Additional revenue is needed to reduce high forecast budget deficits and the sharply rising national debt. Therefore, a major overhaul of the U.S. tax system is needed to broaden the tax base to create additional revenue, while reducing the tax burden to individuals. In December 2010, The National Commission on Fiscal Responsibility and Reform issued a report, The Moment of Truth, which proposed extensive broadening of both the individual income tax base and the corporate income tax base, while eliminating almost all tax expenditures. There are several approaches to tax reform, including:
Some Members of Congress have expressed concern about the large number and high-cost of tax expenditures. Examples of tax expenditures are the deduction for mortgage interest on owner-occupied residences and the deduction for property taxes on owner-occupied residences. Many of these tax expenditures may be reduced or eliminated. A sufficient reduction in tax expenditures would permit a reduction in marginal income tax rates. Lower marginal rates increase economic efficiency and, consequently, promote economic growth.
Revenue from a new tax would allow the retention of more tax expenditures and lower reductions in other tax expenditures. Furthermore, revenue for a new tax could finance a larger reduction in marginal income tax rates and permit a smaller reduction in federal spending. Two broad categories have received the most attention.
Broad-Based Consumption Tax
In recent Congresses, three major types of broad-based consumption taxes have been included in congressional tax proposals: the value-added tax, the retail sales tax, and the flat tax.
A value-added tax is a tax, levied at each stage of production, on a firm's added value. The value added by a firm is the difference between a firm's sales and a firm's purchases of inputs from other firms. The VAT is collected by each firm at every stage of production, and remitted to the government.
A retail sales tax is a consumption tax levied only at a single stage of production, the retail stage. The retailer collects a specific percentage markup in the retail price of a good or service, which is then remitted to the government.
A flat tax could be levied based on the proposal formulated by Robert E. Hall and Alvin Rabushka of the Hoover Institution. Their proposal would have two components: a wage tax and a cash-flow tax on businesses. (A wage tax is a tax only on salaries and wages: a cash-flow tax is generally a tax on gross receipts minus all outlays.) It is essentially a modified VAT, with wages and pensions subtracted from the VAT base and taxed at the individual level. Under a standard VAT, a firm would not subtract its wage and pension contributions when calculating its tax base. Under the flat tax, some wage income would not be included in the tax base because of exemptions. Under a standard VAT, all wage income would be included in the tax base.
Environmental taxes have been proposed to reduce pollution and raise revenue. The most frequently discussed energy tax is a carbon tax that would be levied on the volume of carbon emitted. This tax is frequently recommended by economists, but the Obama Administration is attempting to implement a cap and trade system. One alternative would be higher gasoline taxes.
Anticipated Policy Questions
In evaluating any change in tax policy, the prevailing framework is to analyze the tax policy for equity, efficiency, and simplicity. Tradeoffs may exist between these three objectives. For example, if greater income equality is desired, this may conflict with the goal of economic efficiency.
Economic theory maintains that it is not possible to make interpersonal comparisons of utility. Hence, whether a change in the distribution of income, with gainers and losers, is an improvement in the national welfare is a value judgment. The effects on different groups, however, can be measured and debated. Thus, the following questions can be examined.
How will different income groups be affected annually and over their lifetimes? Will taxpayers in similar circumstances pay approximately the same amount of taxes? What will be the effect on taxpayers in different age groups? Will there be distributional effects by region of the country? How will minority groups be affected? What will be the tax incidence on families versus single taxpayers?
Tax policy should promote economic efficiency; that is, a tax change should be as neutral as possible by minimizing economic distortions. Low marginal tax rates tend to lessen distortions.
Many efficiency questions concern household decisions. What will be the effect of a tax change on households decisions to save versus consume? Will households choices of leisure versus work be affected. Will household decisions about the composition of goods and services consumed be affected?
Other efficiency questions concern firms' decisions. What will be effect on firms' decisions concerning the method of financing (debt or equity), choice among inputs, type of business organization (corporation, partnership, of sole proprietorship), and composition of output?
The greater the simplicity of the tax system, the lower will be the administrative and compliance costs. Thus, tax policy should eliminate any unnecessary complexity and promote transparency. Numerous questions concerning simplicity arise.