records; however, we found that those replacements were not needed. Ultimately, we identified 238 in-scope responses, for a weighted response rate of 87 percent. Each sampled record was subsequently weighted in the analysis to represent all DOD federal civilians deployed to Afghanistan or Iraq. The disposition of the federal civilian deployment records we reviewed at Fo

rt Benning are summarized in the following table: Our probability sample is only one of a large number of samples that we might have drawn. Because each sample could have provided different estimates, we express our confidence in the precision of our particular sample’s results as a 95 percent confidence interval. This is the interval that would contain the actual population value for 95 percent of the Fort Benning, Ga., samples we could have drawn. All percentage estimates from our sample have margins of e

rror (that is, widths of confidence intervals) of plus or minus 5 percentage points or less, at the 95 percent confidence level, unless otherwise noted. We took steps to assess the reliability of DOD federal civilian deployment and health data for the purposes of this review, including consideration of issues such as the completeness of the data from the respective information systems’ program managers and administrators. We also examined whether the data were subjected to quality control measures such as p

eriodic testing of the data against deployment records to ensure the accuracy and reliability of the data. In addition, we reviewed existing documentation related to the data sources and interviewed knowledgeable agency officials about the data. We did not find these deployment and health data to be sufficiently reliable for (1) identifying the universe of DOD federal civilian deployments or (2) use as the sole source for reviewing the health and immunization information for all DOD federal civilian deploym

ents, but we found the information systems to be sufficiently reliable when used as one of several sources in our review of deployment records. In those instances where we did not find a deployment health assessment or immunization in either the deployment records or in the electronic data systems, we concluded that the health assessment or immunization was not documented. To determine the extent to which DOD has established and the components have implemented medical treatment policies for DOD federal civi

lians who deployed in support of contingency operations, we examined pertinent medical treatment policies for DOD federal civilian employees who required treatment for injuries and diseases sustained while supporting contingency operations. In addition, we obtained workers’ compensation claims filed by DOD federal civilian personnel with the Department of Labor’s Office of Workers’ Compensation Programs(OWCP) showing those civilians who sustained injuries and diseases during deployment. We selected and revi

ewed a non-probability sample of claims to assess the components’ processes and procedures for implementing DOD’s medical treatment policies across a range of civilian casualties including injuries, physical and mental illnesses, and diseases. The scope of our review did not extend to the Department of Labor’s claims review process. To identify special pays and benefits provided to DOD federal civilians who deployed in support of contingency operations and to assess the extent that special pays and benefits

differ from those provided to deployed active duty military personnel, we examined major statutory provisions for special pays, disability and death benefits for federal civilians and military personnel, including relevant chapters of Title 5 of the U.S. Code governing federal civilian personnel management; relevant chapters of Title 10 of the U.S. Code governing armed forces personnel management; Section 112 of Title 26 of the U.S. Code governing combat zone tax exemption; relevant chapters of Title 37 of

the U.S. Code governing pay and allowances for the uniformed services; relevant chapters of Title 38 of the U.S. Code governing veterans’ benefits; relevant provisions of applicable public laws governing military and civilian pay and benefits; applicable directives and instructions related to active duty military and DOD federal civilian benefits and entitlements; DOD financial management regulations; Department of State regulations; and prior GAO reports. In addition, we discussed the statutes and guidanc

e with cognizant officials of the Office of the Under Secretary of Defense for Personnel and Readiness, military services’ headquarters, and the Defense Contract Management Agency involved with the administration of active duty and federal civilian personnel entitlements. We did not perform a comprehensive review of all compensation—comprised of a myriad of pays and benefits—offered to active duty military and federal civilian personnel in general. Our analysis focused on selected elements of compensation s

uch as special pays (e.g., hostile fire/imminent danger pay). Also, we did not make direct analytical comparisons between compensation and benefits offered by DOD to deployed federal civilian and military personnel because such comparisons must account for the demands of the military service, such as involuntary relocation, frequent and lengthy separations from family, and liability for combat. After reviewing documents and interviewing officials, we then compiled and analyzed the information on the types a

nd amounts of special pays and benefits available to active duty military and DOD federal civilian personnel who deployed to Afghanistan or Iraq. We interviewed DOD officials to discuss the basis for any differences in compensation. In addition, to illustrate how special pays affect overall compensation provided to DOD federal civilian and military personnel, we modeled scenarios for both groups using similar circumstances, such as length of deployment, pay grades, special pays (e.g., post differential pay,

danger pay, overtime pay, family separation allowance, basic allowance for housing, basic allowance for subsistence), and duty location. Through discussions with senior DOD officials, we made an assumption that deployed DOD federal civilians worked 30 hours of overtime per week. For deployed DOD federal civilians, we subtracted a contribution of $15,000 to the Thrift Savings Plan (TSP) to obtain the adjusted gross income. We assumed that DOD federal civilians, temporarily at a higher tax bracket, would tak

e maximum advantage of the opportunity to defer taxes. We assumed that the military personnel would contribute a smaller percentage of pay, 5 percent of gross income, to TSP. We made this assumption because much of the military pay was not subject to federal taxes, which removes the incentive to contribute to TSP, and because unlike for federal workers, military TSP does not have a matching component. For military personnel, we also deducted the amount of pay not subject to taxes due to the combat zone excl

usion, family separation allowance, basic allowance for subsistence, and basic allowance for housing. Using these assumptions, we generated an adjusted gross income and used that as input into a commercial tax program, Turbo Tax, to obtain federal taxes owed. We assumed that both DOD federal civilian and military personnel were married, filing jointly, with a spouse that earned no income. We assumed that the family had two children and qualified for two child tax credits, and the Earned Income Tax Credit, i

f at that income level. This resulted in four exemptions and a standard deduction of $10,000 in 2005. For purposes of validation, we repeated this exercise using an alternate tax program, Tax Cut, and obtained identical results. We conducted our review from March 2006 to August 2006 in accordance with generally accepted government auditing standards. Both DOD federal civilian and military personnel are eligible to receive disability benefits when they sustain a line-of-duty injury. However, these benefits v

ary in amount. Table 13 shows the temporary disability benefits available to eligible DOD federal civilian and military personnel. As table 13 shows, DOD federal civilians who are injured in the line of duty are eligible to receive continuation of their salary up to 45 days, followed by a recurring payment for wage loss that is based on a percentage of their salary and the existence of dependents, up to a cap. In contrast, military personnel receive continuation of their salaries for generally no longer tha

n a year, followed by a recurring payment for wage loss, which is based on the degree of disability and their number of dependents, and temporary retirement pay based on salary for up to 5 years. When a partial disability is determined to be permanent, both DOD federal civilians and military personnel are eligible to continue receiving recurring compensation payments, but again, the amounts of these benefits vary, as shown in table 14. As table 14 shows, DOD federal civilian personnel with permanent partial

disabilities receive payments based on salary and dependents while military personnel receive payments based on the severity of the injury and their number of dependents, as long as the condition persists. In addition to the contact named above, Sandra Burrell, Assistant Director; William Bates; Dr. Benjamin Bolitzer; Alissa Czyz; George Duncan; Steve Fox; Dawn Godfrey; Nancy Hess; Lynn Johnson; Barbara Joyce; Dr. Ronald La Due Lake; William Mathers; Paul Newton; Dr. Charles Perdue; Jason Porter; Julia Mat

ta; Susan Tieh; John Townes; and Dr. Monica Wolford made key contributions to this report.

Most income derived from private sector business activity in the United States is subject to federal corporate income tax, the individual income tax, or both. The tax treatment that applies to a business depends on its legal form of organization. Firms that are organized under the tax code as “C” corporations (which include most large, publicly held corporations) have their profits taxed once at the entity level under the corporate income tax (on a form 1120) and then a second time under the individual inco

me tax when profits are transferred to individual shareholders in the form of dividends or realized capital gains. Firms that are organized as “pass-through” entities, such as partnerships, limited liability companies, and “S” corporations are generally not taxed at the entity level; however, their net incomes are passed through each year and taxed in the hands of their partners or shareholders under the individual income tax (as part of those taxpayers’ form 1040 filing). Similarly, income from businesses

that are owned by single individuals enters into the taxable incomes of those owners under the individual income tax and is not subject to a separate entity-level tax. The base of the federal corporate income tax includes net income from business operations (receipts, minus the costs of purchased goods, labor, interest, and other expenses). It also includes net income that corporations earn in the form of interest, dividends, rent, royalties, and realized capital gains. The statutory rate of tax on net corp

orate income ranges from 15 to 35 percent, depending on the amount of income earned. The United States taxes the worldwide income of domestic corporations, regardless of where the income is earned, with a foreign tax credit for certain taxes paid to other countries. However, the timing of the tax liability depends on several factors, including whether the income is from a U.S. or foreign source and, if it is from a foreign source, whether it is earned through direct operations or through a subsidiary. The b

ase of the individual income tax covers business-source income paid to individuals, such as dividends, realized net capital gains on corporate equity, and income from self-employment. The statutory rates of tax on net taxable income range from 10 percent to 35 percent. Lower rates (generally 5 percent and 15 percent, depending on taxable income) apply to long-term capital gains and dividend income. Sole proprietors also pay both the employer and employee shares of social insurance taxes on their net busines

s income. Generally, a U.S. citizen or resident pays tax on his or her worldwide income, including income derived from foreign-source dividends and capital gains subject to a credit for foreign taxes paid on such income. Three long-standing criteria—economic efficiency, equity, and a combination of simplicity, transparency and administrability—are typically used to evaluate tax policy. These criteria are often in conflict with each other, and as a result, there are usually trade-offs to consider and people

are likely to disagree about the relative importance of the criteria. Specific aspects of business taxes can be evaluated in terms of how they support or detract from the efficiency, equity, simplicity, transparency, and administrability of the overall tax system. To the extent that a tax system is not simple and efficient, it imposes costs on taxpayers beyond the payments they make to the U.S. Treasury. As shown in figure 1, the total cost of any tax from a taxpayer’s point of view is the sum of the tax li

ability, the cost of complying with the tax system, and the economic efficiency costs that the tax imposes. In deciding on the size of government, we balance the total cost of taxes with the benefits provided by government programs. A complete evaluation of the tax treatment of businesses, which is a critical element of our overall federal tax system, cannot be made without considering how business taxation interacts with and complements the other elements of the overall system, such as the tax treatment of

individuals and excise taxes on selected goods and services. This integrated approach is also appropriate for evaluating reform alternatives, regardless of whether those alternatives take the form of a simplified income tax system, a consumption tax system, or some combination of the two. Businesses contribute significant revenues to the federal government, both directly and indirectly. As figure 2 shows, corporate businesses paid $278 billion in corporate income tax directly to the federal government in 2

005. Individuals earn income from business investment in the form of dividends and realized capital gains from C corporations; income allocations from partnerships and S corporations; entrepreneurial income from their own sole proprietorships; and rents and royalties. In recent years this business- source income, which is all taxed under the individual income tax, has amounted to between roughly 14 percent and 19 percent of the income of individuals who have paid individual income tax. In addition to the ta

xes that are paid on business-source income, most of the remainder of federal taxes is collected and passed on to the government by businesses. Business tax revenues of the magnitude discussed make them very relevant to considerations about how to address the nation’s long-term fiscal imbalance. Over the long term, the United States faces a large and growing structural budget deficit primarily caused by demographic trends and rising health care costs as shown in figure 3, and exacerbated over time by growin

g interest on the ever-larger federal debt. Continuing on this imprudent and unsustainable fiscal path will gradually erode, if not suddenly damage, our economy, our standard of living, and ultimately our national security. We cannot grow our way out of this long-term fiscal challenge because the imbalance between spending and revenue is so large. We will need to make tough choices using a multipronged approach: (1) revise budget processes and financial reporting requirements; (2) restructure entitlement pr

ograms; (3) reexamine the base of discretionary spending and other spending; and (4) review and revise tax policy, including tax expenditures, and tax enforcement programs. Business tax policy, business tax expenditures, and business tax enforcement need to be part of the overall tax review because of the amount of revenue at stake. Business tax expenditures reduce the revenue that would otherwise be raised from businesses. As already noted, to reduce their tax liabilities, businesses can take advantage of

preferential provisions in the tax code, such as exclusions, exemptions, deductions, credits, preferential rates, and deferral of tax liability. Tax preferences—which are legally known as tax expenditures—are often aimed at policy goals similar to those of federal spending programs. For example, there are different tax expenditures intended to encourage economic development in disadvantaged areas and stimulate research and development, while there are also federal spending programs that have similar purpose

s. Also, by narrowing the tax base, business tax expenditures have the effect of raising either business tax rates or the rates on other taxpayers in order to generate a given amount of revenue. The design of the current system of business taxation causes economic inefficiency and is complex. The complexity provides fertile ground for noncompliance and raises equity concerns. Our current system for taxing business income causes economic inefficiency because it imposes significantly different effective rates

of tax on different types of investments. Tax treatment that is not neutral across different types of capital investment causes significant economic inefficiency by guiding investments to lightly taxed activities rather than those with high pretax productivity. However, the goal of tax policy is not to eliminate efficiency costs. The goal is to design a tax system that produces a desired amount of revenue and balances economic efficiency with other objectives, such as equity, simplicity, transparency, and

administrability. Every practical tax system imposes efficiency costs. There are some features of current business taxation that have attracted criticism by economists and other tax experts because of efficiency costs. My point in raising them here is not that these features need to be changed—that is a policy judgment for Congress to make as it balances various goals. Rather, my point is that these economic consequences of tax policy need to be considered as we think about reform. The following are among t

he most noted cases of nonneutral taxation in the federal business tax system: Income earned on equity-financed investments made by C corporations is taxed twice—under both the corporate and individual income taxes, whereas no other business income is taxed more than once. Moreover, even noncorporate business investment is taxed more heavily than owner-occupied housing—a form of capital investment that receives very preferential treatment. As a result, resources have been shifted away from higher-return bus

iness investment into owner-occupied housing, and, within the business sector, resources have been shifted from higher-return corporations to noncorporate businesses. Such shifting of investment makes workers less productive than they would be under a more neutral tax system. This results in employees receiving lower wages because increases in employee wages are generally tied to increases in productivity. As noted above, such efficiency costs may be worth paying in order to meet other policy goals. For exa

mple, many policymakers advocate increased homeownership as a social policy goal. Depreciation allowances under the tax code vary considerably in generosity across different assets causing effective tax rates to vary and, thereby, favoring investment in certain assets over others. For example, researchers have found that the returns on most types of investments in equipment are taxed more favorably than are most investments in nonresidential buildings. These biases shift resources away from some investments

in buildings that would have been more productive than some of the equipment investments that are being made instead. Tax rules for corporations favor the use of debt over shareholder equity as a source of finance for investment. The return on debt- financed investment consists of interest payments to the corporation’s creditors, which are deductible by the corporations. Consequently, that return is taxed only once—in the hands of the creditors. In contrast, the return on equity-financed investment consist

s of dividends and capital gains, which are not deductible by the corporation. These forms of income that are taxed under the individual tax are paid out of income that has already been subject to the corporate income tax. The bias against equity finance induces corporations to have less of an “equity cushion” against business downturns. Capital gains on corporate equity are taxed more favorably than dividends because that tax can be deferred until the gains are realized (typically when shareholders sell th

eir stock). This bias against dividend payments likely means that more profits are retained within corporations than otherwise would be the case and, therefore, the flow of capital to its most productive uses is being constrained. The complex set of rules governing U.S. taxation of the worldwide income of domestic corporations (those incorporated in the United States) leads to wide variations in the effective rate of tax paid on that income, based on the nature and location of each corporation’s foreign ope

rations and the effort put into tax planning. In effect, the active foreign income of some U.S. corporations is taxed more heavily than if the United States followed the practice of many other countries and exempted such income from tax. However, other U.S. corporations are able to take advantage of flexibilities in the U.S. tax rules in order to achieve treatment that is equivalent to or, in some cases, more favorable than the so-called “territorial” tax systems that exempt foreign-source active business i

ncome. As a consequence, some U.S. corporations face a tax disadvantage, while others have an advantage, relative to foreign corporations when competing in foreign countries. Those U.S. corporations that have a disadvantage are likely to locate a smaller share of their investment overseas than would be the case in a tax-free world; the opposite is true for those U.S. corporations with the tax advantage. Moreover, the tax system encourages U.S. corporations to alter their cash-management and financing decisi

ons (such as by delaying the repatriation of profits) in order to reduce their taxes. The taxation of business income is part of the broader taxation of income from capital. The taxation of capital income in general (even when that taxation is uniformly applied) causes another form of inefficiency beyond the inefficiencies caused by the aforementioned cases of differential taxation across types of investments. This additional inefficiency occurs because taxes on capital reduce the after-tax return on saving

s and, thereby, distort the choice that individuals make between current consumption and saving for future consumption. However, although research shows that the demand for some types of savings, such as the demand for tax exempt bonds, is responsive to tax changes, there is greater uncertainty about the effects of tax changes on other choices, such as aggregate savings. Sometimes the concerns about the negative effects of taxation on the U.S. economy are couched in terms of “competitiveness,” where the vag

uely defined term competitiveness is often defined as the ability of U.S. businesses to export their products to foreign markets and to compete against foreign imports into the U.S. market. The goal of those who push for this type of competitiveness is to improve the U.S. balance of trade. However, economists generally agree that trying to increase the U.S. balance of trade through targeted tax breaks for exports does not work. Such a policy, aimed at lowering the prices of exports, would be offset by an in

crease in the value of the dollar which would make U.S. exports more expensive and imports into the Unites States less expensive, ultimately leaving both the balance of trade and the standard of living of Americans unchanged. An alternative definition of competitiveness that is also sometimes used in tax policy debates refers to the ability of U.S.-owned firms operating abroad to compete in foreign markets. The current U.S. policy of taxing the worldwide income of U.S. businesses places some of their foreig

n operations at a disadvantage. The tradeoffs between a worldwide system and a territorial tax system are discussed below. Tax compliance requirements for businesses are extensive and complex. Rules governing the computation of taxable income, expense deductions, and tax credits of U.S. corporations that do business in multiple foreign countries are particularly complex. But even small businesses face multiple levels of tax requirements of varying difficulty. In addition to computing and documenting their i

ncome, expenses, and qualifications for various tax credits, businesses with employees are responsible for collecting and remitting (at varying intervals) several federal taxes on the incomes of those employees. Moreover, if the businesses choose to offer their employees retirement plans and other fringe benefits, they can substantially increase the number of filings they must make. Businesses also have information-reporting responsibilities—employers send wage statements to their employees and to IRS; bank

s and other financial intermediaries send investment income statements to clients and to IRS. Finally, a relatively small percentage of all businesses (which nevertheless number in the hundreds of thousands) are required to participate in the collection of various federal excise taxes levied on fuels, heavy trucks and trailers, communications, guns, tobacco, and alcohol, among other products. It is difficult for researchers to accurately estimate compliance costs for the tax system as a whole or for particu

lar types of taxpayers because taxpayers generally do not keep records of the time and money spent complying with tax requirements. Studies we found that focus on the compliance costs of businesses estimate them to be between about $40 billion and $85 billion per year. None of these estimates include the costs to businesses of collecting and remitting income and payroll taxes for their employees. The accuracy of these business compliance cost estimates is uncertain due to the low rates of response to their

data-collection surveys. In addition, the range in estimates across the studies is due, among other things, to differences in monetary values used (ranging between $25 per hour and $37.26 per hour), differences in the business populations covered, and differences in the tax years covered. Although the precise amount of business tax avoidance is unknown, IRS’s latest estimates of tax compliance show a tax gap of at least $141 billion for tax year 2001 between the business taxes that individual and corporate

taxpayers paid and what they should have paid under the law. Corporations contributed about $32 billion to the tax gap by underreporting about $30 billion in taxes on tax returns and failing to pay about $2 billion in taxes that were reported on returns. Individual taxpayers that underreported their business income accounted for the remaining $109 billion of the business income tax gap. A complex tax code, complicated business transactions, and often multinational corporate structures make determining busin

ess tax liabilities and the extent of corporate tax avoidance a challenge. Tax avoidance has become such a concern that some tax experts say corporate tax departments have become “profit centers” as corporations seek to take advantage of the tax laws in order to maximize shareholder value. Some corporate tax avoidance is clearly legal, some falls in gray areas of the tax code, and some is clearly noncompliance or illegal, as shown by IRS’s tax gap estimate. Often business tax avoidance is legal. For example

, multinational corporations can locate active trade or business operations in jurisdictions that have lower effective tax rates than does the United States and, unless and until they repatriate the income, defer taxation in the United States on that income, thus reducing their effective tax rate. In addition, investors can avoid paying the corporate income tax by putting their money into unincorporated businesses or into real estate. Complicating corporate tax compliance is the fact that in many cases the

law is unclear or subject to differing interpretations. In fact, some have postulated that major corporations’ tax returns are actually just the opening bid in an extended negotiation with IRS to determine a corporation’s tax liability. An illustration—once again from the complex area of international tax rules—is transfer pricing. Transfer pricing involves setting the appropriate price for such things as goods, services, or intangible property (such as patents, trademarks, copyrights, technology, or “know-

how”) that is transferred between the U.S.-based operations of a multinational company and a foreign affiliate. If the price paid by the affiliate to the U.S. operation is understated, the profits of the U.S. operation are reduced and U.S. taxable income is inappropriately reduced or eliminated. The standard for judging the correct price is the price that would have been paid between independent enterprises acting at “arm’s length.” However, it can be extremely difficult to establish what an arm’s length pr

ice would be. Given the global economy and the number of multinational firms with some U.S.-based operations, opportunities for transfer pricing disputes are likely to grow. Tax shelters are one example of how tax avoidance, including corporate tax avoidance, can shade into the illegal. Some tax shelters are legal though perhaps aggressive interpretations of the law, but others cross the line. Abusive shelters often are complex transactions that manipulate many parts of the tax code or regulations and are t

ypically buried among legitimate transactions reported on tax returns. Because these transactions are often composed of many pieces located in several parts of a complex tax return, they are essentially hidden from plain sight, which contributes to the difficulty of determining the scope of the abusive shelter problem. Often lacking economic substance or a business purpose other than generating tax benefits, abusive shelters have been promoted by some tax professionals, often in confidence, for significant

fees, sometimes with the participation of tax-indifferent parties, such as foreign or tax-exempt entities. These shelters may involve unnecessary steps and flow-through entities, such as partnerships, which make detection of these transactions more difficult. Regarding compliance with our tax laws, the success of our tax system hinges greatly on individual and business taxpayers’ perception of its fairness and understandability. Compliance is influenced not only by the effectiveness of IRS’s enforcement eff

orts but also by Americans’ attitudes about the tax system and their government. A recent survey indicated that about 10 percent of respondents say it is acceptable to cheat on their taxes. Furthermore, the complexity of, and frequent revisions to, the tax system make it more difficult and costly for taxpayers who want to comply to do so and for IRS to explain and enforce tax laws. The lack of transparency also fuels disrespect for the tax system and the government. Thus, a crucial challenge in evaluating o

ur business tax system will be to determine how we can best strengthen enforcement of existing laws to give businesses owners confidence that their competitors are paying their fair share and to give wage earners confidence that businesses in general bear their share of taxes. One option that has been suggested as a means of improving public confidence in the tax system’s fairness is to make the reconciliation between book and tax income that businesses present on schedule M-3 of their tax returns available

for public review. Reform of our business tax system will necessarily mean making broad design choices about the overall tax system and how business taxes are coordinated with other taxes. The tax reform debate of the last several years has focused attention on several important choices, including the extent to which our system should be closer to the extreme of a pure income tax or the other extreme of a pure consumption tax, the extent to which sales by U.S. businesses outside of this country should be t

axed, the extent to which taxes should be collected from businesses or individuals, and the extent to which taxpayers are compensated for losses or costs they incur during the transition to any new tax system. Generally there is no single “right” decision about these choices and the options are not limited to selecting a system that is at one extreme or the other along the continuum of potential systems. The choices will involve making tradeoffs between the various goals for our tax system. The fundamental

difference between income and consumption taxes lies in their treatment of savings and investment. Income can be used for either consumption or saving and investment. The tax base of a pure income tax includes all income, regardless of what it is ultimately used for; in contrast, the tax base of a consumption tax excludes income devoted to saving and investment (until it is ultimately used for consumption). The current tax system is a hybrid between a pure income tax and a pure consumption tax because it ef

fectively exempts some types of savings and investment but taxes other types. As noted earlier, evidence is inconclusive regarding whether a shift closer to a consumption tax base would significantly affect the level of savings by U.S. taxpayers. There is, however, a consensus among economists that uneven tax treatment across different types of investment should be avoided unless the efficiency costs resulting from preferential tax treatment are outweighed by the social benefits generated by the tax prefere

nce. That objective could be achieved under either a consumption tax that exempts all new savings and investment from taxation (which means that all business profits are exempt) or a revised income tax that taxed all investments at the same effective rate. In comparison to the current system, a consumption tax’s exemption of business-source income would likely encourage U.S. businesses to increase their investment in the United States relative to their foreign investment. Both income and consumption taxes c

an be structured in a variety of ways, as discussed in the following subsections, and the choice of a specific design for either type of tax can have as significant implications for efficiency, administrability, and equity as the choice between a consumption or income base. The exemption of saving and investment can be accomplished in different ways, so consumption taxes can be structured differently and yet still have the same overall tax base. Both income and consumption taxes can be levied on individuals

or businesses, or on a combination of the two. Whether collected from individuals or businesses, ultimately, individuals will bear the economic burden of any tax (as wage earners, shareholders, or consumers). The choice of whether to collect a tax at the business level or the individual level depends on whether it is thought to be desirable to levy different taxes on different individuals. A business-level tax, whether levied on income or consumption, can be collected “at source”—that is, where it is gener

ated—so there can be many fewer tax filers and returns to administer. Business-level taxes cannot, however, directly tax different individuals at different rates. Individual-level taxes can allow for distinctions between different individuals; for example, standard deductions or graduated rates can be used to tax individuals with low income (or consumption) at a lower rate than individuals with greater income (or consumption). However, individual-level taxes require more tax returns, impose higher complianc

e costs, and would generally require a larger tax administration system. A national retail sales tax, a consumption value-added tax, and an income value-added tax are examples of taxes that would be collected only at the business level. A personal consumption tax and an integrated individual income tax are examples of taxes that would be collected only at the individual level. The “flat tax” proposed by economists Robert Hall and Alvin Rabushka that has received attention in recent years is an example of a

tax collected at both the business and individual level. Our current system for taxing corporate-source income involves taxation at both the corporate and individual level in a manner that results in the double taxation of the same income. Under a pure worldwide tax system the United States would tax the income of U.S. corporations, as it is earned, regardless of where it is earned, and at the same time provide a foreign tax credit that ensures that the combined rate of tax that a corporation pays to all go

vernments on each dollar of income is exactly equal to the U.S. corporate tax rate. Some basic differences between the current U.S. tax system and a pure worldwide system are that (1) in many cases the U.S. system permits corporations to defer U.S. tax on their foreign-source income until it is repatriated and (2) the U.S. foreign tax credit is limited to the amount of U.S. tax that would be due on a corporation’s foreign-source income. In cases where the rate of foreign tax on a corporation’s income exceed

s the U.S. tax rate, the corporation is left paying the higher rate of tax. Under a pure territorial tax system the United States would simply exempt all foreign-source income. (No major country has a pure territorial system; they all tax mobile forms of foreign-source income, such as royalties and income from securities.) The current U.S. tax system has some features that result in some cases in treatment similar to what would exist under a territorial system. First, corporations can defer U.S. tax indefin

itely on certain foreign-source income, as long as they keep it reinvested abroad. Second, in certain cases U.S. corporations are able to use the excess credits that they earned for taxes they paid to high-tax countries to completely offset any U.S. tax that they would normally have to pay on income they earned in low-tax countries. As a result, that income from low-tax countries remains untaxed by the United States—just as it would be under a territorial system. In fact, there are some cases where U.S. cor

porations enjoy tax treatment that is more favorable than under a territorial system. This occurs when they pay no U.S. tax on foreign-source income yet are still able to deduct expenses allocable to that income. For example, a U.S. parent corporation can borrow money and invest it in a foreign subsidiary. The parent corporation generally can deduct its interest payments from its U.S. taxes even if it defers U.S. tax on the subsidiary’s income by leaving it overseas. Proponents of a worldwide tax system and

proponents of a territorial system both argue that their preferred systems would provide important forms of tax neutrality. Under a pure worldwide system all of the income that a U.S. corporation earns abroad would be taxed at the same effective rate that a corporation earning the same amount of income domestically would pay. Such a tax system is neutral in the sense that it does not influence the decision of U.S. corporations to invest abroad or at home. If the U.S. had a pure territorial tax system all o

f the income that U.S. corporations earn in a particular country would be taxed at the same rate as corporations that are residents of that country. The pure territorial system is neutral in the specific sense that U.S. corporations investing in a foreign country would not be at a disadvantage relative to corporations residing in that country or relative to other foreign corporations investing there. In a world where each country sets its own tax rules it is impossible to achieve both types of neutrality at

the same time, so tradeoffs are unavoidable. A change from the current tax system to a pure territorial one is likely to have mixed effects on tax compliance and administration. On the one hand, a pure worldwide tax system, or even the current system, may preserve the U.S. tax base better than a territorial system would because U.S. taxpayers would have greater incentive under a territorial system to shift income and investment into low-tax jurisdictions via transfer pricing. On the other hand, a pure terr

itorial system may be less complex for IRS to administer and for taxpayers to comply with than the current tax system because there would be no need for the antideferral rules or the foreign tax credit, which are among the most complex features of the current system. Broad-based consumption taxes can differ depending on whether they are imposed under a destination principle, which holds that goods and services should be taxed in the countries where they are consumed, or an origin principle, which holds that

goods and services should be taxed in the countries where they are produced. In the long run, after markets have adjusted, neither type of tax would have a significant effect on the U.S. trade balance. This is true for a destination-based tax because products consumed in the United States would be taxed at the same rate, regardless of where they were produced. Therefore, such a tax would not influence a consumer’s choice between buying a car produced in the United States or one imported from Japan. And at

the same time, U.S. exports of cars would not be affected by the tax because they would be exempted. An origin-based consumption tax would not affect the trade balance because the tax effects that taxes have on prices would ultimately be countered by the same price adjustment mechanism that we discussed earlier with respect to targeted tax subsidies for exports. A national retail sales tax limited to final consumption goods would be a destination-principle tax; it would tax imports when sold at retail in th

is country and would not tax exports. Value-added taxes can be designed as either destination or origin-principle taxes. A personal consumption tax, collected at the individual level, would apply to U.S. residents or citizens and could be formulated to tax their consumption regardless of whether it is done domestically or overseas. Under such a system, income earned abroad would be taxable but funds saved or invested abroad would be deductible. In that case, foreign- produced goods imported into the United

States or consumed by U.S. citizens abroad would be taxed. U.S. exports would only be taxed to the extent that they are consumed by U.S. citizens abroad. A wide range of options exist for moving from the current business tax system to an alternative one, and the way that any transition is formulated could have significant effects for economic efficiency, equity, taxpayer compliance burden, and tax administration. For example, one transition issue involves whether tax credits and other tax benefits already e

arned under the current tax would be made available under a new system. Businesses that are deducting depreciation under the current system would not have the opportunity to continue depreciating their capital goods under a VAT unless special rules were included to permit it. Similar problems could arise with businesses’ carrying forward net operating losses and recovering unclaimed tax credits. Depending on how these and other issues are addressed, taxpayer compliance burden and tax administration responsi

bilities could be greater during the transition period than they currently are or than they would be once the transition ends. Transition rules could also substantially reduce the new system’s tax base, thereby requiring higher tax rates during the transition if revenue neutrality were to be achieved. Our publication, Understanding the Tax Reform Debate: Background, Criteria, and Questions, may be useful in guiding policymakers as they consider tax reform proposals. It was designed to aid policymakers in th

inking about how to develop tax policy for the 21st century. The criteria for a good tax system, which our report discusses, provide the basis for a set of principles that should guide Congress as it considers the choices and tradeoffs involved in tax system reform. And, as I also noted earlier, proposals for reforming business taxation cannot be evaluated without considering how that business taxation will interact with and complement the other elements of our overall future tax system. The proposed system

should raise sufficient revenue over time to fund our expected expenditures. As I mentioned earlier, we will fall woefully short of achieving this end if current spending or revenue trends are not altered. Although we clearly must restructure major entitlement programs and the basis of other federal spending, it is unlikely that our long-term fiscal challenge will be resolved solely by cutting spending. The proposal should look to future needs. Like many spending programs, the current tax system was develo

ped in a profoundly different time. We live now in a much more global economy, with highly mobile capital, and with investment options available to ordinary citizens that were not even imagined decades ago. We have growing concentrations of income and wealth. More firms operate multinationally and willingly move operations and capital around the world as they see best for their firms. As an adjunct to looking forward when making reforms, better information on existing commitments and promises must be couple

d with estimates of the long-term discounted net present value costs from spending and tax commitments comprising longer-term exposures for the federal budget beyond the existing 10-year budget projection window. The tax base should be as broad as possible. Broad-based tax systems with minimal exceptions have many advantages. Fewer exceptions generally means less complexity, less compliance cost, less economic efficiency loss, and by increasing transparency may improve equity or perceptions of equity. This

suggests that eliminating or consolidating numerous tax expenditures must be considered. In many cases tax preferences are simply a form of “back-door spending.” We need to be sure that the benefits achieved from having these special provisions are worth the associated revenue losses just as we must ensure that outlay programs— which may be attempting to achieve the same purposes as tax expenditures—achieve outcomes commensurate with their costs. And it is important to supplement these cost-benefit evaluati

ons with analyses of distributional effects—i.e., who bears the costs of the preferences and who receives the benefits. To the extent tax expenditures are retained, consideration should be given to whether they could be better targeted to meet an identified need. If we must raise revenues, doing so from a broad base and a lower rate will help minimize economic efficiency costs. Broad-based tax systems can yield the same revenue as more narrowly based systems at lower tax rates. The combination of less direc

t intervention in the marketplace from special tax preferences, and the lower rates possible from broad-based systems, can have substantial benefits for economic efficiency. For instance, one commonly cited rule of thumb regarding economic efficiency costs of tax increases is that they rise proportionately faster than the tax rates. In other words, a 10 percent tax increase could raise the economic efficiency costs of a tax system by much more than 10 percent. Aside from the base-broadening that minimizes t

argeted tax preferences favoring specific types of investment or other business behavior, it is also desirable on the grounds of economic efficiency to extend the principle of tax neutrality to the broader structural features of a business tax system. For example, improvements in economic efficiency can also be gained by avoiding differences in tax treatment, such as the differences in the current system based on legal form of organization, source of financing, and the nature and location of foreign operati

ons. Removing such differences can shift resources to more productive uses, increasing economic performance and the standard of living of Americans. Shifting resources to more productive uses can result in a step up in the level of economic activity which would be measured as a one-time increase in the rate of growth. Tax changes that increase efficiency can also increase the long-term rate of economic growth if they increase the rate of technological change; however, not all efficiency-increasing tax chang

es will do so. Impact on the standard of living of Americans is also a useful criterion for evaluating policies to improve U.S. competitiveness. As was discussed earlier, narrower goals and policies, such as increasing the U.S. balance of trade through targeted tax breaks aimed at encouraging exports, are generally viewed as ineffective by economists. What determines the standard of living of Americans and how it compares to the standard of living in other countries is the productivity of American workers a