Three versions of tax reform.

• Author: Warren, Alvin C., Jr.

My subject this afternoon is tax reform, which again rose to the top of the U.S. political agenda during last year's presidential campaign. My principal goal in this lecture will be to explore three different versions of tax reform. In order to provide some context for that exploration, I would like to begin by briefly comparing taxation in the United States to taxation in other industrialized countries, focusing on three attributes of a mature tax system.

The first attribute is the overall level of taxation. Although rarely emphasized in American political discourse, the overall level of taxation in the United States is much lower than in other developed countries. In 1994, the most recent year for which comparative figures are available, the total of all taxes, including social security taxes, at all levels of government in the U.S. was 27.6% of gross domestic product.(1) Of the twenty-eight developed countries that made up the membership of the Organisation for Economic Cooperation and Development (OECD), only Turkey and Mexico had lower overall levels of taxation. The OECD average was 38.4% of gross domestic product, while the European Union average was 42.5%.(2)

Turning now from the overall level of taxation to a second attribute, the type of taxes imposed, the United States also differs from most other industrialized nations. Once again, looking at 1994, income taxes provided a comparatively high 44.6% of all American government revenue.(3) Social security taxes provided 25.5%, sales and other consumption taxes 17.9%, and property taxes 12%.(4) Most other developed countries rely significantly less on income taxes and significantly more on consumption taxes. On average, for example, consumption taxes constituted 31.9% of the tax revenue of OECD countries in 1994, almost twice the 17.9% in the United States.(5) To a large extent, this difference is explained by the widespread adoption of value-added taxes over the last thirty-years throughout the industrialized world, with the notable exception of the U.S.

Focusing now particularly on income taxes, the third and final tax system attribute that I want to emphasize is the relationship between the individual and corporate income taxes. The United States continues to have a so-called classical system of income taxation, under which income earned through corporations can be taxed twice, once when earned by the corporation and again on distribution to shareholders. Over the last thirty years, most other developed countries have integrated their individual and corporate income taxes into a single system that is intended to eliminate or reduce this double burden.(6)

This brief international comparison of tax systems can be summarized as follows: first, taxes in the U.S. are lower than in other industrialized countries; second, the U.S. relies relatively more on income taxes and less on consumption taxes than do other industrialized countries; and, finally, the U.S. is one of very few such countries that continues to levy individual and corporate income taxes that are separate and cumulative.

Given that background, let me now turn to three versions of tax reform in the U.S. In each case, I plan to focus on the intellectual foundations of tax reform, the use of those ideas in the political process, and the level of understanding of the ideas by the tax paying public.

1. IMPROVING AN EXISTING TAX BASE

   The first version of tax reform that I want to explore is the regular work of improving an existing tax base. Given the relative importance of income taxation in the United States, it is not surprising that "tax reform" in the U.S. generally has meant refinement and improvement of the income tax.

   The seminal American formulation of the concept of income for these purposes is the celebrated definition articulated by the University of Chicago economist Henry Simons in the 1930s.(7) Given the centrality of what has come to be called the Haig-Simons definition of income to our first version of tax reform, it is worth quoting the concept in detail:

   Personal income may be defined as the algebraic sum of (1) the

   market value of rights exercised in consumption and (2) the

   change in the value of the store of property rights between the

   beginning and end of the period in question. In other words, it is

   merely the result obtained by adding consumption during the

   period to "wealth" at the end of the period and then subtracting

   "wealth" at the beginning. The sine qua non of income is gain,

   as our courts have recognized in their more lucid moments--and

   gain to someone during a specified time interval.(8)

   The key idea in this quite abstract formulation is that gains or increases in wealth, from whatever source, constitute the ideal personal income tax base, whether those gains are saved or spent on current consumption. This idea is not, however, directly translatable into an operational income tax, which has always used transactions, such as the receipt of salary or sale of assets, rather than mere changes in value, to trigger taxation.(9)

   The Haig-Simons definition was thus but the beginning for our first version of tax reform. The concept had to be translated into operational terms to deal with questions such as the following:

   (1) Should fringe benefits be taxed differently from salary under an income tax?

   (2) Should capital gains be taxed at a lower rate than other income?

   (3) How should capital cost recovery for machinery and equipment be designed under an income tax?

   (4) How should the income tax burden be affected by marital or family status?

   These and hundreds of similar questions have been addressed in a remarkable outpouring of writing on income tax policy since the end of the Second World War. One of the notable features of this literature is that it has been a joint enterprise of economists and lawyers in the government, in the universities, and in private practice. For example, the House Ways and Means Committee published an important compendium of papers on "broadening the tax base" in 1959.(10) Academic lawyers and economists debated the merits of a "comprehensive tax base" in the 1960s.(11) Important Treasury Department studies of tax reform were published in 1969,(12) 1977,(13) and 1984.(14) The American Bar Association Section of Taxation published an evaluation of the proposed model "comprehensive income tax" in 1979.(15) And the Brookings Institution organized a series of joint tax reform conferences for economists and lawyers in the 1970s and 1980s.(16)

   As a result of all this intellectual activity, a broad consensus developed among tax policy professionals about how the income tax could be improved, given the assumption that income was to be taxed. The short version of this consensus is that for reasons of fairness, economic efficiency, and ease of administration, the income tax should ideally make as few distinctions as possible among different categories of income and expenditure. According to the consensus, distinctions generally are to be avoided if they treat similarly situated taxpayers differently, if they distort economic decisions, or if they unduly complicate legal rules or business transactions.

   The fullest expression of this view was probably the characterization by Harvard Law School Professor Stanley Surrey, then serving as Assistant Secretary of the Treasury for Tax Policy in the Johnson Administration, of deviations from the ideal as "tax expenditures."(17) Surrey's faith in the consensus view was so strong that he thought legislative deviations from that view should be analyzed as the equivalent of tax receipts that had been collected and then spent on tax-favored activities.

   One result of all this work by tax policy specialists was that whenever political conditions ripened, there were legislative ideas already available for tax reform in the sense of improving the income tax by eliminating distinctions among different kinds of income. One important example was the Tax Reform Act of 1969,(18) which followed Surrey's tenure at Treasury, and which eliminated many tax preferences.

   The most recent example of tax reform in this sense is the Tax Reform Act of 1986.(19) Prior to 1986, the highest individual tax rate was 50%, and the general corporate rate was 46%.(20) Those nominal rates, however, were mitigated by a series of special provisions, including accelerated depreciation for investment in machinery and equipment, as well as preferential treatment of capital gains on certain investments. The tax advantages for some investment activities were marketed as "tax shelters" to investors who had little interest in the tax-preferred business other than the tax advantage.

   In the Tax Reform Act of 1986, Democrats interested in broadening the tax base united with Republicans interested in reducing tax rates to implement the fullest application to date of the first version of tax reform.(21) A plethora of special provisions were eliminated, including tax shelters for individual investors from outside...