Business Tax Reform
Simplification and Increased Uniformity of Taxation Would Yield Benefits Gao ID: GAO-06-1113T September 20, 2006Business income taxes, both corporate and noncorporate, are a significant portion of federal tax revenue. Businesses also play a crucial role in collecting taxes from individuals, through withholding and information reporting. However, the design of the current system of business taxation is widely seen as flawed. It distorts investment decisions, hurting the performance of the economy. Its complexity imposes planning and record keeping costs, facilitates tax shelters, and provides potential cover for those who want to cheat. Not surprisingly, business tax reform is part of the debate about overall tax reform. The debate is occurring at a time when long-range projections show that, without a policy change, the gap between spending and revenues will widen. This testimony reviews the nation's long term fiscal imbalance and what is wrong with the current system of business taxation and provides some principles that ought to guide the debate about business tax reform. This statement is based on previously published GAO work and reviews of relevant literature.
The size of business tax revenues makes them very relevant to any plan for addressing the nation's long-term fiscal imbalance. Reexamining both federal spending and revenues, including business tax policy and compliance must be part of a multipronged approach to address the imbalance. Some features of current business taxes channel investments into tax-favored activities and away from more productive activities and, thereby, reduce the economic well-being of all Americans. Complexity in business tax laws imposes costs of its own, facilitates tax shelters, and provides potential cover for those who want to cheat. IRS's latest estimates show a business tax gap of at least $141 billion for 2001. This in turn undermines confidence in the fairness of our tax system--citizens' confidence that their friends, neighbors, and business competitors pay their fair share of taxes. Principles that should guide the business tax reform debate include: (1) The proposed system should raise sufficient revenue over time to fund our current and future expected expenditures. (2) The tax base should be as broad as possible, which helps to minimize overall tax rates. (3) The proposed system should improve compliance rates by reducing tax preferences and complexity and increasing transparency. (4) To the extent other goals, such as equity and simplicity, allow, the tax system should aim for neutrality by not favoring some business activities over others. More neutral tax policy has the potential to enhance economic growth, increase productivity and improve the competitiveness of the U.S. economy in terms of standard of living. (5) The consideration of transition rules must be an integral part of any reform proposal.
GAO-06-1113T, Business Tax Reform: Simplification and Increased Uniformity of Taxation Would Yield Benefits
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Testimony:
Before the Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
For Release on Delivery Expected at 10:00 a.m. EDT:
Wednesday, September 20, 2006:
Business Tax Reform:
Simplification and Increased Uniformity of Taxation Would Yield
Benefits:
Statement of David M. Walker:
Comptroller General of the United States:
GAO-06-1113T:
GAO Highlights:
Highlights of GAO-06-1113T, a Testimony to the Committee on Finance,
U.S. Senate
Why GAO Did This Study:
Business income taxes, both corporate and noncorporate, are a
significant portion of federal tax revenue. Businesses also play a
crucial role in collecting taxes from individuals, through withholding
and information reporting. However, the design of the current system of
business taxation is widely seen as flawed. It distorts investment
decisions, hurting the performance of the economy. Its complexity
imposes planning and record keeping costs, facilitates tax shelters,
and provides potential cover for those who want to cheat.
Not surprisingly, business tax reform is part of the debate about
overall tax reform. The debate is occurring at a time when long-range
projections show that, without a policy change, the gap between
spending and revenues will widen.
This testimony reviews the nation‘s long term fiscal imbalance and what
is wrong with the current system of business taxation and provides some
principles that ought to guide the debate about business tax reform.
This statement is based on previously published GAO work and reviews of
relevant literature.
What GAO Found:
The size of business tax revenues makes them very relevant to any plan
for addressing the nation's long-term fiscal imbalance. Reexamining
both federal spending and revenues, including business tax policy and
compliance must be part of a multipronged approach to address the
imbalance.
Figure: Distribution of Federal Tax Revenue by Type of Tax, Fiscal Year
2005 ($ billions):
[See PDF for Image]
Source: GAO analysis of data from the Office of Management and Budget
and from Internal Revenue Service (IRS).
[End of Figure]
Some features of current business taxes channel investments into tax-
favored activities and away from more productive activities and,
thereby, reduce the economic well-being of all Americans. Complexity in
business tax laws imposes costs of its own, facilitates tax shelters,
and provides potential cover for those who want to cheat. IRS‘s latest
estimates show a business tax gap of at least $141 billion for 2001.
This in turn undermines confidence in the fairness of our tax
system”citizens‘ confidence that their friends, neighbors, and business
competitors pay their fair share of taxes.
Principles that should guide the business tax reform debate include:
* The proposed system should raise sufficient revenue over time to fund
our current and future expected expenditures.
* The tax base should be as broad as possible, which helps to minimize
overall tax rates.
* The proposed system should improve compliance rates by reducing tax
preferences and complexity and increasing transparency.
* To the extent other goals, such as equity and simplicity, allow, the
tax system should aim for neutrality by not favoring some business
activities over others. More neutral tax policy has the potential to
enhance economic growth, increase productivity and improve the
competitiveness of the U.S. economy in terms of standard of living.
* The consideration of transition rules must be an integral part of any
reform proposal.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-1113T].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact James White at (202) 512-
9110 or whitej@gao.gov.
[End of Section]
Mr. Chairman and Members of the Committee:
I appreciate this opportunity to contribute to your consideration of
business tax reform.
Businesses, both corporate and noncorporate, are a crucial pillar of
our tax system. Corporate businesses paid $278 billion in federal
corporate income taxes in fiscal year 2005. In addition, between
roughly 14 and 19 percent of the income of individuals who pay federal
income tax comes from business sources.[Footnote 1] Beyond paying
income taxes, businesses are also responsible for remitting both the
employer and employee shares of social insurance taxes, which amounted
to $794 billion in fiscal year 2005. Businesses are vital to our tax
system in other ways too. They collect and remit a large fraction of
individual income taxes through withholding. They report information
about individuals' income and deductible expenses to the Internal
Revenue Service (IRS). Such withholding and third-party information
reporting greatly increases individual taxpayers' compliance while
reducing the size and intrusiveness of IRS.
Taxes are necessary because they fund a broad array of essential
services provided by the government. However, business taxes are part
of our overall fiscal system that, as the committee is aware, is
currently running large deficits and, as GAO's long-term budget
simulations illustrate, is projected to run ever larger deficits in the
future.
Beyond raising revenue, taxes affect business decision making, thereby
affecting the performance of the economy. Taxes are only one factor
affecting business decisions--others include input costs and market
conditions--but they are a key factor controlled by policymakers.
Making business decisions based on tax considerations, rather than on
the underlying economic benefits results in the channeling of some
investments into less productive activities. This, in turn, reduces the
standard of living of all Americans.
Complexity in business tax laws imposes costs of its own, facilitates
tax shelters, and provides cover for those who want to cheat. Although
the precise amount of business tax avoidance is unknown, IRS's latest
estimates show a business tax gap of at least $141 billion for 2001.
This in turn undermines confidence in the fairness of our tax system--
citizens' confidence that their friends, neighbors, and business
competitors are paying their fair share of taxes.
Not surprisingly, there is a growing debate about reforming the tax
system, including business taxes. The debate is partly about whether to
reform the current income tax so that it has a broader base and lower
rates or switch in whole or part to some form of a consumption tax. But
it is also about other fundamental design issues such as whether to
maintain different tax treatment for corporate and noncorporate
business and the extent to which business's foreign-source income
should be taxed. The President's Advisory Panel on Federal Tax Reform
has taken a major step in beginning this debate. The panel suggested
two alternative proposals for coordinated reform of the individual and
corporate income taxes.
My statement reviews the nation's long-term fiscal imbalance, describes
what is wrong with our current system of business taxation, lists some
of the major strategic choices we must make about how to tax businesses
in the future, and then provides some principles that ought to guide
the debate about business tax reform. These principles are based on
three long-standing criteria typically used to evaluate tax policy--
equity; economic efficiency; and a combination of simplicity,
transparency, and administrability--which are discussed later.[Footnote
2] The principles include the following:
* The proposed system should raise sufficient revenue over time to fund
our current and future expected expenditures.
* The tax base should be as broad as possible, which generally helps to
minimize tax rates, reduce complexity, lower compliance costs, lower
economic efficiency costs per dollar of revenue raised, and which may
improve equity.
* The proposed system should have attributes associated with high
compliance rates--namely, taxable transactions that are transparent and
few tax preferences or complex provisions.
* To the extent that other objectives, such as equity and simplicity,
allow, the tax system should aim for increased economic efficiency by
remaining as neutral as possible in its other structural features; for
example, avoiding differences in taxation based on legal form of
organization, source of financing, or type of asset. More neutral tax
policy has the potential to enhance economic growth, increase
productivity and improve the competitiveness of the U.S. economy in
terms of standard of living:
* Finally, the consideration of transition rules needs to be an
integral part of the design of a new system.
My statement today is drawn from previous GAO reports and testimonies
covering tax reform, alternative tax systems, and the costs of the
current system, which were done in accordance with generally accepted
government auditing standards, as well as reviews of relevant
literature. The discussions in this statement that are not based on our
own work reflect the consensus (and in some cases competing) views of
economists as summarized in studies by the Joint Committee on Taxation,
the Congressional Budget Office, the Congressional Research Service,
the Department of Treasury, and the President's Advisory Panel on
Federal Tax Reform. (See app. I for a list of relevant studies by GAO
and these other sources.)
Background:
Current Federal Taxation of Businesses:
Most income derived from private sector business activity in the United
States is subject to federal corporate income tax, the individual
income tax, or both. The tax treatment that applies to a business
depends on its legal form of organization. Firms that are organized
under the tax code as "C" corporations (which include most large,
publicly held corporations) have their profits taxed once at the entity
level under the corporate income tax (on a form 1120) and then a second
time under the individual income tax when profits are transferred to
individual shareholders in the form of dividends or realized capital
gains. Firms that are organized as "pass-through" entities, such as
partnerships, limited liability companies, and "S" corporations are
generally not taxed at the entity level; however, their net incomes are
passed through each year and taxed in the hands of their partners or
shareholders under the individual income tax (as part of those
taxpayers' form 1040 filing).[Footnote 3] Similarly, income from
businesses that are owned by single individuals enters into the taxable
incomes of those owners under the individual income tax and is not
subject to a separate entity-level tax.
The base of the federal corporate income tax includes net income from
business operations (receipts, minus the costs of purchased goods,
labor, interest, and other expenses). It also includes net income that
corporations earn in the form of interest, dividends, rent, royalties,
and realized capital gains. The statutory rate of tax on net corporate
income ranges from 15 to 35 percent, depending on the amount of income
earned.[Footnote 4] The United States taxes the worldwide income of
domestic corporations, regardless of where the income is earned, with a
foreign tax credit for certain taxes paid to other countries. However,
the timing of the tax liability depends on several factors, including
whether the income is from a U.S. or foreign source and, if it is from
a foreign source, whether it is earned through direct operations or
through a subsidiary.
The base of the individual income tax covers business-source income
paid to individuals, such as dividends, realized net capital gains on
corporate equity, and income from self-employment. The statutory rates
of tax on net taxable income range from 10 percent to 35 percent. Lower
rates (generally 5 percent and 15 percent, depending on taxable income)
apply to long-term capital gains and dividend income.[Footnote 5] Sole
proprietors also pay both the employer and employee shares of social
insurance taxes on their net business income. Generally, a U.S. citizen
or resident pays tax on his or her worldwide income, including income
derived from foreign-source dividends and capital gains subject to a
credit for foreign taxes paid on such income.
Criteria for Evaluating Business Tax Systems:
Three long-standing criteria--economic efficiency, equity, and a
combination of simplicity, transparency and administrability--are
typically used to evaluate tax policy. These criteria are often in
conflict with each other, and as a result, there are usually trade-offs
to consider and people are likely to disagree about the relative
importance of the criteria.
Specific aspects of business taxes can be evaluated in terms of how
they support or detract from the efficiency, equity, simplicity,
transparency, and administrability of the overall tax system. To the
extent that a tax system is not simple and efficient, it imposes costs
on taxpayers beyond the payments they make to the U.S. Treasury. As
shown in figure 1, the total cost of any tax from a taxpayer's point of
view is the sum of the tax liability, the cost of complying with the
tax system, and the economic efficiency costs that the tax imposes. In
deciding on the size of government, we balance the total cost of taxes
with the benefits provided by government programs.
Figure 1: Components of the Total Cost of a Tax to Taxpayers:
[See PDF for image]
Source: GAO.
[End of figure]
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.
Taxes on Business Income Are a Significant Source of Federal Revenue
and Must Be Part of the Overall Considerations for Fiscal Reform:
Businesses contribute significant revenues to the federal government,
both directly and indirectly. As figure 2 shows, corporate businesses
paid $278 billion in corporate income tax directly to the federal
government in 2005. Individuals earn income from business investment in
the form of dividends and realized capital gains from C corporations;
income allocations from partnerships and S corporations;
entrepreneurial income from their own sole proprietorships; and rents
and royalties. In recent years this business-source income, which is
all taxed under the individual income tax, has amounted to between
roughly 14 percent and 19 percent of the income of individuals who have
paid individual income tax.[Footnote 6] In addition to the taxes that
are paid on business-source income, most of the remainder of federal
taxes is collected and passed on to the government by businesses.
Figure 2: Distribution of Federal Tax Revenue by Type of Tax, 2005
(Billions of Dollars):
[See PDF for image]
Source: GAO analysis of data from the Office of Management and Budget
and from the Internal revenue service (IRS).
Note: The business source income referred to in the figure includes the
income of sole proprietors, income from partnerships and S
corporations, dividends, capital gains, rents, and royalties. The
percentage equals the ratio of (net business-source income minus
losses) over adjusted gross income. When computing these percentages we
did not include any income or losses of individuals who did not have a
tax liability in a given year.
[End of figure]
Business tax revenues of the magnitude discussed make them very
relevant to considerations about how to address the nation's long-term
fiscal imbalance. Over the long term, the United States faces a large
and growing structural budget deficit primarily caused by demographic
trends and rising health care costs as shown in figure 3, and
exacerbated over time by growing interest on the ever-larger federal
debt. [Footnote 7] 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.
Figure 3: Composition of Federal Spending as a Share of Gross Domestic
Product (GDP), Assuming Discretionary Spending Grows with GDP after
2006 and All Expiring Tax Provisions Are Extended:
[See PDF for image]
Source: GAO's August 2006 analysis.
Note: The revenue projection in this figure includes certain tax
provisions that expired at the end of 2005.
[End of figure]
We cannot grow our way out of this long-term fiscal challenge because
the imbalance between spending and revenue is so large. We will need to
make tough choices using a multipronged approach: (1) revise budget
processes and financial reporting requirements; (2) restructure
entitlement programs; (3) reexamine the base of discretionary spending
and other spending; and (4) review and revise tax policy, including tax
expenditures, and tax enforcement programs. Business tax policy,
business tax expenditures, and business tax enforcement need to be part
of the overall tax review because of the amount of revenue at stake.
Business tax expenditures reduce the revenue that would otherwise be
raised from businesses. As already noted, to reduce their tax
liabilities, businesses can take advantage of preferential provisions
in the tax code, such as exclusions, exemptions, deductions, credits,
preferential rates, and deferral of tax liability. Tax preferences--
which are legally known as tax expenditures--are often aimed at policy
goals similar to those of federal spending programs. For example, there
are different tax expenditures intended to encourage economic
development in disadvantaged areas and stimulate research and
development, while there are also federal spending programs that have
similar purposes. Also, by narrowing the tax base, business tax
expenditures have the effect of raising either business tax rates or
the rates on other taxpayers in order to generate a given amount of
revenue.
Efficiency, Complexity, Compliance, and Equity Concerns Contribute to
Calls for Business Tax Reform:
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.
Varying Effective Rates of Taxation Across Different Types of Business
Investments Reduce Economic Efficiency:
Our current system for taxing business income causes economic
inefficiency because it imposes significantly different effective rates
of tax on different types of investments.[Footnote 8] Tax treatment
that is not neutral across different types of capital investment causes
significant economic inefficiency by guiding investments to lightly
taxed activities rather than those with high pretax productivity.
However, the goal of tax policy is not to eliminate efficiency costs.
The goal is to design a tax system that produces a desired amount of
revenue and balances economic efficiency with other objectives, such as
equity, simplicity, transparency, and administrability. Every practical
tax system imposes efficiency costs.
There are some features of current business taxation that have
attracted criticism by economists and other tax experts because of
efficiency costs. My point in raising them here is not that these
features need to be changed--that is a policy judgment for Congress to
make as it balances various goals. Rather, my point is that these
economic consequences of tax policy need to be considered as we think
about reform. The following are among the most noted cases of
nonneutral taxation in the federal business tax system:
* Income earned on equity-financed investments made by C corporations
is taxed twice--under both the corporate and individual income taxes,
whereas no other business income is taxed more than once. Moreover,
even noncorporate business investment is taxed more heavily than owner-
occupied housing--a form of capital investment that receives very
preferential treatment. As a result, resources have been shifted away
from higher-return business investment into owner-occupied housing,
and, within the business sector, resources have been shifted from
higher-return corporations to noncorporate businesses. Such shifting of
investment makes workers less productive than they would be under a
more neutral tax system. This results in employees receiving lower
wages because increases in employee wages are generally tied to
increases in productivity. [Footnote 9] As noted above, such efficiency
costs may be worth paying in order to meet other policy goals. For
example, many policymakers advocate increased homeownership as a social
policy goal.
* Depreciation allowances under the tax code vary considerably in
generosity across different assets causing effective tax rates to vary
and, thereby, favoring investment in certain assets over others. For
example, researchers have found that the returns on most types of
investments in equipment are taxed more favorably than are most
investments in nonresidential buildings.[Footnote 10] These biases
shift resources away from some investments in buildings that would have
been more productive than some of the equipment investments that are
being made instead.
* Tax rules for corporations favor the use of debt over shareholder
equity as a source of finance for investment. The return on debt-
financed investment consists of interest payments to the corporation's
creditors, which are deductible by the corporations. Consequently, that
return is taxed only once--in the hands of the creditors. In contrast,
the return on equity-financed investment consists of dividends and
capital gains, which are not deductible by the corporation. These forms
of income that are taxed under the individual tax are paid out of
income that has already been subject to the corporate income tax. The
bias against equity finance induces corporations to have less of an
"equity cushion" against business downturns.[Footnote 11]
* Capital gains on corporate equity are taxed more favorably than
dividends because that tax can be deferred until the gains are realized
(typically when shareholders sell their stock). This bias against
dividend payments likely means that more profits are retained within
corporations than otherwise would be the case and, therefore, the flow
of capital to its most productive uses is being constrained.[Footnote
12]
* The complex set of rules governing U.S. taxation of the worldwide
income of domestic corporations (those incorporated in the United
States) leads to wide variations in the effective rate of tax paid on
that income, based on the nature and location of each corporation's
foreign operations and the effort put into tax planning. In effect, the
active foreign income of some U.S. corporations is taxed more heavily
than if the United States followed the practice of many other countries
and exempted such income from tax. However, other U.S. corporations are
able to take advantage of flexibilities in the U.S. tax rules in order
to achieve treatment that is equivalent to or, in some cases, more
favorable than the so-called "territorial" tax systems that exempt
foreign-source active business income. As a consequence, some U.S.
corporations face a tax disadvantage, while others have an advantage,
relative to foreign corporations when competing in foreign countries.
Those U.S. corporations that have a disadvantage are likely to locate a
smaller share of their investment overseas than would be the case in a
tax-free world; the opposite is true for those U.S. corporations with
the tax advantage. Moreover, the tax system encourages U.S.
corporations to alter their cash-management and financing decisions
(such as by delaying the repatriation of profits) in order to reduce
their taxes.
The taxation of business income is part of the broader taxation of
income from capital. The taxation of capital income in general (even
when that taxation is uniformly applied) causes another form of
inefficiency beyond the inefficiencies caused by the aforementioned
cases of differential taxation across types of investments. This
additional inefficiency occurs because taxes on capital reduce the
after-tax return on savings and, thereby, distort the choice that
individuals make between current consumption and saving for future
consumption. However, although research shows that the demand for some
types of savings, such as the demand for tax exempt bonds, is
responsive to tax changes, there is greater uncertainty about the
effects of tax changes on other choices, such as aggregate savings.
Sometimes the concerns about the negative effects of taxation on the
U.S. economy are couched in terms of "competitiveness," where the
vaguely defined term competitiveness is often defined as the ability of
U.S. businesses to export their products to foreign markets and to
compete against foreign imports into the U.S. market. The goal of those
who push for this type of competitiveness is to improve the U.S.
balance of trade. However, economists generally agree that trying to
increase the U.S. balance of trade through targeted tax breaks for
exports does not work. Such a policy, aimed at lowering the prices of
exports, would be offset by an increase in the value of the dollar
which would make U.S. exports more expensive and imports into the
Unites States less expensive, ultimately leaving both the balance of
trade and the standard of living of Americans unchanged.[Footnote 13]
An alternative definition of competitiveness that is also sometimes
used in tax policy debates refers to the ability of U.S.-owned firms
operating abroad to compete in foreign markets. The current U.S. policy
of taxing the worldwide income of U.S. businesses places some of their
foreign operations at a disadvantage. The tradeoffs between a worldwide
system and a territorial tax system are discussed below.
Businesses Bear Significant Compliance Burdens Arising Both from the
Complexity of the Tax System and from Their Multiple Roles within the
System:
Tax compliance requirements for businesses are extensive and complex.
Rules governing the computation of taxable income, expense deductions,
and tax credits of U.S. corporations that do business in multiple
foreign countries are particularly complex. But even small businesses
face multiple levels of tax requirements of varying difficulty. In
addition to computing and documenting their income, expenses, and
qualifications for various tax credits, businesses with employees are
responsible for collecting and remitting (at varying intervals) several
federal taxes on the incomes of those employees. Moreover, if the
businesses choose to offer their employees retirement plans and other
fringe benefits, they can substantially increase the number of filings
they must make. Businesses also have information-reporting
responsibilities--employers send wage statements to their employees and
to IRS; banks and other financial intermediaries send investment income
statements to clients and to IRS.[Footnote 14] Finally, a relatively
small percentage of all businesses (which nevertheless number in the
hundreds of thousands) are required to participate in the collection of
various federal excise taxes levied on fuels, heavy trucks and
trailers, communications, guns, tobacco, and alcohol, among other
products.
It is difficult for researchers to accurately estimate compliance costs
for the tax system as a whole or for particular types of taxpayers
because taxpayers generally do not keep records of the time and money
spent complying with tax requirements. Studies we found that focus on
the compliance costs of businesses estimate them to be between about
$40 billion and $85 billion per year.[Footnote 15] 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.
Business Tax Complexity Also Makes IRS's Job of Enforcing Tax Rules
Very Challenging and Can Reduce Public Confidence in the Fairness of
the System:
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.[Footnote 16] 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.[Footnote
17]
A complex tax code, complicated business transactions, and often
multinational corporate structures make determining business tax
liabilities and the extent of corporate tax avoidance a challenge. Tax
avoidance has become such a concern that some tax experts say corporate
tax departments have become "profit centers" as corporations seek to
take advantage of the tax laws in order to maximize shareholder value.
Some corporate tax avoidance is clearly legal, some falls in gray areas
of the tax code, and some is clearly noncompliance or illegal, as shown
by IRS's tax gap estimate.
Often business tax avoidance is legal. For example, multinational
corporations can locate active trade or business operations in
jurisdictions that have lower effective tax rates than does the United
States and, unless and until they repatriate the income, defer taxation
in the United States on that income, thus reducing their effective tax
rate. In addition, investors can avoid paying the corporate income tax
by putting their money into unincorporated businesses or into real
estate.
Complicating corporate tax compliance is the fact that in many cases
the law is unclear or subject to differing interpretations. In fact,
some have postulated that major corporations' tax returns are actually
just the opening bid in an extended negotiation with IRS to determine a
corporation's tax liability. An illustration--once again from the
complex area of international tax rules--is transfer pricing. Transfer
pricing involves setting the appropriate price for such things as
goods, services, or intangible property (such as patents, trademarks,
copyrights, technology, or "know-how") that is transferred between the
U.S.-based operations of a multinational company and a foreign
affiliate. If the price paid by the affiliate to the U.S. operation is
understated, the profits of the U.S. operation are reduced and U.S.
taxable income is inappropriately reduced or eliminated. The standard
for judging the correct price is the price that would have been paid
between independent enterprises acting at "arm's length." However, it
can be extremely difficult to establish what an arm's length price
would be. Given the global economy and the number of multinational
firms with some U.S.-based operations, opportunities for transfer
pricing disputes are likely to grow.
Tax shelters are one example of how tax avoidance, including corporate
tax avoidance, can shade into the illegal. Some tax shelters are legal
though perhaps aggressive interpretations of the law, but others cross
the line.[Footnote 18] Abusive shelters often are complex transactions
that manipulate many parts of the tax code or regulations and are
typically buried among legitimate transactions reported on tax returns.
Because these transactions are often composed of many pieces located in
several parts of a complex tax return, they are essentially hidden from
plain sight, which contributes to the difficulty of determining the
scope of the abusive shelter problem. Often lacking economic substance
or a business purpose other than generating tax benefits, abusive
shelters have been promoted by some tax professionals, often in
confidence, for significant fees, sometimes with the participation of
tax-indifferent parties, such as foreign or tax-exempt entities. These
shelters may involve unnecessary steps and flow-through entities, such
as partnerships, which make detection of these transactions more
difficult.
Regarding compliance with our tax laws, the success of our tax system
hinges greatly on individual and business taxpayers' perception of its
fairness and understandability. Compliance is influenced not only by
the effectiveness of IRS's enforcement efforts but also by Americans'
attitudes about the tax system and their government. A recent survey
indicated that about 10 percent of respondents say it is acceptable to
cheat on their taxes. Furthermore, the complexity of, and frequent
revisions to, the tax system make it more difficult and costly for
taxpayers who want to comply to do so and for IRS to explain and
enforce tax laws. The lack of transparency also fuels disrespect for
the tax system and the government. Thus, a crucial challenge in
evaluating our business tax system will be to determine how we can best
strengthen enforcement of existing laws to give businesses owners
confidence that their competitors are paying their fair share and to
give wage earners confidence that businesses in general bear their
share of taxes. One option that has been suggested as a means of
improving public confidence in the tax system's fairness is to make the
reconciliation between book and tax income that businesses present on
schedule M-3 of their tax returns available for public review.
Business Tax Reform Entails Broad Design Choices about the Overall Tax
System:
Reform of our business tax system will necessarily mean making broad
design choices about the overall tax system and how business taxes are
coordinated with other taxes. The tax reform debate of the last several
years has focused attention on several important choices, including the
extent to which our system should be closer to the extreme of a pure
income tax or the other extreme of a pure consumption tax, the extent
to which sales by U.S. businesses outside of this country should be
taxed, the extent to which taxes should be collected from businesses or
individuals, and the extent to which taxpayers are compensated for
losses or costs they incur during the transition to any new tax system.
Generally there is no single "right" decision about these choices and
the options are not limited to selecting a system that is at one
extreme or the other along the continuum of potential systems. The
choices will involve making tradeoffs between the various goals for our
tax system.
Income vs. Consumption as the Tax Base:
The fundamental difference between income and consumption taxes lies in
their treatment of savings and investment. Income can be used for
either consumption or saving and investment. The tax base of a pure
income tax includes all income, regardless of what it is ultimately
used for; in contrast, the tax base of a consumption tax excludes
income devoted to saving and investment (until it is ultimately used
for consumption). The current tax system is a hybrid between a pure
income tax and a pure consumption tax because it effectively exempts
some types of savings and investment but taxes other types.
As noted earlier, evidence is inconclusive regarding whether a shift
closer to a consumption tax base would significantly affect the level
of savings by U.S. taxpayers. There is, however, a consensus among
economists that uneven tax treatment across different types of
investment should be avoided unless the efficiency costs resulting from
preferential tax treatment are outweighed by the social benefits
generated by the tax preference. That objective could be achieved under
either a consumption tax that exempts all new savings and investment
from taxation (which means that all business profits are exempt) or a
revised income tax that taxed all investments at the same effective
rate. In comparison to the current system, a consumption tax's
exemption of business-source income would likely encourage U.S.
businesses to increase their investment in the United States relative
to their foreign investment.
Both income and consumption taxes can be structured in a variety of
ways, as discussed in the following subsections, and the choice of a
specific design for either type of tax can have as significant
implications for efficiency, administrability, and equity as the choice
between a consumption or income base. [Footnote 19] 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.
Collecting the Tax at the Business or Individual Level:
Both income and consumption taxes can be levied on individuals or
businesses, or on a combination of the two. Whether collected from
individuals or businesses, ultimately, individuals will bear the
economic burden of any tax (as wage earners, shareholders, or
consumers). The choice of whether to collect a tax at the business
level or the individual level depends on whether it is thought to be
desirable to levy different taxes on different individuals. A business-
level tax, whether levied on income or consumption, can be collected
"at source"--that is, where it is generated--so there can be many fewer
tax filers and returns to administer. Business-level taxes cannot,
however, directly tax different individuals at different rates.
Individual-level taxes can allow for distinctions between different
individuals; for example, standard deductions or graduated rates can be
used to tax individuals with low income (or consumption) at a lower
rate than individuals with greater income (or consumption). However,
individual-level taxes require more tax returns, impose higher
compliance costs, and would generally require a larger tax
administration system.[Footnote 20]
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.[Footnote 21] 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.
Territorial vs. Worldwide Taxation under an Income Tax:
Under a pure worldwide tax system the United States would tax the
income of U.S. corporations, as it is earned, regardless of where it is
earned, and at the same time provide a foreign tax credit that ensures
that the combined rate of tax that a corporation pays to all
governments on each dollar of income is exactly equal to the U.S.
corporate tax rate. Some basic differences between the current U.S. tax
system and a pure worldwide system are that (1) in many cases the U.S.
system permits corporations to defer U.S. tax on their foreign-source
income until it is repatriated and (2) the U.S. foreign tax credit is
limited to the amount of U.S. tax that would be due on a corporation's
foreign-source income. In cases where the rate of foreign tax on a
corporation's income exceeds the U.S. tax rate, the corporation is left
paying the higher rate of tax.
Under a pure territorial tax system the United States would simply
exempt all foreign-source income. (No major country has a pure
territorial system; they all tax mobile forms of foreign-source income,
such as royalties and income from securities.) The current U.S. tax
system has some features that result in some cases in treatment similar
to what would exist under a territorial system. First, corporations can
defer U.S. tax indefinitely on certain foreign-source income, as long
as they keep it reinvested abroad. Second, in certain cases U.S.
corporations are able to use the excess credits that they earned for
taxes they paid to high-tax countries to completely offset any U.S. tax
that they would normally have to pay on income they earned in low-tax
countries.[Footnote 22] As a result, that income from low-tax countries
remains untaxed by the United States--just as it would be under a
territorial system. In fact, there are some cases where U.S.
corporations enjoy tax treatment that is more favorable than under a
territorial system. This occurs when they pay no U.S. tax on foreign-
source income yet are still able to deduct expenses allocable to that
income. For example, a U.S. parent corporation can borrow money and
invest it in a foreign subsidiary. The parent corporation generally can
deduct its interest payments from its U.S. taxes even if it defers U.S.
tax on the subsidiary's income by leaving it overseas.
Proponents of a worldwide tax system and proponents of a territorial
system both argue that their preferred systems would provide important
forms of tax neutrality. Under a pure worldwide system all of the
income that a U.S. corporation earns abroad would be taxed at the same
effective rate that a corporation earning the same amount of income
domestically would pay. Such a tax system is neutral in the sense that
it does not influence the decision of U.S. corporations to invest
abroad or at home. If the U.S. had a pure territorial tax system all of
the income that U.S. corporations earn in a particular country would be
taxed at the same rate as corporations that are residents of that
country. The pure territorial system is neutral in the specific sense
that U.S. corporations investing in a foreign country would not be at a
disadvantage relative to corporations residing in that country or
relative to other foreign corporations investing there.[Footnote 23] In
a world where each country sets its own tax rules it is impossible to
achieve both types of neutrality at the same time, so tradeoffs are
unavoidable.
A change from the current tax system to a pure territorial one is
likely to have mixed effects on tax compliance and administration. On
the one hand, a pure worldwide tax system, or even the current system,
may preserve the U.S. tax base better than a territorial system would
because U.S. taxpayers would have greater incentive under a territorial
system to shift income and investment into low-tax jurisdictions via
transfer pricing. On the other hand, a pure territorial system may be
less complex for IRS to administer and for taxpayers to comply with
than the current tax system because there would be no need for the
antideferral rules or the foreign tax credit, which are among the most
complex features of the current system.
Destination-Principle vs. Origin-Principle Consumption Tax:
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.[Footnote 24]
A national retail sales tax limited to final consumption goods would be
a destination-principle tax; it would tax imports when sold at retail
in this country and would not tax exports. Value-added taxes can be
designed as either destination or origin-principle taxes.
A personal consumption tax, collected at the individual level, would
apply to U.S. residents or citizens and could be formulated to tax
their consumption regardless of whether it is done domestically or
overseas. Under such a system, income earned abroad would be taxable
but funds saved or invested abroad would be deductible. In that case,
foreign-produced goods imported into the United States or consumed by
U.S. citizens abroad would be taxed. U.S. exports would only be taxed
to the extent that they are consumed by U.S. citizens abroad.
The Extent of Transition Provisions:
A wide range of options exist for moving from the current business tax
system to an alternative one, and the way that any transition is
formulated could have significant effects for economic efficiency,
equity, taxpayer compliance burden, and tax administration. For
example, one transition issue involves whether tax credits and other
tax benefits already earned under the current tax would be made
available under a new system. Businesses that are deducting
depreciation under the current system would not have the opportunity to
continue depreciating their capital goods under a VAT unless special
rules were included to permit it. Similar problems could arise with
businesses' carrying forward net operating losses and recovering
unclaimed tax credits. Depending on how these and other issues are
addressed, taxpayer compliance burden and tax administration
responsibilities could be greater during the transition period than
they currently are or than they would be once the transition ends.
Transition rules could also substantially reduce the new system's tax
base, thereby requiring higher tax rates during the transition if
revenue neutrality were to be achieved.[Footnote 25]
Criteria for a Good Tax System Provide Principles to Guide Decisions
and Issues for Consideration:
Our publication, Understanding the Tax Reform Debate: Background,
Criteria, and Questions,[Footnote 26] may be useful in guiding
policymakers as they consider tax reform proposals. It was designed to
aid policymakers in thinking about how to develop tax policy for the
21st century. The criteria for a good tax system, which our report
discusses, provide the basis for a set of principles that should guide
Congress as it considers the choices and tradeoffs involved in tax
system reform. And, as I also noted earlier, proposals for reforming
business taxation cannot be evaluated without considering how that
business taxation will interact with and complement the other elements
of our overall future tax system.
The proposed system should raise sufficient revenue over time to fund
our expected expenditures. As I mentioned earlier, we will fall
woefully short of achieving this end if current spending or revenue
trends are not altered. Although we clearly must restructure major
entitlement programs and the basis of other federal spending, it is
unlikely that our long-term fiscal challenge will be resolved solely by
cutting spending.
The proposal should look to future needs. Like many spending programs,
the current tax system was developed in a profoundly different time. We
live now in a much more global economy, with highly mobile capital, and
with investment options available to ordinary citizens that were not
even imagined decades ago. We have growing concentrations of income and
wealth. More firms operate multinationally and willingly move
operations and capital around the world as they see best for their
firms.
As an adjunct to looking forward when making reforms, better
information on existing commitments and promises must be coupled with
estimates of the long-term discounted net present value costs from
spending and tax commitments comprising longer-term exposures for the
federal budget beyond the existing 10-year budget projection window.
The tax base should be as broad as possible. Broad-based tax systems
with minimal exceptions have many advantages. Fewer exceptions
generally means less complexity, less compliance cost, less economic
efficiency loss, and by increasing transparency may improve equity or
perceptions of equity. This suggests that eliminating or consolidating
numerous tax expenditures must be considered. In many cases tax
preferences are simply a form of "back-door spending." We need to be
sure that the benefits achieved from having these special provisions
are worth the associated revenue losses just as we must ensure that
outlay programs--which may be attempting to achieve the same purposes
as tax expenditures--achieve outcomes commensurate with their costs.
And it is important to supplement these cost-benefit evaluations with
analyses of distributional effects--i.e., who bears the costs of the
preferences and who receives the benefits. To the extent tax
expenditures are retained, consideration should be given to whether
they could be better targeted to meet an identified need.
If we must raise revenues, doing so from a broad base and a lower rate
will help minimize economic efficiency costs. Broad-based tax systems
can yield the same revenue as more narrowly based systems at lower tax
rates. The combination of less direct intervention in the marketplace
from special tax preferences, and the lower rates possible from broad-
based systems, can have substantial benefits for economic efficiency.
For instance, one commonly cited rule of thumb regarding economic
efficiency costs of tax increases is that they rise proportionately
faster than the tax rates. In other words, a 10 percent tax increase
could raise the economic efficiency costs of a tax system by much more
than 10 percent.
Aside from the base-broadening that minimizes targeted tax preferences
favoring specific types of investment or other business behavior, it is
also desirable on the grounds of economic efficiency to extend the
principle of tax neutrality to the broader structural features of a
business tax system. For example, improvements in economic efficiency
can also be gained by avoiding differences in tax treatment, such as
the differences in the current system based on legal form of
organization, source of financing, and the nature and location of
foreign operations. Removing such differences can shift resources to
more productive uses, increasing economic performance and the standard
of living of Americans. Shifting resources to more productive uses can
result in a step up in the level of economic activity which would be
measured as a one-time increase in the rate of growth. Tax changes that
increase efficiency can also increase the long-term rate of economic
growth if they increase the rate of technological change; however, not
all efficiency-increasing tax changes will do so.[Footnote 27]
Impact on the standard of living of Americans is also a useful
criterion for evaluating policies to improve U.S. competitiveness. As
was discussed earlier, narrower goals and policies, such as increasing
the U.S. balance of trade through targeted tax breaks aimed at
encouraging exports, are generally viewed as ineffective by economists.
What determines the standard of living of Americans and how it compares
to the standard of living in other countries is the productivity of
American workers and capital. That productivity is determined by
factors such as education, technological innovation, and the amount of
investment in the U.S. economy. Tax policy can contribute to American
productivity in several ways. One, discussed in this statement, is
through neutral taxation of investment alternatives. Another, which I
have discussed on many occasions, is through fiscal policy. Borrowing
to finance persistent federal deficits absorbs savings from the private
sector reducing funds available for investment. Higher saving and
investment from a more balanced fiscal policy would contribute to
increased productivity and a higher standard of living for Americans
over the long term.
A reformed business tax system should have attributes associated with
high compliance rates. Because any tax system can be subject to tax
gaps, the administrability of reformed systems should be considered as
part of the debate for change. In general, a reformed system is most
likely to have a small tax gap if the system has few tax preferences or
complex provisions and taxable transactions are transparent.
Transparency in the context of tax administration is best achieved when
third parties report information both to the taxpayer and the tax
administrator.
Minimizing tax code complexity has the potential to reduce
noncompliance for at least three broad reasons. First, it could help
taxpayers to comply voluntarily with more certainty, reducing
inadvertent errors by those who want to comply but are confused because
of complexity. Second, it may limit opportunities for tax evasion,
reducing intentional noncompliance by taxpayers who can misuse the
complex code provisions to hide their noncompliance or to achieve ends
through tax shelters. Third, reducing tax-code complexity could improve
taxpayers' willingness to comply voluntarily.
Finally, the consideration of transition rules needs to be an integral
part of the design of a new system. The effects of these rules can be
too significant to leave them simply as an afterthought in the reform
process.
Concluding Observations:
The problems that I have reviewed today relating to the compliance
costs, efficiency costs, equity, and tax gap associated with the
current business tax system would seem to make a strong case for a
comprehensive review and reform of our tax policy. Further, businesses
operate in a world that is profoundly different--more competitive and
more global--than when many of the existing provisions of the tax code
were adopted. Despite numerous and repeated calls for reform, progress
has been slow. I discussed reasons for the slow progress in a previous
hearing on individual tax reform before this committee. One reason why
reform is difficult to accomplish is that the provisions of the tax
code that generate compliance costs, efficiency costs, the tax gap and
inequities also benefit many taxpayers. Reform is also difficult
because, even when there is agreement on the amount of revenue to
raise, there are differing opinions on the appropriate balance among
the often conflicting objectives of equity, efficiency, and
administrability. This, in turn, leads to widely divergent views on
even the basic direction of reform.
However, I have described some basic principles that ought to guide
business tax reform. One of them is revenue sufficiency. Fiscal
necessity, prompted by the nation's unsustainable fiscal path, will
eventually force changes to our spending and tax policies. We must
fundamentally rethink policies and everything must be on the table.
Tough choices will have to be made about the appropriate degree of
emphasis on cutting back federal programs versus increasing tax
revenue.
Other principles, such as broadening the tax base and otherwise
promoting tax neutrality, could help improve economic performance.
While economic growth alone will not solve our long-term fiscal
problems, an improvement in our overall economic performance makes
dealing with those problems easier.
The recent report of the President's Advisory Panel on Federal Tax
Reform recommended two different tax reform plans. Although each plan
is intended to improve economic efficiency and simplify the tax system,
neither of them addresses the growing imbalance between federal
spending and revenues that I have highlighted. One approach for getting
the process of comprehensive fiscal reform started would be through the
establishment of a credible, capable, and bipartisan commission, to
examine options for a combination of selected entitlement and tax
reform issues.
Mr. Chairman and Members of the Committee, this concludes my statement.
I would be pleased to answer any questions you may have at this time.
Contact and Acknowledgments:
For further information on this testimony, please contact James White
on (202) 512-9110 or whitej@gao.gov. Contact points for our Offices of
Congressional Relations and Public Affairs may be found on the last
page of this testimony. Individuals making key contributions to this
testimony include Jim Wozny, Assistant Director; Donald Marples; Jeff
Arkin; and Cheryl Peterson.
[End of section]
Appendix I: List of Studies Reviewed:
Government Accountability Office:
Individual Income Tax Policy: Streamlining, Simplification, and
Additional Reforms Are Desirable. GAO-06-1028T. Washington, D.C.:
August 3, 2006.
Tax Compliance: Opportunities Exist to Reduce the Tax Gap Using a
Variety of Approaches. GAO-06-1000T. Washington, D.C.: July 26, 2006.
Tax Compliance: Challenges to Corporate Tax Enforcement and Options to
Improve Securities Basis Reporting. GAO-06-851T. Washington, D.C.: June
13, 2006.
Understanding the Tax Reform Debate: Background, Criteria, & Questions.
GAO-05-1009SP. Washington, D.C.: September 2005.
Government Performance and Accountability: Tax Expenditures Represent a
Substantial Federal Commitment and Need to Be Reexamined. GAO-05-690.
Washington, D.C.: Sept. 23, 2005.
Tax Policy: Summary of Estimates of the Costs of the Federal Tax
System. GAO-05-878. Washington, D.C.: August 26, 2005.
Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal
Sustainability but Will Require a Variety of Strategies. GAO-05-527T.
Washington, D.C.: April 14, 2005.
21st Century Challenges: Reexamining the Base of the Federal
Government. GAO-05-325SP. Washington, D.C.: February 1, 2005.
Tax Administration: Potential Impact of Alternative Taxes on Taxpayers
and Administrators. GAO/GGD-98-37. Washington, D.C.: January 14, 1998.
Congressional Budget Office:
Corporate Income Tax Rates: International Comparisons. Washington,
D.C.: November 2005.
Taxing Capital Income: Effective Rates and Approaches to Reform.
Washington, D.C.: October 2005.
Effects of Adopting a Value-Added Tax. Washington, D.C.: February 1992.
Congressional Research Service:
Brumbaugh, David L. Taxes and International Competitiveness. RS22445.
Washington, D.C.: May 19, 2006.
Brumbaugh, David L. Federal Business Taxation: The Current System, Its
Effects, and Options for Reform. RL33171. Washington, D.C.: December
20, 2005.
Gravelle, Jane G. Capital Income Tax Revisions and Effective Tax Rates.
RL32099. Washington, D.C.: January 5, 2005.
Joint Committee on Taxation:
The Impact of International Tax Reform: Background and Selected Issues
Relating to U.S. International Tax Rules and the Competitiveness of
U.S. Businesses. JCX-22-06. Washington, D.C.: June 21, 2006.
Options to Improve Tax Compliance and Reform Tax Expenditures. JCS-02-
05. Washington, D.C.: January 27, 2005.
The U.S. International Tax Rules: Background, Data, and Selected Issues
Relating to the Competitiveness of U.S.-Based Business Operations. JCX-
67-03. Washington, D.C.: July 3, 2003.
Background Materials on Business Tax Issues Prepared for the House
Committee on Ways and Means Tax Policy Discussion Series. JCX-23-02.
Washington, D.C.: April 4, 2002.
U.S. Department of the Treasury:
Report to The Congress on Depreciation Recovery Periods and Methods.
Washington, D.C.: July 2000.
Integration of The Individual and Corporate Tax Systems: Taxing
Business Income Once. Washington, D.C.: January 1992.
President's Advisory Panel on Federal Tax Reform:
Simple, Fair, and Pro-Growth: Proposals to Fix America's Tax System.
Washington, D.C.: November 2005.
[End of section]
Appendix II: Descriptions of Alternative Tax Systems:
Over the past decade, several proposals for fundamental tax reform have
been put forward. These proposals would significantly change tax rates,
the tax base, and the level of tax (whether taxes are collected from
individuals, businesses, or both). Some of the proposals would replace
the federal income tax with some type of consumption tax levied only on
businesses. Consumption taxes levied only on businesses include retail
sales taxes (RST) and value-added taxes (VAT). The flat tax would also
change the tax base to consumption but include both a relatively simple
individual tax along with a business tax. A personal consumption tax, a
consumption tax levied primarily on individuals, has also been
proposed. Similar changes in the level at which taxes are collected
could be made while retaining an income tax base. This appendix
provides a brief description of several of these proposals.
National Retail Sales Tax:
The consumption tax that Americans are most familiar with is the retail
sales tax, which in many states, is levied when goods or services are
purchased at the retail level. The RST is a consumption tax because
only goods purchased by consumers are taxed, and sales to businesses,
including sales of investment goods, are generally exempt from tax. In
contrast to an income tax, then, income that is saved is not taxed
until it is used for consumption. Under a national RST, different tax
rates could be applied to different goods, and the sale of some goods
could carry a zero tax rate (exemption). However, directly taxing
different individuals at different rates for the same good would be
very difficult.
Consumption Value-Added Tax:
A consumption VAT, which like the RST, is a business-level consumption
tax levied directly on the purchase of goods and services. The two
taxes differ in the manner in which the tax is collected and paid. In
contrast to a retail sales tax, sales of goods and services to
consumers and to businesses are taxable under a VAT. However,
businesses can either deduct the amount of their purchases of goods and
services from other businesses (under a subtraction VAT) or can claim a
credit for tax paid on purchases from other businesses (under a credit
VAT). Under either method, sales between businesses do not generate net
tax liability under a VAT because the amount included in the tax base
by businesses selling goods is equal to the amount deducted by the
business purchasing goods. The only sales that generate net revenue for
the government are sales between businesses and consumers, which is the
same case as the RST.
Income Value-Added Tax:
An income VAT would move the taxation of wage income to the business
level as well. No individual returns would be necessary, so the burden
of complying with the tax law would be eliminated for individuals. An
income VAT would not allow businesses to deduct dividends, interest, or
wages, so the income VAT remitted by businesses would include tax on
these types of income. Calculations would not have to be made for
different individuals, which would simplify tax administration and
compliance burdens but not allow for treating different individuals
differently.
Flat Tax:
The flat tax was developed in the early 1980s by economists Robert Hall
and Alvin Rabushka.[Footnote 28] The Hall-Rabushka flat tax proposal
includes both an individual tax and a business tax. As described by
Hall and Rabushka, the flat tax is a modification of a VAT; the
modifications make the tax more progressive (less regressive) than a
VAT. In particular, the business tax base is designed to be the same as
that of a VAT, except that businesses are allowed to deduct wages and
retirement income paid out as well as purchases from other businesses.
Wage and retirement income is then taxed when received by individuals
at the same rate as the business tax rate. By including this individual-
level tax as well as the business tax, standard deductions can be made
available to individuals. Individuals with less wage and retirement
income than the standard deduction amounts would not owe any tax.
Personal Consumption Tax:
A personal consumption tax would look much like a personal income tax.
The major difference between the two is that under the consumption tax,
taxpayers would include all income received, amounts borrowed, and cash
flows received from the sale of assets, and then deduct the amount they
saved. The remaining amount would be a measure of the taxpayer's
consumption over the year. When funds are withdrawn from bank accounts,
or stocks or bonds are sold, both the original amount saved and
interest earned are taxable because they are available for consumption.
If withdrawn funds are reinvested in another qualified account or in
stock or bonds, the taxable amount of the withdrawal would be offset by
the deduction for the same amount that is reinvested. While the
personal consumption tax would look like a personal income tax, the tax
base would be the same as an RST. Instead of collecting tax on each
sale of consumer products at the business level, a personal consumption
tax would tax individuals annually on the sum of all their purchases of
consumption goods. Because it is an individual-level tax, different tax
rates could be applied to different individuals so that the tax could
be made more progressive, and other taxpayer characteristics, such as
family size, could be taken into account if desired.[Footnote 29]
FOOTNOTES
[1] See the explanation below for how these percentages were estimated
and why we could not estimate them in terms of percent of taxed paid.
[2] These criteria are also discussed at greater length in GAO,
Understanding the Tax Reform Debate: Background, Criteria, & Questions,
GAO-05-1009SP (Washington, D.C.: September 2005).
[3] Limited liability companies can elect to be taxed as C
corporations, partnerships, or as "disregarded entities." Under the
last option the company's income and expenses are simply attributed to
its parent corporation.
[4] Also, marginal rates are higher over limited income ranges to
recapture the benefits of the rates below 35 percent. In addition,
present law imposes an alternative minimum tax (AMT) on corporations to
the extent that their minimum tax liability exceeds their regular tax
liability. In general, the AMT applies a lower tax rate to a broader
tax base. Specifically, the regular tax base is increased for AMT
purposes by adding back certain items treated as tax preferences and
disallowing certain deductions and credits.
[5] Individuals may also pay tax under the alternative minimum tax
(AMT). The base of this tax equals regular taxable income, plus the
value of various tax items, including personal exemptions and certain
itemized deductions that are added back into the base. This AMT income
base is then reduced by a substantial exemption and then taxed at a
rate of 26 percent or 28 percent, depending on the taxpayer's income
level. Taxpayers compare their AMT tax liabilities to their regular tax
liabilities and pay the greater of the two.
[6] Given the time frame available for preparing this statement we
could not obtain the detailed data we would need to estimate the
average rates of tax applied to business-source and non-business-source
income. Consequently, we have not tried to estimate the percent of
individual income tax attributable to business-source income.
[7] Additional information about GAO's long-term fiscal simulations,
assumptions, data, and charts can be found at [Hyperlink,
http://www.gao.gov/special.pubs/longterm/].
[8] Statutory and effective tax rates are not necessarily the same. An
effective tax rate, which is often lower--even substantially lower--
than the statutory rate, measures the amount of tax that a corporation
actually pays on a dollar of its economic income, when all aspects of
the tax (deductions, credits, deferrals, etc.) are taken into account.
[9] Although it is difficult to estimate effective tax rates for broad
categories of assets with precision, the estimates from one recent
study showing the marginal effective tax rates on corporate investment,
noncorporate investments, and owner-occupied housing to be 32 percent,
18 percent, and 2 percent, respectively, suggest the potential
magnitude of the distortions. See Jane Gravelle, "The Corporate Tax:
Where Has It Been and Where Is It Going?" National Tax Journal, vol.
57, no. 4 (2004): 903-23.
[10] See Jane G. Gravelle, Capital Income Tax Revisions and Effective
Tax Rates, Congressional Research Service Report RL32099 (Washington,
D.C.: Jan. 5, 2005); and U.S. Department of the Treasury, Report to The
Congress on Depreciation Recovery Periods and Methods (Washington,
D.C.: July 2000).
[11] For a more detailed discussion of these issues see U.S. Department
of the Treasury, Integration of the Individual and Corporate Tax
Systems: Taxing Business Income Once (Washington, D.C.: January 1992).
[12] Recent legislation has, at least temporarily, reduced and
equalized the tax rates on dividends and realized capital gains. These
changes have both reduced the extent of double taxation and the extent
to which capital gains are favored over dividends. Capital gains still
receive some preferred treatment because of the tax deferral.
[13] See relevant discussions in Joint Committee on Taxation, The
Impact of International Tax Reform: Background and Selected Issues
Relating to U.S. International Tax Rules and the Competitiveness of
U.S. Businesses, JCX-22-06 (Washington, D.C.: June 21, 2006); CBO,
Effects of Adopting a Value-Added Tax, (Washington, D.C.: February
1992); Brumbaugh, David L., Federal Business Taxation: The Current
System, Its Effects, and Options for Reform, Congressional Research
Service report RL33171 (Washington, D.C.: December 20, 2005); and Eric
Toder, Assistant Deputy Secretary (Tax Analysis), U.S. Department of
Treasury, Testimony before the Senate Budget Committee, February 22,
1995.
[14] Although this information reporting increases the compliance
burden on businesses, it does enable IRS to enforce tax compliance by
wage earners and investors at lower cost. This reduction in
administrative costs, which are paid out of the federal budget, means
that taxes are slightly lower than they otherwise would have to be.
[15] See GAO, Tax Policy: Summary of Estimates of the Costs of the
Federal Tax System, GAO-05-878 (Washington, D.C.: Aug. 26, 2005).
[16] Overall, IRS estimated a gross tax gap of $345 billion for tax
year 2001. It further estimated that eventually $55 billion of the tax
gap would be recovered through late payments and enforcement actions,
resulting in a net tax gap of $290 billion. The tax gap includes
underreporting of taxes on tax returns, underpayment of taxes reported
on returns, or nonfiling, which is when taxpayers fail to file returns
on time or altogether.
[17] The amount of the business income tax gap attributed to individual
taxpayers could be greater than $109 billion. Although IRS estimated
the tax gap for individual income tax underpayment and nonfiling ($23
billion and $25 billion, respectively, for tax year 2001), it did not
estimate to what extent such noncompliance was attributed to business
income, as opposed to nonbusiness income such as salaries and wages.
Also, IRS estimated the tax gap that arises from individuals
misreporting tax deductions and credits, but does not estimate what
portion of the misreporting was from business-related deductions and
credits.
[18] In a 2003 testimony, we reported that IRS had identified 27 kinds
of abusive shelter transactions--called listed transactions--promoted
to corporations and others. As of September 2006, IRS's Web site lists
31 such listed transactions. IRS also had a number of other
transactions that had to be reported to IRS and may have had some
characteristics of abusive shelters but were not, and possibly never
would be, listed.
[19] For additional information on how differences in the structures of
both income and consumption taxes can affect tax administration and
taxpayer compliance burdens, see Tax Administration: Potential Impact
of Alternative Taxes on Taxpayers and Administrators, GAO/GGD-98-37
(Washington, D.C.: Jan. 14, 1998).
[20] For a further discussion of these issues, see GAO/GGD-98-37.
[21] See app. II for brief descriptions of each of these types of
taxes.
[22] In cases where a U.S. corporation earns income in a country with a
higher income tax than in the United States that corporation earns a
larger tax credit than is needed to offset the U.S. tax owed on that
foreign-source income. The difference between the foreign tax credit
earned on a specific amount of foreign-source income and the amount of
U.S. tax owed on that income is known as an excess foreign tax credit.
[23] The disadvantage that U.S. corporations have under the current
system is one reason why some U.S. multinational businesses have
undergone "corporate inversions," whereby their parent corporations
have changed their place of incorporation from the United States to a
foreign country.
[24] This time the mechanism would operate in the reverse direction--
the tax on U.S. exports would decrease the foreign demand for those
products, leading to a drop in the value of the dollar. That decline in
the dollar's value would reverse the tax-induced increase in the price
of U.S. exports and would raise the price of imports into the United
States, offsetting any price advantage they had gained from being
exempt from the consumption tax.
[25] For further discussion of transition issues see GAO-05-1009SP.
[26] GAO-05-1009SP.
[27] See GAO-05-1009SP for further discussion on the relationship
between efficiency and economic growth.
[28] See Robert E. Hall and Alvin Rabushka, The Flat Tax, 2nd ed.
(Stanford, Calif.: Hoover Press, 1995).
[29] To tax certain types of consumption that can occur within a
business, such as fringe benefits or the personal use of goods such as
cars, many personal consumption tax proposals also include a business-
level "cash flow" tax. Investment would be expensed under such a tax to
ensure that the overall tax base would be consumption.
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