Tax Reform

Pressure has been mounting for many years for reform of the federal tax system. The core function of any tax system is to raise revenue to pay the cost of government associated with national defense, homeland security, and various domestic programs designed to address shared concerns. To this core function a secondary purpose has been added: for many years the tax code has been used as a vehicle to promote certain behaviors through a variety of tax deductions, exemptions, and credits. This secondary purpose impacts revenue collection by reducing the taxable base and shifting a higher tax burden on those dollars not used for the various favored purposes, raising concerns about the simplicity and the fairness of our current system.

Tax reform is generally thought to refer to any proposal that would widen the tax base by removing various tax preferences and lower the rate at which taxes are applied to that base. Even with these common goals, various forms of tax reform take very different approaches and suggest radically different tax collection schemes. Many proposals appear to fall into one of four broad categories.

The first, a national sales tax, would place a tax on the retail purchase of goods and services and would be collected from consumers at the point of sale. A national sales tax would replace the current income tax system and eliminate the necessity of filing tax returns with a federal agency. The second basic reform type, the value added tax (VAT), is similar to the sales tax in that it is a tax applied to products on the basis of a single percentage rate. The VAT, however, would be applied at each level of production with businesses paying tax on the difference between a product's sales price and its cost of production. Like the sales tax, the VAT would ultimately be collected from consumers at the point of purchase with a system of credits to account for intermediate tax payments. A third type of reform, the consumption based income tax, would tax the difference between spending and savings and take into account all income, including that from non-wage sources such as real estate and stock investments. In essence, money spent would be taxed and any tax on invested income would be deferred until it too is spent. A final type of tax system, the flat tax, would apply a single tax rate against all income. This tax is most similar to our current system as the requirement to file a return would remain and, in most flat tax proposals, some base amount of income would be exempted in order to retain a progressive structure. On a theoretical level, each of these systems has its merits and defects, though it is difficult to gauge how any of these fundamental reforms would impact individual taxpayers and the flow of revenue to the federal government.

President Bush signaled his agreement that tax reform is needed by issuing an executive order calling for the formation of the President's Advisory Panel on Federal Tax reform and charging that panel with the task of recommending options to make our tax code fairer, simpler, and more conducive to economic growth. This executive order also required the recommendations be written to keep government revenue streams at their current level. In November 2005, the Panel issued its report which recommended two separate, but similar, plans that provide comprehensive reform and maintain revenue neutrality.

These two plans address the problems of our tax system head-on, but to those hoping for more fundamental reform these recommendations appear to fall far short of that goal. Thinking back to the four basic types of tax reform, the Advisory Panel's proposals can best be described as hybrid plans which employ some features of various reform models while retaining the basic form of our tax structure. The recommendations are intended to make tax compliance simpler, allow certain tax benefits to be enjoyed more broadly, and provide incentives for savings and investment to encourage and support capital formation. More information on the specifics of this proposal can be found at the Web site of the President's Advisory Panel on Federal Tax Reform.

In any effort to reform tax policy, there will be those who perceive themselves as winners or as losers under any potential alteration. Those who have benefited under current law will struggle to maintain their benefits, while other taxpayers will remain aloof believing that tax policy is beyond their grasp. These pressures will bring themselves to bear on Congress, and comprehensive reform will face opposition to one or more of tax modifications. Already, the Advisory Tax Panel's plans have been criticized for provisions which would alter the tax benefits for mortgage interest payments and investments in certain life insurance policies. Tax reform is an important goal, but it is imperative that reforms not cause economic harm. The Panel's tax reform suggestions, as well as the critiques they will inspire, deserve careful study by Congress. It appears, however, that the current political environment lacks the bipartisan collegiality necessary to craft a plan of fundamental tax reform.

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