Executive Summary

In December 1995, the American Institute of Certified Public Accountants issued Flat Taxes and Consumption Taxes: A Guide to the Debate. The Study was well received by tax experts and regarded as a comprehensive and balanced analysis of consumption tax alternatives. Now in 2005, tax reform is in the forefront again. Central to the current debate is President George W. Bush announcing his intent to make tax reform a key priority in his second term.  

While the tax reform debate is different in 2005, many of the reasons that support a call for reform have not changed and the nature of reform proposals remains fairly consistent. One area where the debate has changed is greater consideration today of hybrid reform approaches—that is, a system with both an income and a consumption tax or significant elements of each.

In response, the AICPA has undertaken this 2005 report to serve as a resource to those engaged or interested in the current tax reform debate. The AICPA's objective is to provide policymakers, its members and other interested individuals with a clear understanding of the issues and alternatives involved in federal tax reform, and to foster informed discussion by providing unbiased information and analysis.

Accordingly, this report describes the nature of the issues leading to a tax report debate, suggests a balanced approach for analyzing tax reform proposals, and summarizes key issues to be addressed whether taxing income or consumption. Descriptive material on consumption tax alternatives is derived from the 1995 report, with additional coverage of recent developments. The 1995 study contains more detailed information on consumption tax issues and is available below.

The United States is on the brink of significant events that will impact federal tax revenues: (1) the "baby boomers" will start to retire, placing additional burdens on already strained entitlement programs; (2) the 2001 and 2003 tax cuts will expire, generating additional government revenues without corresponding examination of appropriate and fair tax burdens; and (3) the alternative minimum tax will grow exponentially, subjecting millions of taxpayers to unintended, higher levels of taxation. Further, the debate over the appropriate levels of federal deficits and national debt—and thus, the appropriate levels of federal revenues and spending— is far from settled. Finally, President Bush has made reviewing and reforming the federal income tax system a priority and identified three important tax principles to be considered: simplification, fairness and economic growth. These events and concerns provide the impetus to undertaking federal tax reform at this time.

Three general approaches to tax reform have emerged in the current debate. The first approach reforms the current system rather than replaces it. Under this approach, current law would be adjusted as necessary to achieve the goals of reform. This report refers to this incremental approach as "bottom-up" reform, which would reach many tax reform goals by modifying the current income tax system.

The report outlines efforts to improve the current system without changing its fundamental character as an income tax, including wide-ranging simplification efforts, increasing fairness, reducing revenue lost from tax evasion (known as the "tax gap"), and broadening the tax base. "Bottom-up" proposals address economic growth by creating incentives for capital formation, accelerating depreciation, eliminating double taxation of corporate profits, and increasing tax-preferred savings options. Other areas of taxation, such as reform of the Social Security tax and the estate and gift tax, have been mentioned for consideration in conjunction with income tax reform. Although this report does not include this type of expansive reform, the AICPA has issued Understanding Social Security Reform: The Issues and Alternatives, and jointly with the ABA and other interested organizations, the Report on Reform of Federal Wealth Transfer Taxes.

The second approach would replace the entire current tax system (or major parts of it) with a new system of taxation. The most dramatic manifestations of this approach would significantly reduce tax filing by most individuals. This substitution approach is often referred to as "fundamental tax reform." A consumption tax system is the most frequently proposed substitute.

The report examines the five major consumption tax alternatives: a retail sales tax, a credit-invoice value-added tax (VAT), a subtraction-method VAT, "the flat tax" (a single-rate consumption tax), and a personal consumption tax. Despite considerable differences in appearance—a credit-invoice VAT looks like a sales tax; a subtraction-method VAT looks like a corporate income tax; and a personal consumption tax looks like the current individual income tax—all consumption taxes have similar economic impacts.

Income and consumption taxes differ in their effects on: (1) saving, investment, and overall economic growth; (2) distribution of the tax burden among income classes; (3) treatment of imports and exports; and (4) administration and compliance burdens. In general, income taxes are considered more progressive, while consumption taxes are considered simpler and more conducive to economic growth. However, these general observations may not hold true for specific proposals.

The third approach consists of hybrid proposals that would include features of both an income tax and a consumption tax. The current income tax is better characterized as a hybrid income-consumption tax than as a "pure" income tax because many forms of investment are subject to reduced tax rates (capital gains, dividends), a zero tax rate (state and municipal bond interest), or deferred tax recognition (retirement plans, certain important features of life insurance contracts). Recognizing this fact may be essential to understanding the next round of tax reform if there is movement toward consumption taxation.

Transition concerns arise from any major tax reform. Special rules to facilitate a transition from an income tax to a consumption tax would surely be needed to prevent retroactive tax increases on existing investments. In their absence many investments may be subject to unintended tax penalties.

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Goals for Evaluating Tax Reform Proposals

As policymakers engage in the current federal tax reform debate, a framework for evaluating the tax system and alternatives must be followed. In this report and in the AICPA's initial comments to the President's Advisory Panel on Federal Tax Reform, we provide principles of analysis that we believe should be used to evaluate competing proposals for reform based on the AICPA's Tax Policy Concept Statement #1: Guiding Principles for Good Tax Policy.

The AICPA recommends employing the following, widely recognized indicators of good tax policy to analyze proposed changes. These ten guiding principles are equally important, and should be considered both separately and together when evaluating the current system and reform proposals.

1. Simplicity: The tax law should be simple so that taxpayers understand the rules and can comply with them correctly and in a cost-efficient manner.
   
   
2. Fairness: Similarly situated taxpayers should be taxed similarly.
   
   
3. Economic Growth and Efficiency: The tax system should not impede or reduce the productive capacity of the economy.
   
   
4. Neutrality:The effect of the tax law on a taxpayer's decisions as to how to carry out a particular transaction or whether to engage in a transaction should be kept to a minimum.
   
   
5. Transparency: Taxpayers should know that a tax exists and how and when it is imposed upon them and others.
   
   
6. Minimizing Noncompliance: A tax should be structured to minimize noncompliance.
   
   
7. Cost-Effective Collection: The costs to collect a tax should be kept to a minimum for both the government and taxpayers.
   
   
8. Impact on Government Revenues: The tax system should enable the government to determine how much tax revenue will likely be collected and when.
   
   
9. Certainty: The tax rules should clearly specify when the tax is to be paid, how it is to be paid, and how the amount to be paid is to be determined.
   
   
10. Payment Convenience: A tax should be due at a time or in a manner that is most likely to be convenient for the taxpayer.

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Conclusion

The American Institute of Certified Public Accountants does not take a position on the "best possible solution" to reforming the current federal income tax system. We do, however, encourage an in-depth debate of the issues, undertaken through an organized and logical process, with the goal of enacting "good tax policy" reforms in the near future. As the Administration and Congress consider federal tax reform, the unifying goals should be established now to make the effort one that is rational, thoughtful and lasting.