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United States Government Accountability Office: 

Understanding the Tax Reform Debate: 

Background, Criteria, & Questions: 

September 2005: 

GAO-05-1009SP: 

Contents: 

Preface: 

Introduction: 

Section 1: Revenue--Taxes Exist to Fund Government: 

The Current Tax System: 

Historical Trends in Tax Revenue: 

Historical Trends in Federal Spending: 

Borrowing versus Taxing as a Source of Resources: 

Long-term Fiscal Challenge: 

Revenue Effects of Federal Tax Policy Changes: 

General Options Suggested for Fundamental Tax Reform: 

Key Questions: 

Section 2: Criteria for a Good Tax System: 

Equity: 

Equity Principles: 

Measuring Who Pays: Distributional Analysis: 

Key Questions: 

Economic Efficiency: 

Taxes and Economic Decision Making: 

Measuring Economic Efficiency: 

Taxing Work and Savings Decisions: 

Realizing Efficiency Gains: 

Key Questions: 

Simplicity, Transparency, and Administrability: 

Simplicity: 

Transparency: 

Administrability: 

Trade-offs between Equity, Economic Efficiency, and Simplicity, 
Transparency, and Administrability: 

Key Questions: 

Section 3: Transitioning to a Different Tax System: 

Deciding if Transition Relief Is Necessary: 

Identifying Affected Parties: 

Revenue Effects of Transition Relief: 

Policy Tools for Implementing Transition Rules: 

Key Questions: 

Appendixes: 

Appendix I: Key Questions: 

Section I: Revenue Needs--Taxes Exist to Fund Government: 

Section II: Criteria for a Good Tax System: 

Equity: 

Efficiency: 

Simplicity, Transparency, and Administrability: 

Section III: Transitioning to a Different Tax System: 

Appendix II: Selected Bibliography and Related Reports: 

Government Accountability Office: 

Congressional Budget Office: 

Other Selected Sources: 

Appendix III: Glossary: 

Tables: 

Table 1: Features of the Current Tax System: 

Table 2: The 10 Largest Tax Expenditures in 2004, Outlay Equivalent 
Estimates: 

Table 3: Measures of Tax Burden, Distribution of Total Federal Taxes 
and Individual Income Taxes in 2004: 

Table 4: The Corporate Tax Rate Schedule: Simple but Not Transparent: 

Figures: 

Figure 1: Issues to Consider When Assessing Alternative Tax Proposals: 

Figure 2: Revenue Overview: 

Figure 3: Sum of Tax Expenditure Outlay-Equivalent Estimates Compared 
to Discretionary Spending, 1981-2004: 

Figure 4: Federal Revenue as a Percentage of GDP and by Source, 1962- 
2004: 

Figure 5: Federal Spending as a Percentage of GDP and by Spending 
Category, 1962-2004: 

Figure 6: Federal Tax Revenue versus Federal Spending, 1962-2004: 

Figure 7: Composition of Federal Spending as a Share of GDP, Assuming 
Discretionary Spending Grows with GDP after 2004 and That Expiring Tax 
Provisions Are Extended: 

Figure 8: Formula for Determining Tax Revenue: 

Figure 9: Trade-offs in the Criteria for Assessing Tax Reform: 

Figure 10: Equity Overview: 

Figure 11: Efficiency Costs Are One Cost Taxpayers Face in Complying 
with the Tax System: 

Figure 12: Efficiency Overview: 

Figure 13: Simplicity, Transparency, and Administrability Overview: 

Figure 14: Compliance Burden Is One Cost Taxpayers Face in Complying 
with the Tax System: 

Figure 15: Taxpayer Noncompliance Categorized by Amount of Withholding 
and Information Reporting, 1992: 

Figure 16: Transition Issues Overview: 

[End of section]

Preface: 

Taxes are necessary because they fund the services provided by 
government. In 2005, Americans will pay about $2.1 trillion in combined 
federal taxes, including income, payroll, and excise taxes, or about 
16.8 percent of gross domestic product. 

Beyond funding government, the federal tax system has profound effects 
on the economy as a whole and on individual taxpayers, both for today 
and tomorrow. Taxes change people's behavior and influence the economy 
by altering incentives to work, consume, save, and invest. This, in 
turn, affects economic growth and future income--and thus future 
government revenues. At the same time, the current tax system generates 
fierce controversy over fairness--who should pay and how much they 
should pay. In addition, the current tax system is widely viewed as 
overly complex, thereby reducing the ability of individuals to 
understand and comply with the tax laws. Furthermore, the tax system is 
costly to administer with most of the costs of administration, such as 
record keeping, understanding the laws, and preparing returns, borne by 
taxpayers. 

Concerns about the economic effectiveness, fairness, and growing 
complexity of the current tax system raise questions about its 
credibility. These concerns have led to a growing debate about the 
fundamental design of the federal tax system. The debate includes the 
type of base--income or consumption--and the rate structure--flatter or 
more progressive. Additionally, some question to what extent and how 
the tax system should be used to influence economic behavior and social 
policy. 

Some see tax rates as too high--discouraging work, savings, and 
investment and consequently slowing economic growth. At the same time, 
the myriad of tax deductions, credits, special rates, and so forth 
cause taxpayers to doubt the fairness of the tax system because they do 
not know whether those with the same ability to pay actually pay the 
same amount of tax. In addition, tax expenditures, also called tax 
preferences, just like spending programs, can lead to higher tax rates 
over time. Complexity and the lack of transparency that it can create 
exacerbate doubts about the current tax system's fairness. Public 
confidence in the nation's tax laws and tax administration is critical 
because we rely heavily on a system of voluntary compliance. If 
taxpayers do not believe that the tax system is credible, is easy to 
understand, and treats everyone fairly, then voluntary compliance is 
likely to decline. 

The debate about the fundamental design of the tax system is occurring 
at a time when the nation also faces large current deficits and a 
significant and structural long-term fiscal imbalance. Long-term budget 
simulations by GAO, the Congressional Budget Office, the Office of 
Management and Budget, and nongovernment analysts show that absent 
policy changes, the federal budget is on an unsustainable path. Known 
demographic trends and rising health care costs will cause ultimately 
unsustainable deficits and debt that will threaten our national 
security as well as the standard of living for the American people in 
the future. 

While additional economic growth is critical and can help to ease the 
burden, the projected fiscal gap is so great that it is unrealistic to 
expect that growth alone will solve the problem. Ultimately, the nation 
will have to decide what it wants from the federal government, that is, 
what level of spending do we want on programs, tax preferences, and 
other government services and how we will pay for that spending. 
Clearly, tough choices will be required. Addressing the projected 
fiscal gap will prompt policymakers to examine the advisability, which 
includes both the effectiveness and affordability, of a broad range of 
existing programs and policies throughout the entire federal budget-- 
spanning discretionary spending, mandatory spending, entitlement 
programs, tax expenditures tax rates, and tax system design. This 
examination will likely result in actions affecting both tax revenues 
and tax expenditures. 

The background, criteria, and questions presented in this report are 
designed to aid policymakers and the public in thinking about how to 
develop tax policy for the 21ST century. This report, while not 
intended to break new conceptual ground, brings together a number of 
topics that tax experts have identified as those that should be 
considered when evaluating tax policy. This report attempts to provide 
information about these topics in a clear, concise, and easily 
understandable manner for a nontechnical audience. In developing this 
report, we relied on government studies, academic articles, and the 
advice of tax experts to provide us with information on the issues 
surrounding the tax reform debate. For a short bibliography of related 
publications, see appendix II. For easy reference, key terms are 
defined in the glossary located in appendix III--these glossary terms 
appear in bold type the first time they are used in the text. 

This publication was prepared under the direction of James R. White, 
Director, Strategic Issues (Tax Policy and Administration Issues), who 
may be reached at (202) 512-9110 or [Hyperlink, WhiteJ@gao.gov]. 
Contact points for our Offices of Congressional Relations and Public 
Affairs may be found on the last page of this report. Kevin Daly,

Tom Gilbert, Don Marples, Donna Miller, Ed Nannenhorn, and Amy 
Rosewarne made key contributions. This report will be available at no 
charge on the GAO Web site at [Hyperlink, http://www.gao.gov]. 

Signed by: 

David M. Walker: 
Comptroller General of the United States: 

[End of section]

Introduction: 

This report provides background information, criteria, and key 
questions for assessing the pros and cons of tax reform proposals, both 
proposals for a major overhaul of the current federal tax system and 
incremental changes to the system. Figure 1 outlines the key issues 
that we address. First, we discuss how the size and role of the federal 
government drive the government's revenue needs. Second, we describe a 
set of widely accepted criteria for assessing alternative tax 
proposals. These criteria include the equity, or fairness, of the tax 
system; the economic efficiency, or neutrality, of the system; and the 
simplicity, transparency, and administrability of the system. The 
weight one places on each of these criteria is a value judgment and 
will vary among individuals. As we note, there are trade-offs to 
consider among these criteria, and we discuss how these criteria can 
sometimes be in conflict with each other. Finally, we turn to a 
consideration of the issues involved in transitioning from the current 
tax system to an alternative tax system. 

Figure 1: Issues to Consider When Assessing Alternative Tax Proposals: 

[See PDF for image] 

[End of figure] 

The primary purpose of the tax system is to collect the revenue needed 
to fund the operations of the federal government, including its 
promises and commitments. Tax revenues may not fully match government 
spending each year, but over time, the federal government needs to be 
able to raise sufficient revenue to cover its current and expected 
financial obligations. Decisions about spending and the role of 
government have a direct impact on the government's ultimate revenue 
needs. 

Whether the resources to fund government spending are provided through 
taxes or borrowing has consequences for the economy and the federal 
budget. Borrowing (which has often led to budget deficits) may be 
appropriate for federal investment such as building roads and 
scientific research, and during times of recession, war, and other 
temporary challenges. However, federal borrowing also absorbs scarce 
savings that would otherwise be available for growth-enhancing private 
investment. In addition, large amounts of borrowing may increase the 
share of interest payments in the federal budget overtime, placing 
additional pressure on future budgets. 

One's view about the equity of a tax system is based on subjective 
judgments about the fairness of the distribution of tax burdens. The 
actual burden of a tax--the reduction in economic well-being caused by 
the tax--is not always borne by the people who pay the tax to the 
government because tax burdens can be shifted to other parties. For 
example, the burden of a tax on business can sometimes be shifted to 
consumers by increasing prices or to workers by decreasing wages. 
Public debates regarding the equity of the tax system reflect a range 
of opinions about who should pay taxes and how much of the tax burden 
should be shouldered by different types of taxpayers. 

Taxes impose efficiency costs by altering taxpayers' behavior, inducing 
them to shift resources from higher valued uses to lower valued uses in 
an effort to reduce tax liability. This change in behavior can cause a 
reduction in taxpayers' well-being that, for example, may include lost 
production (or income) and consumption opportunities. Efficiency costs, 
along with the tax liability paid to the government and the costs of 
complying with tax laws, are part of the total cost of taxes to 
taxpayers. One of the goals of tax policy, but not the only goal, is to 
minimize compliance and efficiency costs. The extent to which 
efficiency costs can be reduced by reforming the tax system depends on 
the design features of the new tax system, such as the nature and 
number of any tax preferences. 

Simplicity, transparency, and administrability are related but 
different characteristics of a tax system. Simplicity is a gauge of the 
time and other resources taxpayers spend to comply with the tax laws. 
This includes the time and resources spent on record keeping, learning 
about tax obligations, and preparing tax returns. The transparency of a 
tax system refers to taxpayers' ability to understand how their 
liabilities are calculated, the logic behind the tax laws, what their 
own tax burden and that of others is, and the likelihood of facing 
penalties for noncompliance. Administrability refers to the costs, 
ultimately borne by taxpayers, of collecting and processing tax 
payments as well as to the costs of enforcing the tax laws. While 
simplicity, transparency, and administrability are related concepts, 
they are not the same thing. A very simple tax rule may not be 
transparent if the rationale for the rule is not clear. Similarly, not 
all simple taxes are easy to administer. 

Designing tax policy requires making trade-offs among these criteria. 
For example, a proposal to improve the efficiency and simplicity of the 
tax code may involve eliminating exemptions or deductions originally 
introduced to improve the equity of the system. Moreover, some criteria 
include subjective elements. One individual's perception of the equity 
of a tax proposal can differ from another's. However, being subjective 
or objective does not make a criterion superior. 

In addition to determining the type of tax system, policymakers also 
determine the amount of revenue to be raised, which involves balancing 
the costs of taxes against the benefits of government services. Despite 
the fact that no tax system is perfectly fair, efficient, simple, 
transparent, and without administrative costs, in general people are 
willing to pay taxes and bear the other costs of the tax system because 
they desire the benefits of government and understand that sufficient 
tax resources are necessary for a sound fiscal policy in the long term. 

Finally, because moving to an alternative tax system creates winners 
and losers, transition rules may be included in tax reform proposals to 
mitigate some of the windfall gains and windfall losses that are likely 
to occur. However, debate exists as to whether transition rules, which 
are usually proposed on equity grounds, are appropriate because they 
may also reduce the efficiency of the tax system and temporarily make 
the tax system more complex. 

Tax reform proposals can range from small changes to the tax code to 
more comprehensive changes. The issues and questions we discuss in this 
report are designed to apply to both incremental changes to the tax 
system, such as changing tax expenditures to encourage savings, and to 
more comprehensive tax reform proposals, such as switching from a 
predominantly income-based tax to a consumption tax base. 

In addition to discussing the criteria used to evaluate changes to the 
tax system, this report provides information about economic and 
budgetary trends, the current tax system, and definitions of important 
tax concepts. For each section of the report, we provide a set of key 
questions designed to help identify the important features of the 
proposals This is information that we believe would be useful for 
evaluating the proposals and identifying limitations of the data and 
analysis. 

[End of section]

Section 1: Revenue--Taxes Exist to Fund Government: 

Taxes exist to fund the services provided and the promises made by the 
government. Since tax revenue may not match spending in each year, the 
resources needed to fund government can be also be raised by borrowing 
(deficit financing). Both taxes and borrowing affect economic 
performance. Taxes can affect the economy because they alter decision 
making by people and businesses. Federal borrowing absorbs savings 
otherwise available for private investment and postpones the need to 
tax or reduce spending. (See fig. 2.)

Figure 2: Revenue Overview: 

[See PDF for image] 

[End of figure] 

The Current Tax System: 

The federal tax system in the United States primarily consists of five 
types of taxes: (1) personal income taxes; (2) social insurance taxes 
(employee and employer contributions for Social Security, Medicare, and 
unemployment compensation); (3) corporate income taxes; (4) estate and 
gift taxes; and (5) excise taxes based on the value of goods and 
services sold and other taxes. The tax bases, rates, and collection 
points of the major federal taxes are summarized in table 1. 

Table 1: Features of the Current Tax System: 

Type of tax: Personal income taxes (PIT); 
Tax base: Regular PIT: Personal income, including income from wages, 
interest and dividends, capital gains, and small business income; 
Numerous tax expenditures exist that reduce the size of the tax base; 
Personal alternative minimum tax (AMT): Taxable income exceeding 
certain threshold amounts based on filing status; 
Tax rates: Regular PIT: Graduated rate structure: Statutory marginal 
rates of 10%, 15%, 25%, 28%, 33%, and 35%. Deductions and other tax 
expenditures, such as refundable tax credits like the Earned Income Tax 
Credit, create a group of taxpayers who have no tax liability or a 
negative tax liability; Personal AMT: 26% or 28% depending on taxable 
income subject to the AMT. Individuals are eligible for a credit for a 
portion of the AMT paid in a prior year; 
Collection points: Regular PIT: Employers withhold payments, but 
individuals file tax returns wherein they are also required to disclose 
nonwage income and remit appropriate taxes. Small business owners self-
report income and remit taxes to the government. Personal AMT: 
Individuals compare their regular PIT liability to their AMT liability 
and pay the greater of the two (less taxes previously withheld or paid 
during the year). 

Type of tax: Corporate income taxes (CIT); 
Tax base: Regular CIT: Corporate profits (total revenues less total 
expenses). Numerous tax expenditures exist that reduce the size of the 
tax base; Corporate AMT: Broader definition of the tax base (corporate 
income) than regular CIT; less generous accounting rules; 
Tax rates: Regular CIT: Statutory marginal rates range from 15% to 35%; 
Corporate AMT: 20% for all corporate income subject to the tax less the 
AMT credit for that tax year; 
Collection points: Regular CIT: Corporations file tax returns and remit 
payment to the government. Corporate AMT: Corporations compare regular 
CIT to corporate AMT liability and pay the greater of the two. 

Type of tax: Social insurance taxes; 
Tax base: Social security: First $90,000 of employee wages; Medicare: 
All wages; 
Tax rates: 6.2% employee contribution; 6.2% employer contribution; 
12.4% for self-employed; Medicare: 1.45% employee contribution; 1.45% 
employer contribution; 2.90% for self-employed; 
Collection points: Social security: Employers withhold taxes from 
employee paychecks; The self-employed remit taxes themselves. Medicare: 
Employers withhold taxes from employee paychecks; The self-employed 
remit taxes themselves. 

Type of tax: Unified transfer tax--estate, gift, and generation 
skipping tax (GST); 
Tax base: Estate tax: Fair market value of the decedent's cash and 
securities, real estate, trusts, annuities, business interests, and 
other assets included in the decedent's estate at death less allowable 
deductions in excess of $1.5 million in 2005. There is an unlimited 
deduction for transfers to a surviving spouse; Gift tax: Tax is imposed 
on the value of lifetime taxable transfers of gifts of property. 
Applicable exclusion amount of $1 million for 2005. In addition, there 
is an annual exclusion of $11,000 per donee and an unlimited exclusion 
for tuition and medical payments; GST: Total generation skipping 
transfers (such as from a grandparent to a grandchild) in excess of 
$1.5 million in 2005; 
Tax rates: Estate tax: Rates range from 45% to 47% in 2005. As a result 
of recent tax legislation, estate tax rates will fluctuate before the 
estate tax is eliminated in 2010. However, the estate tax will be 
reinstated in 2011; Gift tax: Rates range from 41% to 47% in 2005. 
Rates fluctuate in the same manner as for the estate tax in coming 
years. Gift tax will be retained following repeal of estate and GST; 
GST: 47% (or highest statutory marginal tax rate for the estate tax) in 
2005. GST rates decrease until the tax is repealed in 2010. GST is 
reinstated in 2011; 
Collection points: Estate tax: Decedent's estate is responsible for 
filing returns and remitting payment to the government. Gift tax: Gift 
donor is responsible for filing returns and remitting payment to the 
government. GST: Depending on the form of the generation skipping 
transfer, gift donor, donee trustee, or decedent's estate is 
responsible for filing returns and remitting payment to the government. 

Type of tax: Excise and other taxes; 
Tax base: Estate tax: Selected goods, services, and other items (i.e., 
gasoline, alcoholic beverages, tobacco, airline tickets, etc.); 
Tax rates: Various rates apply to different goods, services, and other 
items; 
Collection points: Generally collected by businesses, which remit 
payments to the government on a quarterly basis. 

Source: GAO analysis of Internal Revenue Service information. 

[End of table]

The revenue raised by the major federal taxes is determined by the size 
of their bases, their rates, and their levels of compliance. In 
addition, each tax base is affected by the size and growth rate of the 
economy. 

Although called income taxes, the current federal individual and 
corporate income taxes have some features characteristic of a 
consumption tax. The current income tax system taxes the income of 
individuals and corporations, such as wages, interest, dividend income, 
capital gains, and other types of business income, including that of 
sole proprietorships and partnerships. (Some income is double taxed-- 
corporate earnings are subject to the corporate income tax and are 
taxed again under the individual income tax when they are distributed 
as dividends or as realized capital gains when shareholders sell their 
stock.) However, some income is treated as it would be under a 
consumption tax where income that is saved or invested is exempted from 
tax until it is consumed. For example, up to certain limits, income 
that is contributed to individual retirement accounts and defined 
contribution pension plans is tax-deferred during accumulation. The 
result is a hybrid income-consumption tax base wherein some types of 
savings and investment are exempt from taxation, but other types are 
not. 

The current tax system includes tax expenditures, also called tax 
preferences, which reduce the size of the tax base. Tax expenditures 
are usually justified on the grounds that they promote certain social 
or economic goals. They grant special tax relief (through deductions, 
credits, exemptions, etc.) that encourages certain types of behavior by 
taxpayers or aids taxpayers in certain circumstances. Tax expenditures 
can promote a wide range of goals. For example, individual retirement 
accounts, discussed above, promote the goal of increased personal 
savings and investment, and the tax expenditures for owner-occupied 
homes encourage homeownership. 

Summing one measure of tax expenditures, called outlay-equivalents, 
indicates that the aggregate value of tax expenditures was about $850 
billion in fiscal year 2004. Outlay-equivalents are budget outlays that 
would be required to provide the taxpayers who receive the tax 
expenditures with the same after-tax income as would be received 
through the tax expenditures.[Footnote 1] As an indication of the size 
and impact of tax expenditures, figure 3 compares them to discretionary 
spending. In some years the outlay-equivalents for income tax 
expenditures exceeded federal discretionary spending. 

Figure 3: Sum of Tax Expenditure Outlay-Equivalent Estimates Compared 
to Discretionary Spending, 1981-2004: 

[See PDF for image] 

[End of figure] 

A few large income tax expenditures account for most of the aggregate 
value. The 10 tax expenditures listed in table 2 accounted for over 60 
percent of the outlay-equivalents in fiscal year 2004. The estimates in 
the table are for income tax expenditures. They do not include 
provisions that exclude income from other taxes, such as payroll taxes. 
For example, the income tax exclusion for health care permits the value 
of health insurance premiums to be excluded from employees' taxable 
earnings and also excludes this value from the calculation of Social 
Security and Medicare payroll taxes for both employees and employers. 

Table 2: The 10 Largest Tax Expenditures in 2004, Outlay Equivalent 
Estimates: 

Dollars in billions. 

Tax preference: Exclusion of employer contributions to medical 
insurance premiums and medical care; 
Outlay equivalents: $126.7.

Tax preference: Deductibility of mortgage interest on owner-occupied 
homes; 
Outlay equivalents: $61.5.

Tax preference: Net exclusion of pension contributions and earnings: 
401(k); 
Outlay equivalents: $58.2.

Tax preference: Net exclusion of pension contributions and earnings: 
employer plans; 
Outlay equivalents: $57.3.

Tax preference: Deductibility of nonbusiness state and local taxes 
(other than on owner-occupied homes); 
Outlay equivalents: $45.3.

Tax preference: Accelerated depreciation of machinery and equipment; 
Outlay equivalents: $44.7.

Tax preference: Exclusion of interest on public purpose state and local 
debt; 
Outlay equivalents: $37.5.

Tax preference: Capital gains (other than agriculture, timber, iron 
ore, and coal); 
Outlay equivalents: $35.9.

Tax preference: Capital gains exclusion on home sales; 
Outlay equivalents: $35.0.

Tax preference: Exclusion of net imputed rental income on owner-
occupied homes; 
Outlay equivalents: $32.8.

Source: GAO analysis of Office of Management and Budget (OMB), Budget 
of the United States Government, Fiscal Year 2006, Analytical 
Perspectives. 

[End of table]

In the current tax system, tax rates vary across types of tax. 
Individual income and corporate income above certain levels are 
generally taxed at graduated rates. Taxes on individual income have six 
statutory marginal tax rates (the rate of tax paid on the next dollar 
of income that a taxpayer earns), ranging from 10 percent to 35 
percent. Income earned by corporations has a statutory marginal rate 
structure that ranges from 15 percent to 35 percent. A separate rate 
structure exists for the individual Alternative Minimum Tax (AMT)--a 
tax on individual income that was originally designed to keep taxpayers 
with higher incomes from taking advantage of various tax provisions in 
order to pay little or no income tax. The current tax system also 
includes social insurance taxes, which are applied to wages at flat 
rates and remitted in equal shares by employees and employers. However, 
currently the first $90,000 of an individual's wages is subject to 
payroll taxes for Social Security, while all wages are subject to 
payroll taxes for Medicare. 

The government's administrative burden and taxpayers' compliance burden 
vary depending on the type of taxpayer, the type of tax, and the 
collection point of the tax. For the individual income tax and social 
insurance taxes, the primary collection point occurs at the business 
level: employers bear the burden of withholding employees' taxes from 
their wages and remitting the tax payments to the government. However, 
all individuals with income above certain thresholds based on personal 
allowances and a standard deduction still must file tax returns. The 
Internal Revenue Service (IRS) bears the administrative burden of 
monitoring taxpayer compliance and applying penalties to noncompliant 
taxpayers when necessary. 

Historical Trends in Tax Revenue: 

Total federal tax revenues have fluctuated from roughly 16 to 21 
percent of gross domestic product (GDP) over the last 43 years. In 
figure 4, total federal revenue is highest in 2000 at 20.9 percent of 
GDP and lowest in 2004 at 16.3 percent of GDP. 

As figure 4 also illustrates, there have been important changes to the 
composition of federal revenues over the last 43 years. Corporate and 
excise tax receipts as a percentage of GDP have declined since 1960, 
while social insurance tax receipts have grown. The individual income 
tax and social insurance taxes have accounted for the majority of 
federal revenues during this period. 

Figure 4: Federal Revenue as a Percentage of GDP and by Source, 1962- 
2004: 

[See PDF for image] 

[End of figure] 

Historical Trends in Federal Spending: 

As figure 5 illustrates, over the last 43 years, federal spending as a 
portion of GDP has ranged from a low of 17.2 percent of GDP in 1965 to 
a high of 23.5 percent of GDP in 1983. In addition, figure 5 
illustrates that as is the case with revenues, important changes to the 
composition of federal spending have occurred. For example, since 1962, 
the total share of federal spending devoted to national defense has 
decreased relative to the share devoted to Social Security and health 
care. Government provision of Social Security and health care accounted 
for over 40 percent of government spending in 2004, a dramatic increase 
from the share before 1965 when the Medicare and Medicaid programs were 
enacted. 

Figure 5: Federal Spending as a Percentage of GDP and by Spending 
Category, 1962-2004: 

[See PDF for image] 

[End of figure] 

Borrowing versus Taxing as a Source of Resources: 

The resources to fund government are raised primarily through taxes. 
However, borrowing is another source. Figure 6 combines figures 4 and 5 
to show that the federal government has generally run a deficit in 
recent decades. 

Figure 6: Federal Tax Revenue versus Federal Spending, 1962-2004: 

[See PDF for image] 

[End of figure] 

Public sector resources, whether from taxes or borrowing, make the 
benefits of government possible. However, taxes and borrowing also have 
costs. Obviously, they transfer money from the pockets of the public to 
the government. But they also affect the performance of the economy. As 
will be discussed under the criteria for a good tax system, taxes 
affect the performance of the economy by altering decisions, such as 
how much to work and save, what to consume, and where to invest. 

Federal borrowing has advantages and disadvantages that vary depending 
on economic circumstances. Borrowing, in lieu of higher taxes or lower 
government spending, may be viewed as appropriate during times of 
economic recession, war, or other temporary challenges. Federal 
borrowing might also be viewed as appropriate for federal investment, 
such as building roads, training workers, and conducting scientific 
research, that contributes to the nation's capital stock and 
productivity. If well chosen, such activities could ultimately help 
produce a larger economy. However, if not well chosen, such spending 
could displace more productive private sector investments. 

Federal borrowing also can impose significant costs and risks. 
Borrowing for additional spending or lower taxes for current 
consumption improves short-term well-being for today's workers and 
taxpayers, but does not enhance our ability to repay the borrowing in 
the future. In the near term, federal borrowing also absorbs scarce 
savings available for private investment and can exert upward pressure 
on interest rates. Over the long term, federal borrowing that restrains 
economic growth will also restrain the standard of living of future 
workers and taxpayers. 

Long-term Fiscal Challenge: 

As discussed in our report on challenges facing the government, the 
fiscal policies in place today--absent substantive entitlement reform 
and changes in tax and spending policies--will result in large, 
escalating, and persistent deficits that are economically unsustainable 
over the long term.[Footnote 2] In other words, given current forecasts 
for growth, government spending and resources, today's policies cannot 
continue and must change. 

Over the next few decades, as the baby boom generation retires, federal 
spending on retirement and health programs, such as Social Security, 
Medicare, and Medicaid, will grow dramatically and bind the nation's 
fiscal future. Absent policy changes on the spending and/or revenue 
sides of the budget, a growing imbalance between federal spending and 
tax revenues will mean escalating and ultimately unsustainable federal 
deficits and debt. For example, as figure 7 indicates, if discretionary 
spending grows at the same rate as the economy and all expiring tax 
provisions are extended, federal revenues could be adequate to cover 
little more than interest on the federal debt by 2040. 

Figure 7: Composition of Federal Spending as a Share of GDP, Assuming 
Discretionary Spending Grows with GDP after 2004 and That Expiring Tax 
Provisions Are Extended: 

[See PDF for image] 

Notes: This figure is based on the assumption that discretionary 
spending grows at the same rate as GDP after 2004 and that expiring tax 
provisions are extended. Despite our assumption that expiring tax 
provisions are extended, revenue as a share of GDP increases through 
2015 due to (1) real bracket creep, (2) more taxpayers being subject to 
the AMT, and (3) increased revenue from tax-deferred retirement 
accounts. After 2015, revenue as a share of GDP is held constant. 

[End of figure] 

Regardless of the assumptions used, reasonable long-term simulations 
indicate that the problem is too big to be solved by economic growth 
alone or by making modest changes to existing spending and tax 
policies. While entitlement reform as well as mandatory and 
discretionary spending cuts will likely be needed to close the long- 
term financial gap, the structure of the tax system should also be part 
of the debate as policymakers grapple with the nation's long-term 
fiscal challenge. As part of this process, consideration could be given 
to improving taxpayer compliance and enforcement efforts, expanding the 
tax base, increasing current tax rates and tax rates on future 
generations, or a combination of these. 

Revenue Effects of Federal Tax Policy Changes: 

The amount of revenue raised from a tax is determined by the tax base, 
the tax rate, and the compliance rate, as shown in figure 8. Changes to 
the tax code can be revenue neutral, meaning that they are designed to 
raise the same amount of revenue as the current tax laws, or tax code 
changes can be designed to raise more or less revenue than the current 
tax laws. Additionally, changes to the federal tax system can have 
significant implications for state and local government tax revenues. 

Figure 8: Formula for Determining Tax Revenue: 

[See PDF for image] 

[End of figure] 

Tax revenue can be affected by changing the current tax base, which 
could include replacing it with a pure consumption tax base or 
broadening the current tax base by eliminating certain tax 
expenditures. As we noted earlier, tax expenditures, which the 
government uses to encourage specific social and economic goals, reduce 
the size of the tax base. Tax expenditures may be justified because, in 
some cases, it may be less costly to achieve these goals through 
reductions to the tax base than through spending programs. The choice 
of whether to use tax expenditures or spending depends on which 
approach better targets and meets the program's objectives at the 
lowest cost. Even though spending programs show up in the federal 
budget and tax expenditures are not included as federal spending, 
taxpayers are paying for the program in either case. Both should be 
transparent and subject to periodic oversight concerning such factors 
as whether they meet the program's objectives or conflict with other 
government programs, grants, and regulations that have similar 
objectives. The tax expenditure for employer-provided health care, 
discussed in text box 1, illustrates the importance of such oversight. 

Text Box 1: Tax Expenditure for Employer Medical Insurance Premiums and 
Medical Care; The current U.S. tax system excludes employer-provided 
health insurance from individuals' taxable income even though such 
insurance is a form of income (noncash compensation). As table 2 
showed, the Treasury Department estimates that the tax subsidy for 
employer-provided health insurance was over $126 billion in outlay- 
equivalents during 2004, not including forgone social insurance taxes 
and state taxes; The tax exclusion increases the proportion of the 
population covered by health insurance. Currently, nearly 45 million 
Americans are without health insurance. The tax exclusion encourages 
employers to offer and employees to participate in health insurance 
plans, increasing the proportion of workers covered. The exclusion 
addresses a well-known problem with health insurance. Because 
individuals may be better able to anticipate their health care needs 
than insurers, health care plans may attract customers with higher risk 
of poor health, resulting in higher premiums. By encouraging the 
pooling of high-and low-risk individuals, the tax exclusion may help to 
reduce premiums below those that individuals would face if they 
purchased insurance on their own; However, some question whether the 
tax subsidy for health insurance is the best way to increase health 
insurance coverage. For example, the tax exclusion provides the most 
assistance to taxpayers who have high marginal tax rates (those with 
high incomes)--the exclusion saves those taxpayers more in taxes owed 
than it saves those with lower marginal tax rates; The tax exclusion 
for health insurance also contributes to higher health care costs. The 
exclusion, by lowering premiums, encourages more extensive insurance 
coverage, which compounds another well-known problem with health 
insurance. Because much of the cost of medical treatment is paid for by 
a third party (the insurer), patients and doctors are generally unaware 
of the total costs of health care and have little incentive to 
economize on health care spending; Unlike the tax exclusion for 
employer-provided health insurance, an ideal health care payment system 
would foster the delivery of care that is both effective and efficient, 
resulting in better value for the dollars spent on health care. 

[End of text box]

Tax revenue can also be affected by changes in tax rates, where the 
amount collected depends on the definition of the tax base and taxpayer 
responses to changes in the rate. If the tax base is broad with few 
exclusions, deductions, and credits, then the tax rates required to 
generate a particular amount of revenue will be lower than if the base 
is narrow. The Tax Reform Act of 1986 broadened the current tax base, 
which is based largely on income, by eliminating some tax expenditures, 
which made more income taxable. Without any changes in rates, tax 
revenue would have increased, but instead, rates were lowered to keep 
revenue about the same. Within some range, rate increases bring in more 
revenue, but rates can become so high that a further increase 
discourages enough of the taxed activity to reduce revenue. A tax 
system is more adaptable to increased revenue needs to the extent that 
tax rates can be increased without other fundamental changes to the 
system and without excessively discouraging the taxed activity or 
increasing noncompliance. 

Tax revenue is also affected by policies that change compliance rates. 
Noncompliance means that only part of the tax liability actually gets 
paid. Increasing compliance would bring in more revenue from the 
existing tax base without having to raise rates. IRS estimates that the 
net tax gap (the difference between taxes legally owed to the 
government and what taxpayers actually paid to the government) was at 
least $257 billion in 2001, the most recent year available. This is 
about 13 percent of federal revenue. Some experts believe that 
simplicity and transparency can contribute to compliance, as voluntary 
compliance is likely to increase if taxpayers are less likely to make 
errors on their tax returns and have fewer opportunities to evade 
taxes. 

While federal tax policy changes may alter the amount of revenue 
collected by the federal government these changes can also alter the 
amount of revenue that state and local governments collect. State and 
local governments collect nearly one-third of all the tax revenue 
generated in the United States each year. 

In many cases, state governments link their tax bases to the federal 
tax base. For example, some states use a taxpayer's adjusted gross 
income from the federal tax return to calculate state income taxes. If 
the federal government enacted provisions that reduce the size of the 
tax base used to calculate a taxpayer's adjusted gross income, then 
absent policy changes in the affected states, these state governments 
would likely see a decrease in state tax revenues. Conversely, if the 
federal government reduced the number of tax expenditures, increasing 
the size of the tax base, state governments would likely see an 
increase in state tax revenues. Thus, major changes to the federal tax 
base could lead to a variety of challenging tax system changes at the 
state level. For example, if the federal government adopted a 
consumption tax base, many states may have to consider whether they 
wish to maintain state income taxes. 

General Options Suggested for Fundamental Tax Reform: 

Recent years have seen a variety of proposals for fundamental tax 
reform. These proposals would significantly change the tax base, tax 
rates, and collection points of the tax. 

Some of the proposals would replace the federal income tax with some 
type of consumption tax. The retail sales tax, value-added taxes, the 
personal consumption tax, and the flat tax are all types of consumption 
taxes. They vary in their collection points and structure. Similarly, 
collection points and rate structure will vary under an income tax 
base. 

Text box 2 briefly summarizes the general categories of proposals. 

Text Box 2: General Categories of Tax Reform Proposals; In recent 
years, lawmakers and analysts have suggested a variety of tax reform 
proposals that would change the way in which Americans pay taxes; 

* National retail sales tax (NRST): An NRST would be collected by 
businesses with, in most cases, no need for individuals to file tax 
returns (some taxpayers may be required to file tax returns in order to 
get back taxes that they paid on items for business use). The base 
would be retail sales of goods and services to final customers. Rates 
could not vary by individual; 

* Value-added taxes (VAT): VATs, now widely used in other countries, 
are collected by businesses with no need for individual tax returns. 
The VAT taxes all sales to both consumers and other businesses, 
adjusting for purchases from other businesses, which is equivalent to 
the base of an NRST. Rates do not vary by individual. Some experts 
believe a VAT would be easier to enforce than an NRST; 

* Flat tax: A consumption flat tax would have the same base as an NRST 
or a VAT but would split collection between businesses and individuals 
by making wages deductible by businesses but taxable at the individual 
level. Generally, a single tax rate would apply to both individuals and 
businesses. Because of the individual component of the tax, wages up to 
some level can be exempted from tax, which would introduce some 
progressivity into this tax system; 

* Personal consumption taxes: A personal consumption tax would look 
much like the current individual income tax. Individuals would report 
their income from wages, interest, dividends, and so on. It would 
differ in that borrowed funds would be included in the tax base, and 
funds that are saved or invested would be deducted. The base is 
equivalent to that of other consumption taxes. Rates could vary based 
on individual characteristics; 

* Reformed income tax system: Over the years, the Department of the 
Treasury and others have discussed options for reforming the current 
tax system that would replace the current income tax with a more 
broadly based income tax. For example, proposals have been advanced to 
integrate the personal and corporate income tax and to eliminate 
preferences on certain types of income, which would broaden the tax 
base and could result in reduced tax rates (if the proposal were 
revenue neutral). 

[End of text box]

Key Questions: 

1. What current taxes would the proposal change?

* Does the proposal change personal income taxes, social insurance 
taxes, corporate income taxes, and/or estate and gift taxes?

2. What is the nature of the proposed change to the tax system?

* Does the proposal change the tax base from income to consumption?

* Does the proposal include tax expenditures?

* Does the proposal change the tax rates?

* Does the proposal change the collection points for the tax?

3. How will the proposed change affect total revenues?

* Are proposed changes to the tax code likely to be revenue neutral?

* If not, will they generate more or less revenue than the current tax 
laws?

4. What effect would the proposal have on the nation's projected 
budgets and long-term fiscal outlook?

* Does the proposal take into consideration the sizable long-term 
fiscal gap that the country faces?

5. What tax expenditures are included in the proposal, and what tax 
expenditures, if any, have been removed from the current tax system?

* Are the social and economic goals of the tax expenditures likely to 
be achieved and worth the cost in lost revenue?

* When the total costs of a program are considered, would it be less 
costly to implement the program as a tax expenditure or as a spending 
program?

6. If the proposal changes the tax base, the tax rates, or the 
collection points, how would these changes alter the amount of revenue 
that the government is able to collect?

7. What implications, if any, would the proposal have on the ability of 
state and local governments to collect tax revenues?

* Would the proposal tax the same base that many states rely on?

* Would the proposal allow many states to continue to rely on the 
federal tax base as a starting point for determining state taxes?

[End of section]

Section 2: Criteria for a Good Tax System: 

How should a tax system be designed to raise a given amount of revenue? 
More specifically, what criteria should be used to evaluate the 
advantages and disadvantages of a particular tax system, or a 
particular tax policy proposal? The answers matter because various 
combinations of tax bases and rates can raise the same amount of 
revenue. 

Three long-standing criteria--equity; economic efficiency; 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 between the criteria when evaluating a particular tax 
proposal. Some of the criteria, such as equity and transparency, are 
more subjective while other aspects of some of the criteria, such as 
economic efficiency, can be defined more objectively. Additionally, 
people may disagree about the relative importance of the criteria. 
Consequently, citizens and elected officials are likely to hold a wide 
range of opinions about what the ideal tax system should look like. 
(See fig. 9.)

Figure 9: Trade-offs in the Criteria for Assessing Tax Reform: 

[See PDF for image] 

[End of figure] 

In the following sections, we explain these criteria. The fact that a 
particular tax is viewed favorably from the perspective of one of the 
criteria is not an overall endorsement of the tax. 

Equity: 

There are a wide range of opinions regarding what constitutes an 
equitable, or fair, tax system. There are principles--a taxpayer's 
ability to pay taxes and who receives the benefits from the tax revenue 
that is collected--that are useful for thinking about the equity of the 
tax system. However, these principles do not change the fact that 
conclusions about whether one tax is more or less equitable than 
another are value judgments. Similarly, analytical tools, such as 
distributional analysis, while providing useful factual information 
about who pays a tax and how much they pay, do not replace individuals' 
value judgments about what constitutes a fair tax system. (See fig. 10.)

Figure 10: Equity Overview: 

[See PDF for image] 

[End of figure] 

Equity Principles: 

Two principles of equity underlie debates about the fairness of 
different tax policies. The ability to pay principle and the benefits 
received principle do not identify one tax policy as more equitable 
than another, but they can be used to clarify and support judgments 
about equity. When making judgments about the overall equity of 
government policy, it is important to consider both how individuals are 
taxed and how the benefits of government spending are distributed. Even 
if some judge tax policy to be inequitable, government policy as a 
whole may be considered more equitable once the distribution of both 
taxes and government benefits is accounted for. For the purposes of 
this report, we have confined our discussion of equity to the 
distribution of tax burdens. 

Ability to Pay Principle: 

The ability to pay principle states that those who are more capable of 
bearing the burden of taxes should pay more taxes than those with less 
ability to pay. The ability to pay principle relates taxes paid to some 
measure of ability to pay, such as overall wealth, income, or 
consumption. However, ability to pay may vary depending on the measure 
chosen. For example, a taxpayer's ability to pay, measured by overall 
wealth, may differ significantly from his or her ability to pay 
measured by income. A taxpayer who worked for many years and then 
retired may have accumulated a significant amount of wealth and may, as 
a result, have a higher ability to pay taxes but may have low current 
income. 

Some features of the current income tax can be viewed as reflecting 
attempts to account for differences in ability to pay. For example, two 
taxpayers with the same income may not have the same level of economic 
well-being--the same ability to pay--if one has high medical expenses 
and the other does not. For this reason, the current income tax allows 
deductions for large medical expenses. Other provisions of the tax 
code, such as the deduction for the number of dependents, may also 
adjust income to better reflect ability to pay. Some items that clearly 
affect ability to pay, such as the contribution provided by a 
nonworking spouse to a family's well-being, are not included in taxable 
income, in part because of difficulties in valuing these aspects of 
economic well-being. People have different views about the factors that 
affect ability to pay. 

Additionally, some do not agree that income is the best measure of 
ability to pay. As noted above, some argue that consumption provides a 
better measure of a taxpayer's ability to pay taxes than income. 

Horizontal and Vertical Equity: 

The concepts of horizontal equity and vertical equity are refinements 
of the ability to pay principle. 

Horizontal equity requires that taxpayers who have similar ability to 
pay taxes receive similar tax treatment. Targeted tax expenditures, 
such as deductions and credits, could affect horizontal equity 
throughout the tax system because they may favor certain types of 
economic behavior over others by taxpayers with similar financial 
conditions. For example, two taxpayers with the same income and 
identical houses may be taxed differently if one owns his or her house 
and the other rents because mortgage interest on owner-occupied housing 
is tax deductible. 

Vertical equity deals with differences in ability to pay. Subjective 
judgments about vertical equity are reflected in debates about the 
overall fairness of the following three types of rate structures, where 
for this example, income is used as the measure of ability pay: 

* Progressive tax rates: The tax liability as a percentage of income 
increases as income increases. 

* Proportional tax rates: Taxpayers pay the same percentage of income, 
regardless of the size of their income. 

* Regressive tax rates: The tax liability is a smaller percentage of a 
taxpayer's income as income increases. 

Just because the statutory rate structure for a tax is progressive does 
not necessarily mean that the tax system is progressive overall. For 
example, when considering an individual income tax, if statutory 
marginal tax rates increase as taxable income increases the tax rate 
structure is progressive. However, as shown in text box 3, statutory 
tax rates are not the same as effective tax rates--progressive 
statutory tax rates could be offset by other features of the tax 
system. Average effective tax rates, or the amount of tax that a 
taxpayer actually pays as a percentage of his or her total income 
(after deductions, credits, and exclusions are removed from the 
equation) may make the tax less progressive if there are a variety of 
provisions in the tax code that reduce the taxable income of wealthier 
taxpayers. 

Text Box 3: Examples of Different Types of Tax Rates; Conclusions about 
the overall equity of the tax system may be different depending on 
which type of tax rate one considers; Statutory tax rates are the tax 
rates that are defined by law in the tax code and applied to taxable 
income. Effective tax rates differ from statutory tax rates in that 
they are typically measured using a broader definition of income, which 
includes items excluded under the current tax code in order to provide 
an estimate of what a taxpayer pays in relation to his or her overall 
total income; Marginal tax rates are the rates that taxpayers pay on 
the next dollar of income that is earned. Marginal tax rates can be 
presented as both marginal statutory rates and marginal effective 
rates. Average tax rates are the total amount of tax a taxpayer pays 
divided by some measure of his or her income. In the current tax 
system, average tax rates are sometimes presented as the amount of tax 
a taxpayer pays divided by his or her taxable income. Average effective 
tax rates differ in that they are developed using a broader measure of 
total income than taxable income; The following tax rates are often 
discussed when considering the equity of the tax system; 

* Marginal statutory tax rates: The tax rate that a taxpayer pays on 
his or her next dollar of income earned as defined by law in the tax 
code; 

* Marginal effective tax rates: The actual rate of tax that a taxpayer 
faces on the next dollar of income earned when all other provisions of 
the tax (deductions, credits, etc.) are included; 

* Average effective tax rates: The overall rate of tax a taxpayer pays 
as a percentage of his or her total income after all other provisions 
of the tax system (deductions, credits, etc.) are included; Conclusions 
about the progressivity of the tax system may differ, for example, 
depending upon whether they are based on an examination of the 
statutory marginal rate structure or on the effective marginal rate 
structure. 

[End of text box]

People hold different opinions as to whether the current rate structure 
is vertically equitable. Some believe that the rate structure should be 
more progressive, and that effective tax rates should rise with income 
more rapidly than they do under the current system. Others support a 
proportional rate structure. They believe that a tax system that 
imposes a single flat tax rate on income is more equitable because each 
additional dollar earned is taxed at the same rate. 

Benefits Received Principle: 

In contrast to the ability to pay principle, the benefits received 
principle states that the amount of tax paid should be directly related 
to the benefits that a taxpayer receives from the government. In 
practice, the benefits received principle requires the government to 
identify who benefits from specific government services. As a result, 
the benefits received principle is usually not applicable when 
considering government programs intended to provide societywide 
benefits or redistribute wealth. 

The federal tax on gasoline is an example of a tax that is sometimes 
justified on the benefits received principle. Gas taxes are paid by 
road users. This means that the people who pay the tax (drivers) are 
the same taxpayers who receive the benefits from the revenue collected 
in the form of both new and improved highways. User fees, such as 
postage stamps or fees to enter national parks, are another example of 
taxes based on the benefits received principle. 

Measuring Who Pays: Distributional Analysis: 

Distributional analysis, which shows tax burden by differing income 
groups, is used to measure how different tax proposals would affect 
taxpayers with varying ability to pay, or the way in which the tax 
burden is to be shared among various income groups. Some tax reform 
proposals may alter the distribution of taxes paid among various groups 
of taxpayers, while other tax reform proposals may be distributionally 
neutral, or maintain the same distribution of tax burdens as the tax 
system that is already in place. The Tax Reform Act of 1986 is an 
example of a tax reform proposal that was intended to be 
distributionally neutral. 

The distributional analyses of a specific tax proposal may differ for a 
variety of reasons. Among the most important are (1) the time period 
included in the analysis, (2) the manner in which ability to pay is 
measured, (3) the unit of analysis, (4) assumptions regarding tax 
incidence, (5) the taxes included in the analysis, and (6) the measures 
of tax burden used in the table. 

Time period of the analysis: Most distributional analysis tables use 
annual measures of income and taxes, although some use longer periods. 
However, a 1-year time horizon provides a limited perspective on the 
distributional effects of federal taxes. For example, consider the same 
individual at different points in his or her life. When he or she 
enters the workforce, income and wealth usually are relatively low but 
increase over time when prime earnings years are reached and assets and 
savings begin to be accumulated. With retirement, annual wages fall and 
savings are the primary support for the retirees lifestyle. As a result 
of fluctuations in income over time, annual tables measuring the 
distribution of tax burdens may group together people who have 
different lifetime economic circumstances. 

Ability to pay measure: Most studies that measure distributional 
effects of alternative tax proposals include a broad measure of income 
that includes more than just taxable income to measure a taxpayer's 
ability to pay. Some types of nonwage income, such as investment 
income, are relatively easy to identify and include in distributional 
tables, while others are more difficult. For example, distributional 
analyses may attempt to adjust for such factors as the value of 
employer-provided fringe benefits in order to broaden the definition of 
income to better reflect ability to pay. 

However, while income is the most commonly used measure of ability to 
pay in distributional analysis, other measures of ability to pay, such 
as consumption, may also be used to create distributional tables. As we 
mentioned earlier, some believe that consumption is a better measure of 
ability to pay taxes than income. 

Unit of analysis: The unit of analysis used to group taxpayers together 
may also affect the outcome of distributional tables. Some analysts 
create distributional tables using individual taxpayers as the unit of 
analysis, while others group taxpaying units (people included on a tax 
return, families, or households) together. Distributional tables may 
differ if one table uses individual taxpayers and another table uses a 
taxpaying unit because a taxpaying unit may include more than one 
individual who pays taxes. 

Tax incidence: The actual burden of a tax does not always fall on the 
people or businesses that actually pay the tax to the government, and 
assumptions about tax incidence may affect the results of 
distributional tables. The statutory incidence of a tax--the parties 
who are legally required to pay the tax--may not be the same as its 
economic incidence--the parties who actually bear the burden of the 
tax--because taxpayers who legally must pay the tax can sometimes shift 
the burden to others through changes in prices, wages, and returns on 
investments. For example, from a statutory perspective, the employee 
and employer contribution to the payroll tax are equal. However, most 
analysts agree that employees bear the entire burden of the payroll tax 
in the form of reduced wages. 

Determining who bears the burden of the corporate income tax is an 
example of how difficult it can be to determine the incidence of a tax. 
Text box 4 illustrates some of the issues associated with identifying 
the incidence of the corporate income tax. 

Text Box 4: Incidence of the Corporate Income Tax; Corporations do not 
actually bear the ultimate burden of the corporate income tax; instead, 
individuals bear the burden of the corporate income tax. A corporation 
writes a check to the U.S. Treasury to pay its tax liability, but the 
burden of the tax is shifted to other groups of people through lower 
incomes or higher prices; 

The money to pay the tax must come from reduced returns to investors in 
the corporation, lower wages to the company's employees, or higher 
prices that consumers pay for the company's products. In the short 
term, the incidence of the corporate income tax is likely to fall on 
stockholders or investors in general. However, because corporate income 
taxes may lead to reduced capital investment, in the longer term some 
of the burden of the corporate income tax is more likely shifted to 
people who earn income from labor. Reduced capital investment can lead 
to lower productivity and, consequently, lower wages; 

Due to the difficulty of identifying the incidence of the corporate 
income tax, some, including the Joint Committee on Taxation, often 
exclude the corporate income tax from distributional tables altogether. 

[End of text box]

Taxes included in the analysis: Some distributional tables include 
different taxes in the analysis, so when comparing two distribution 
tables, identifying which taxes are included in the analysis is 
necessary to ensure that a valid comparison can be made between the two 
estimates. For example, in table 3, one side of the table includes all 
federal taxes, while the other side only includes the federal income 
tax. Because it is often difficult to isolate the incidence of some 
taxes, analysts sometimes exclude those taxes from the analysis. 

Measures of tax burden: Distributional tables may also produce 
different results based on the measures of tax burden that are used. 
Effective tax rates and share of tax liability (portion of total taxes 
that households in each quintile collectively remitted to the 
government), the measures used in table 3, are two common measures of 
tax burden. Some distributional tables show how effective tax rates 
would change if the tax code were changed. 

Different Assumptions Lead to Different Distributional Analyses: 

The Office of Tax Analysis in the Treasury Department, the 
Congressional Budget Office (CBO), and the Joint Committee on Taxation 
are the three government sources of tax distributional analysis, and 
their distributional tables may differ based on the assumptions that 
they make about the issues we have outlined above. 

The example in table 3, which shows two measures of tax burden, 
illustrates the fact that making different assumptions when conducting 
distributional analysis can lead to different results. 

Table 3: Measures of Tax Burden: Distribution of Total Federal Taxes 
and Individual Income Taxes in 2004: 

Income quintiles: Lowest quintile; 
Total federal taxes: Effective tax rates: 5.2%; 
Total federal taxes: Share of tax liability: 1.1%; 
Individual income taxes: Effective tax rates: -5.7%; 
Individual income taxes: Share of tax liability: -2.7%. 

Income quintiles: Second quintile; 
Total federal taxes: Effective tax rates: 11.1%; 
Total federal taxes: Share of tax liability: 5.2%; 
Individual income taxes: Effective tax rates: -0.1%; 
Individual income taxes: Share of tax liability: -0.1%.

Income quintiles: Middle quintile; 
Total federal taxes: Effective tax rates: 14.6%; 
Total federal taxes: Share of tax liability: 10.5%; 
Individual income taxes: Effective tax rates: 3.5%; 
Individual income taxes: Share of tax liability: 5.4%. 

Income quintiles: Fourth quintile; 
Total federal taxes: Effective tax rates: 18.5%; 
Total federal taxes: Share of tax liability: 19.5%; 
Individual income taxes: Effective tax rates: 6.6%; 
Individual income taxes: Share of tax liability: 15.2%.

Income quintiles: Highest quintile; 
Total federal taxes: Effective tax rates: 23.8%; 
Total federal taxes: Share of tax liability: 63.5%; 
Individual income taxes: Effective tax rates: 14.2%; 
Individual income taxes: Share of tax liability: 82.1%. 

Income quintiles: All; 
Total federal taxes: Effective tax rates: 19.6%; 
Total federal taxes: Share of tax liability: 100.0%; 
Individual income taxes: Effective tax rates: 9.0%; 
Individual income taxes: Share of tax liability: 100.0%. 

Source: Congressional Budget Office, Effective Federal Tax Rates Under 
Current Law, 2001 to 2014 (Washington, D.C.: August 2004). 

Note: In table 3, numbers do not always add due to rounding. 

[End of table]

Both of the distribution tables were prepared by CBO using the same 
methodology to measure the distributional effects of the tax system in 
2004 using 2001 income (adjusted for inflation and nominal income 
growth to reflect income in 2004) as the base for the analysis. The 
only difference between the left side of the table and the right side 
of the table is the taxes that are included in the analysis. The left 
side includes total federal taxes, excluding estate and gift taxes and 
several other miscellaneous sources of revenue, while the right side of 
the table only includes individual income taxes. The table that 
presents total federal taxes uses the assumption that individuals bear 
the burden of the employee and employer share of payroll taxes, and 
owners of capital income bear the burden of the corporate income tax. 
The effective tax rates for individual income taxes are negative for 
the two lowest income quintiles because the table includes some offsets 
to tax liability, such as the earned income tax credit. 

Key Questions: 

1. How is a taxpayer's ability to pay broadly defined: 

* Income?

* Consumption?

* A broader definition of overall wealth?

2. What factors other than income, such as medical expenses, number of 
dependents, and so forth, does the proposal account for when 
considering a taxpayer's ability to pay taxes?

3. Will taxpayers with equal ability to pay taxes pay the same amount?

* If not, what provisions of the proposal do not adhere to the 
principle of horizontal equity?

4. How will the tax system tax people with differing ability to pay?

* Are the statutory tax rates progressive, proportional, or regressive?

* Are the average effective tax rates progressive, proportional, or 
regressive (accounting for credits, deductions, and other tax 
expenditures)?

5. Are there any components of the tax proposal that are justified on 
the benefits received principle?

* If so, what mechanisms are in place to determine that taxpayers who 
pay taxes for a particular government program are the same taxpayers 
who benefit from the provisions of that program?

6. Does the proposal maintain the distribution of taxes (i.e., is the 
proposal distributionally neutral)?

* If not, who will be paying more in taxes and who will be paying less?

* If so, what features of the proposal are in place to ensure that it 
will remain distributionally neutral?

7. What type of distributional analysis was done?

* What time period is covered? For example, does the distributional 
analysis measure the lifetime or annual effects of the tax system?

* How is ability to pay (income, consumption, or wealth) measured?

* What is the unit of analysis (individuals, households, or taxpaying 
units)?

* What assumptions are made about tax incidence (e.g., who is assumed 
to pay the corporate income tax)?

* What taxes are covered in the distributional analyses?

* What measures (e.g., tax rates, share of tax liability) are being 
used to calculate the distribution of tax burden?

Economic Efficiency: 

One reason people bear taxes is they desire the benefits of government 
programs and services. As taxpayers, they balance the costs of taxes 
with the benefits of government. From a taxpayer's perspective, the 
cost of taxes includes more than the tax liability paid to the 
government. These costs include efficiency costs, which result from 
taxes changing the economic decisions that people make--decisions such 
as how much to work, how much to save, what to consume, and where to 
invest. These changes, referred to by economists as distortions, reduce 
people's well-being in a variety of ways that can include a loss of 
output or consumption opportunities. These reductions in well-being are 
efficiency costs, also called deadweight losses, excess burdens (excess 
because they are a cost in addition to the tax liability), or welfare 
losses. 

Because taxes generally create inefficiencies, minimizing efficiency 
costs is one criterion for a good tax. However, the goal of tax policy 
is not to eliminate efficiency costs. The fact that taxes impose 
efficiency and other costs beyond the tax liability does not mean that 
taxes are not worth paying. The goal of tax policy is to design a tax 
system that produces the desired amount of revenue and balances 
economic efficiency with other objectives, such as equity, simplicity, 
transparency, and administrability. Moreover, as noted in the revenue 
section, the failure to provide sufficient tax revenues to finance the 
level of spending we choose as a nation gives rise to deficits and 
debt. Large sustained deficits could ultimately have a negative impact 
on economic growth and productivity. 

Because taxes impose efficiency costs, the total cost of taxes to 
taxpayers is larger than their tax liability (the check they send to 
the U.S. Treasury). The total cost of taxes from a taxpayer's point of 
view is the sum of the tax liability, the efficiency costs, and the 
costs of complying with the system (which we discuss later), as shown 
in figure 11. 

Figure 11: Efficiency Costs Are One Cost Taxpayers Face in Complying 
with the Tax System: 

[See PDF for image] 

[End of figure] 

From a national perspective tax revenue is not a cost. Tax revenue is 
not lost to the nation--it is moved from taxpayers' pockets to the 
Treasury in order to pay for the programs and services that the 
government provides. On the other hand, efficiency costs and compliance 
burden are costs from a national perspective because, for example, they 
can result in forgone production and consumption opportunities, as well 
as the loss of taxpayers' time spent on complying. 

Tax systems can differ in the magnitude and nature of their efficiency 
costs. Differences in the base, rates, preferences, or tax-induced 
responses can all affect the extent one tax distorts when compared to 
another. Tax systems can cause distortions that affect both individual 
taxpayers and businesses. Figure 12 outlines some of the key issues to 
consider when thinking about the efficiency of the tax system. 

Figure 12: Efficiency Overview: 

[See PDF for image] 

[End of figure] 

Equity concerns may force a trade-off between fairness and efficiency. 
Progressive tax rate schedules are believed to have higher efficiency 
costs than a proportional schedule that raises the same amount of 
revenue. However, proponents of progressive rates are willing to trade 
off some efficiency in order to gain, in their view, more vertical 
equity. As will be shown below, efficiency costs, although they are 
hard to measure, often can be defined objectively. Nevertheless, they 
still must be balanced with the more subjective criteria like equity 
when reaching general conclusions about a tax proposal. 

Taxes and Economic Decision Making: 

Economic efficiency can be thought of as the effectiveness with which 
an economy utilizes its resources to satisfy people's preferences. 
Economists generally agree that (from the perspective of efficiency and 
ignoring other considerations, such as equity) markets are often the 
best method for determining what goods and services should be produced 
and how resources should be allocated. Self-interest is assumed to 
motivate resource owners to try to use their resources in a manner that 
realizes the highest return. When resources are directed to their 
highest valued uses the economy is said to be efficient. 

Inefficiencies reduce the economic well-being of people in the 
aggregate, since resources are not directed to their highest valued 
uses. By reallocating resources from lower valued uses to higher valued 
uses, the economic well-being of people can be increased. However, 
gains from reallocating resources from lower valued uses to higher 
valued uses may not be distributed in manner considered fair, that is, 
some people may lose because of the reallocation. 

Generally, taxes alter or distort decisions about how to use resources, 
creating economic inefficiencies. By changing the relative 
attractiveness of highly taxed and lightly taxed activities, taxes 
distort decisions such as what to consume, how much to work, and how to 
invest. Households and firms generally respond to taxes by choosing 
more of lower taxed items and less of higher taxed items than they 
would have otherwise. The change in behavior can ultimately leave 
individuals with a combination of consumption and leisure that they 
value less than the combination that they would have chosen under a tax 
system that does not distort their behavior. 

As a simple example of the effects of a tax distortion, suppose an 
investor is choosing between two investments, one that has an expected 
annual return of 10 cents on every dollar invested and a second that 
has an expected annual return of 15 cents. If the income from neither 
investment is taxed, or if the income is taxed equally, the investor 
will choose the second investment with its higher economic rate of 
return. However, if the first investment continues to be untaxed, while 
the second is subject to a 40 percent tax, the decision will be based 
on the investment's after-tax rate of return. In this case the after- 
tax return on the first investment continues to be 10 cents for every 
dollar invested, while the after-tax return on the second investment is 
now 9 cents. An investor would choose the first investment because it 
has a higher after-tax return. However, this results in a loss to the 
economy, or inefficiency. Society gains a 10 cent return from the first 
investment, all of which goes to the investor. Society would have 
gotten the 15 cent return from the second investment, 9 cents for the 
investor, and 6 cents for the government. 

Note that a tax does not actually have to raise revenue to cause 
inefficiencies. In the previous example, the investor who chose the 
first investment would pay no tax. However, the tax system design has 
distorted the investor's decision-making and reduced output. 

The example of the tax-preferred treatment of owner-occupied housing 
illustrates a trade-off between efficiency costs and using the tax 
system to achieve other social goals. Text box 5 presents some 
estimates of the efficiency costs of the tax treatment of owner- 
occupied housing due to large differences in effective tax rates across 
three major investment categories. However, even in situations such as 
the one outlined in the text box, where the tax preference imposes some 
efficiency costs, there may still be valid reasons for using tax 
preferences as a tool of government for achieving certain social and 
economic goals. As we note in the example, most economists agree that 
the tax-preferred treatment of owner-occupied housing distorts 
investment patterns in the economy. The tax preference promotes the 
social goal of increased home ownership--a goal that many policymakers 
advocate. 

Text Box 5: Tax Treatment of Owner-Occupied Housing Distorts Investment 
Choices and Lowers Wages: 

Compared to other types of investment, owner-occupied housing enjoys 
tax advantages primarily because the value that homeowners receive from 
housing services, which is a part of the return on their investment in 
housing, is excluded from taxation. Economists view these services, 
called imputed rent, as income in kind, which is valued at what the 
homeowner would receive as income if the house was rented. Under a pure 
income tax, imputed rent net of such costs as mortgage interest would 
be taxed. This tax treatment would help insure that investment in 
housing is taxed as other investments are taxed. As the table below 
shows, the tax advantages under the current system lead to lower 
marginal effective tax rates (METR) for housing relative to other 
investments. 

METRs on Capital Income, by Source, in 2003. 

* Owner-occupied housing: 2%; 

* Noncorporate investment: 18%; 

* Corporate investment: 32%. 

Source: Jane Gravelle, "The Corporate Tax: Where Has It Been and Where 
Is It Going?" National Tax Journal, vol. 57, no. 4 (2004): 903-23. 

Economists generally agree that the favorable treatment of owner-
occupied housing, by lowering METR, distorts investment in the economy, 
resulting in too much investment in housing and too little business 
investment. The consequence of this is that businesses invest less in 
productivity- enhancing technology. This in turn results in employees 
receiving lower wages because increases in employee wages are generally 
tied to increases in productivity; 

The resulting distortions from the tax- preferred treatment of owner-
occupied housing lead to efficiency costs that have been estimated to 
be large. Gravelle's summary of estimates reports that the efficiency 
costs of the tax-preferred treatment of owner-occupied housing could be 
as much as 0.1 to 1 percent of GDP; 

In addition to efficiency concerns, the tax treatment of owner-occupied 
housing also raises equity concerns. The current exclusions from income 
are more valuable to taxpayers in high tax brackets. Taxpayers in lower 
brackets receive a less valuable homeownership subsidy or no subsidy at 
all. 

[End of text box]

Although taxes generally result in efficiency losses, there are 
exceptions. In special cases, tax distortions may offset other 
inefficiencies, which can be caused by what economists call market 
failures. An example is an externality or spillover, where the benefits 
or costs of an activity are not fully captured by the individuals or 
firms undertaking the activity. Research and development is commonly 
cited as generating positive externalities--in some cases, the entity 
doing the research and development may produce knowledge that enters 
the public realm and is freely available to users. For example, some 
medical innovations, such as surgical techniques, cannot be patented. 
To the extent that benefits cannot be sold in a market, private firms 
that innovate will not reap the full financial benefits of the 
innovation and, therefore, will invest too little in research. Tax 
incentives for research might be one way to address the problem, but 
other governmental tools such as grants, loans, or regulations could 
also be considered. Efficient taxes are special cases--tax systems 
large enough to fund the federal government impose efficiency costs. 

Measuring Economic Efficiency: 

While economists generally agree that the tax system imposes 
significant efficiency costs, estimating the magnitude of tax-related 
efficiency costs in an economy as complex as ours is extremely 
difficult. However, several attempts have been made to estimate the 
efficiency costs of parts of the tax system. For example, one study 
estimated the total efficiency cost of the personal income tax on labor 
income, which distorts labor supply decisions, to be from $137 billion 
to $363 billion in 1994.[Footnote 3] A second study estimated the 
effects of the unequal taxation of savings and consumption to be about 
$45 billion in 1995.[Footnote 4] Text box 5 summarized estimates of the 
efficiency losses associated with the tax treatment of owner-occupied 
housing as ranging from 0.1 to 1 percent of GDP. For further 
information on efficiency cost estimates, see GAO, Tax Policy: Summary 
of Estimates of the Costs of the Federal Tax System, [Hyperlink, 
http://www.gao.gov/cgi-bin/getrpt?GAO-05-878] (forthcoming). 

These partial estimates indicate the significant uncertainty 
surrounding the magnitude of tax-induced efficiency costs. 
Nevertheless, they suggest that the overall efficiency costs imposed by 
the tax system are large--on the order of several percentage points of 
GDP. 

As a result of these difficulties, simple rules of thumb are commonly 
used to provide rough estimates of the efficiency costs of taxes. Text 
box 6 describes two such rules of thumb. 

Text Box 6: Rules of Thumb for Estimating Efficiency Costs; 

Because of the difficulty of measuring efficiency costs, several rules 
of thumb have been used to approximate efficiency costs in certain 
situations. These rules suggest that efficiency costs from taxes may be 
considerable; 

Two commonly cited rules are as follows: 

* According to OMB guidance, the efficiency cost of a tax increase, 
which should be included as part of the total cost when calculating the 
benefits and costs of a government spending project, is equal to 25 
percent of the tax revenue collected used to fund the project. 

* Some economists agree that the efficiency cost of a tax increases 
with the square of the tax rate: a 50 percent tax increase, for 
example, from 25 percent 37.5 percent, would more than double the 
efficiency cost. For this reason, progressive tax rate schedules, which 
have higher top marginal rates, are believed to have higher efficiency 
costs than a proportional schedule that raises the same amount of 
revenue. 

[End of text box]

The extent to which tax reform can reduce such tax-induced 
inefficiencies and thus increase our economic well-being depends on the 
design of a reformed system. All practical tax systems distort some 
decisions so it is not possible to eliminate all the efficiency costs 
associated with taxes. The magnitude of the efficiency costs in a 
reformed tax system would depend on such design features as the 
treatment of savings versus consumption, the number of tax 
expenditures, and the level and progressivity of tax rates. While some 
economists believe that a pure consumption tax with no preferences and 
a flat rate would reduce efficiency costs relative to the current tax 
system, such a pure tax may not be a feasible alternative because of 
equity and other concerns. 

In addition, as has been discussed, the revenue consequences of tax 
reform have economic effects. The efficiency gains from a reformed tax 
system could be offset if the new system increases long-term deficits. 

Taxing Work and Savings Decisions: 

In part because of the difficulty of measuring the efficiency cost of 
taxes, discussions of the impact of taxes on the economy sometimes 
focus on the effect that taxes have on changes in the output of the 
economy, labor supply, or other such economic variables. However, such 
changes do not necessarily measure efficiency costs. Efficiency loss is 
the difference between individuals' well-being with a tax and 
individuals' well-being under a revenue neutral, hypothetical tax that 
does not distort, called a lump sum tax. 

Three choices commonly discussed are the choice between work and 
leisure, the choice between consumption and saving, and the choice 
between domestic and foreign investment. Intertwined with effects that 
taxes have on these choices is the effect of taxes on economic growth. 

Work versus leisure: Taxes--both income and consumption taxes--can 
affect the decisions that people make about how much time to devote to 
work or leisure in two ways. First, taxes may increase the incentive to 
work because workers must work more to maintain their after tax income. 
Second, taxes may reduce the incentive to work because workers earn 
less from an additional hour of work. The net effect may be no change 
to the overall supply of labor. However, even in this case, there is 
still an efficiency cost, which is determined by the second effect. By 
reducing hourly after tax earnings, income and consumption taxes 
distort decisions about how many hours to devote to work or leisure. 

Empirical research generally shows that at least for primary wage 
earners, decisions about labor force participation are not very 
responsive to taxes. However, decisions about labor force participation 
by secondary wage earners have been shown to be more responsive to 
changes in the tax system. 

Consumption versus savings: Taxes on capital reduce the after-tax 
return to savings. In effect, this makes future consumption (savings) 
more expensive relative to current consumption and thus has the 
potential to distort savings decisions. While research has shown that 
the demand for some types of savings, such as the demand for tax-exempt 
bonds, is responsive to changes in the tax system, there is greater 
uncertainty about the effects of changes in the tax system on other 
choices, such as aggregate savings. 

Domestic versus foreign investment: Taxes on income from capital can 
affect the location of investment by changing the relative after-tax 
return on domestic and foreign investment. This matters because the 
location of investment can affect the income of U.S. citizens. The 
income of people working in the United States is closely tied to their 
productivity, which generally increases with the amount of domestic 
investment. At the same time, U.S. citizens who own capital can earn 
higher incomes by investing their capital--in the United States or 
abroad--wherever it earns the highest rate of return. In a world of 
increasing capital mobility due to increasing trade and decreasing 
communication and transportation costs, the effect of taxes on the 
location of investment is even more important than in the past: 

Efficiency and economic growth: Removing or reducing distortions caused 
by the tax system can affect the size of the economy. Increasing the 
efficiency of the tax system can expand the economy through a temporary 
increase in the rate of growth. An increase in efficiency is an 
increase in well-being that comes from using existing resources in a 
better way. Efficiency raises capacity to a higher level but does not 
necessarily continue to increase it without additional resources. Such 
an increase could show up as a temporary increase in the growth of the 
economy. However, the long-term growth rate depends on the rates of 
change in population, the capital stock, and technology. Changes to the 
tax system that would increase economic efficiency could increase the 
long-term growth rate if they increase the rate of technological 
change. Thus, tax changes that increase economic efficiency may or may 
not result in an increased long-term rate of economic growth. 

Efficiency versus fiscal effects: As has been discussed, taxes may have 
both efficiency effects and fiscal policy effects. Government spending 
in excess of government revenues creates deficits, which if large 
enough and continued over a period of time will ultimately have a 
negative impact on economic growth and productivity to the extent that 
they absorb savings that would otherwise finance investment in the 
private economy. Thus, the gain from changing the tax system to 
increase economic efficiency could be offset if the tax changes 
increase the deficit. 

Tax policies designed to enhance economic efficiency can be designed 
independently of fiscal policy. For example, the Tax Reform Act of 1986 
was designed, in part, to achieve increased efficiency by broadening 
the tax base and lowering rates in a way that was revenue neutral. Such 
a revenue neutral change would have no effect on deficits and debt. 

Realizing Efficiency Gains: 

The extent to which efficiency gains are realized by switching to an 
alternative tax system depends on at least two factors. First, the 
efficiency gains of switching to a new tax system depend on the extent 
to which that tax system reduces distortions caused by tax preferences, 
rate differences, sectoral differences, and switching the base from 
income to consumption. Second, the change to a new tax system may not 
improve the overall efficiency of the economy if the distorting tax 
incentives eliminated by switching to a new tax system are replaced 
with government spending or regulation that provides the same 
incentives. 

Key Questions: 

1. Does the proposal tax income, spending, assets, and investments 
differentially?

* Which types of income, spending, assets, and investments are tax 
preferred?

* Which decisions are likely to be distorted?

2. What social goals, if any, is the tax proposal trying to promote?

* Is there an efficiency justification for the goal, or is the goal 
justified on other grounds, such as equity?

3. Do estimates of the cost of achieving the goal include efficiency 
costs?

4. What are the trade-offs between equity, efficiency, and the other 
criteria?

5. Is the tax proposal accompanied by estimates of the efficiency gains 
or losses to be realized by the new tax system?

* Is the tax proposal accompanied by estimates of economic activity 
(e.g., change in labor supply or change in GDP) that will be encouraged 
or discouraged by the new tax system?

* Is the proposal accompanied by estimates of the efficiency loss or 
gain associated with these changes in economic activity?

6. How does the tax change affect leisure versus work decisions?

7. How does the tax change affect savings versus consumption decisions?

8. How does the tax change affect decisions about foreign versus 
domestic investment?

9. How does the tax change affect choices between different types of 
investments and different types of consumption?

10. Is the tax proposal likely to increase economic growth?

* Is the growth achieved through a onetime rearranging of resources?

* Is the growth achieved through a permanent increase in the rate of 
growth?

* Does the tax proposal contain estimates of its effect on growth 
(often measured by changes in GDP) and estimates of the costs of 
achieving the growth (such as reduced leisure time)?

11. In addition to efficiency effects, will the proposal have other 
economic effects by increasing or reducing the deficit?

Simplicity, Transparency, and Administrability: 

Simplicity, transparency, and administrability are interrelated and 
desirable features of a tax system. Simple tax systems are, in many 
cases, the most administrable, and tax systems that are both simple and 
administrable are often considered to be the most transparent. However, 
even though there is considerable overlap between simplicity, 
transparency, and administrability, they are not identical. (See fig. 
13.)

Because there is considerable overlap between these concepts, even 
though they are not the same thing, we combine simplicity, 
transparency, and administrability into one section and discuss them as 
a group. While others may not use the same terminology, the debates 
implicitly use the same or very similar criteria. 

Figure 13: Simplicity, Transparency, and Administrability Overview: 

[See PDF for image] 

[End of figure] 

Simplicity: 

Simple tax systems impose less of a compliance burden on the taxpayer 
than more complex systems. Taxpayer compliance burden is the value of 
the taxpayer's own time and resources, along with any out-of-pocket 
costs to paid tax preparers and other tax advisors, invested to ensure 
compliance with tax laws. As figure 14 demonstrates, in addition to the 
actual tax payments remitted to the government and the efficiency costs 
of taxation that we discussed earlier, compliance burden is the third 
cost that the tax system imposes on taxpayers. Compliance costs include 
the value of time and resources devoted to (1) record keeping, (2) 
learning about requirements and planning, (3) preparing and filing tax 
returns, and (4) responding to IRS notices and audits. Taxpayers can 
either choose to fulfill these responsibilities on their own or they 
can hire paid preparers to aid them in complying with the tax code. 
According to IRS, over 61 percent of returns filed in 2003 included a 
paid preparer's signature, contributing to considerable out-of-pocket 
costs to taxpayers. 

Figure 14: Compliance Burden Is One Cost Taxpayers Face in Complying 
with the Tax System: 

[See PDF for image] 

[End of figure] 

The current tax system has grown increasingly complex over time, and 
many believe that taxpayer compliance burden has grown accordingly. The 
amount of time that taxpayers actually spend filling out tax forms may 
only constitute a small amount of the overall compliance burden. For 
many taxpayers, the bulk of the compliance burden comes in the form of 
tax planning and record keeping. For example, taxpayers spend time 
determining how the growing number of tax expenditures will affect 
their respective tax liabilities. The Treasury Department listed 146 
tax expenditures in 2004, up about 26 percent since the last major tax 
reform legislation in 1986. Frequent changes in the tax code reduce its 
stability, contributing to compliance burden by making tax planning 
more difficult and increasing uncertainty about future tax liabilities. 
Moreover, an increasing number of taxpayers are becoming subject to the 
individual AMT. Determining how the provisions of the AMT affect a 
taxpayer's tax liability adds to the compliance burden. 

Compliance burden is difficult to measure in part because it is 
difficult to measure the amount of time taxpayers spend planning and 
preparing their returns and the value of that time.[Footnote 5] 
Nevertheless, researchers have made several attempts to quantify the 
costs that taxpayers incur while complying with the tax system. Most 
estimates suggest that taxpayer compliance burden falls between $100 
billion and $200 billion each year. 

Because compliance burden is difficult to measure, other, less direct 
measures of burden are frequently used. These include the number of 
pages in the tax code, the number of IRS forms to fill out, the length 
of tax instructions, and the number of lines on the tax form. These 
measures are believed to be correlated with compliance burden, but the 
correlation is recognized to be far from perfect. In some situations, 
longer instructions and more details on a form may reduce compliance 
burden by clarifying what a taxpayer must do to comply with the tax 
laws. These alternative measures of simplicity may provide some insight 
into the simplicity of the tax code, but they do not directly measure 
the impact that the tax code has on the costs to taxpayers of complying 
with the nation's tax laws. 

The intergovernmental effects of tax policy changes can also affect 
compliance burden. Due to the close links between the federal tax 
system and the tax systems in many states, changes to the federal tax 
system could have implications for the compliance burden that taxpayers 
face when completing their state tax returns. For example, if the 
federal government switched from the current income tax system to a 
national retail sales tax, or a different type of consumption tax, but 
states--most of which have developed income tax forms that are based in 
large part on an individual's federal tax return--maintain their income 
tax requirements, then overall taxpayer burden would not likely be 
greatly reduced. Taxpayers might not have to file federal tax returns, 
but many, if not all, of the record keeping and administrative tasks 
would still exist when complying with the state-level income tax 
requirements. 

Transparency: 

A transparent tax system is one that taxpayers are able to understand. 
Transparent tax systems impose less uncertainty on taxpayers, allowing 
them to better plan their decisions about employment, investment, and 
consumption. This leads to more confidence that they can accurately 
predict their future tax liabilities and contributes to the credibility 
of the tax system. Tax systems that are difficult to comply with and 
administer may lack transparency. A nontransparent tax system could be 
difficult to administer because tax administrators may have difficulty 
consistently applying the law to taxpayers in similar situations. In 
this sense, transparency is closely linked to the simplicity and 
administrability of the tax system. Transparent tax systems include the 
following elements: 

* Taxpayers can easily calculate their liabilities: Taxpayers can 
easily follow instructions and tax rate tables in order to determine 
their tax base, their marginal tax rate, and their tax liability to the 
government. 

* Taxpayers grasp the logic behind tax laws and tax rates: Taxpayers 
can look at a tax form or a tax rate schedule and understand lawmakers' 
reasoning. For example, whether or not they agree with it, taxpayers 
are likely to be able to comprehend the logic behind a progressive rate 
schedule. 

* Taxpayers know their own tax burden and the tax burden of others: 
Irrespective of who actually writes a check to the government, 
taxpayers can identify who actually bears the burden of a tax. For 
example, the payroll tax is not transparent to the extent that 
taxpayers in general are unaware of the incidence of the tax. Even 
though payroll taxes are divided equally between employees and 
employers, economists generally agree that employees bear the entire 
burden of payroll taxes in the form of reduced wages. 

* Taxpayers are aware of the extent of compliance by others: Taxpayers 
understand the extent to which the tax laws are enforced, meaning that 
they know how likely their friends, neighbors, and business competitors 
are to actually pay what they owe. 

While the concept of transparency is closely linked to simplicity and 
administrability, they are not always the same. For example, some tax 
provisions may be simple but not transparent. The corporate tax rate 
schedule example in table 4 illustrates this. While determining taxable 
income under the corporate income tax is often a complex procedure, it 
is relatively simple for corporations to calculate their tax 
liabilities by referring to tax tables published by the IRS once this 
income has been determined. However, the logic underlying the marginal 
tax rates in the corporate tax schedule is not transparent. The 
marginal rate structure is progressive up to taxable income of 
$335,000, but marginal rates then decrease before increasing again and 
then decreasing once more. 

Table 4: The Corporate Tax Rate Schedule: Simple but Not Transparent: 

Tax bracket (taxable corporate income): $0 to $50,000; 
Marginal tax rate in the tax bracket: 15%. 

Tax bracket (taxable corporate income): $50,001 to $75,000; 
Marginal tax rate in the tax bracket: 25%. 

Tax bracket (taxable corporate income): $75,001 to $100,000; 
Marginal tax rate in the tax bracket: 34%. 

Tax bracket (taxable corporate income): $100,001 to $335,000; 
Marginal tax rate in the tax bracket: 39%. 

Tax bracket (taxable corporate income): $335,001 to $10,000,000; 
Marginal tax rate in the tax bracket: 34%. 

Tax bracket (taxable corporate income): $10,000,001 to $15,000,000; 
Marginal tax rate in the tax bracket: 35%. 

Tax bracket (taxable corporate income): $15,000,001 to $18,333,333; 
Marginal tax rate in the tax bracket: 38%. 

Tax bracket (taxable corporate income): Over $18,333,333; 
Marginal tax rate in the tax bracket: 35%.

Source: IRS instructions for Form 1120. 

[End of table]

Some experts who have written on transparency believe that the tax 
code's transparency has declined in recent years. Numerous tax 
provisions have made it more difficult for taxpayers to understand how 
their tax liability is calculated, the logic behind the tax laws, and 
what other taxpayers are required to pay. 

Administrability: 

Administrable tax systems allow the government to collect taxes as cost 
effectively as possible. Even though tax administration is usually 
considered to be IRS's responsibility, taxpayers, employers, and 
financial intermediaries such as banks and tax professionals play 
important roles in administering the tax code. For example, under the 
current system, banks file information returns about the amount of 
interest earned by deposit holders that assist IRS in determining tax 
liabilities. There is overlap between the simplicity and the 
administrability of a tax system, but simple tax systems are not always 
easier to administer. 

Comparing the Administrability of Tax Systems: 

All tax systems have administrative costs. A more administrable tax 
system collects more of the statutorily required tax at a lower cost 
per dollar collected. However, there are trade-offs between the level 
of compliance and administrative costs to IRS. The costs of enforcing 
the tax code sufficiently to achieve complete compliance from all 
taxpayers are likely to be prohibitive. In addition, the costs of 
administrating the tax code are not limited to the budgetary costs of 
IRS. As noted above, some of these costs are shared by other parties in 
the form of increased compliance burden. Finally, the costs can be 
affected by the use of different enforcement policies. 

The following summarizes the key tasks required for administering tax 
systems: 

* Processing tax returns and payments: Currently, IRS processes over 
130 million individual income tax returns each year, which taxpayers 
file electronically or through the mail. Under today's technology and 
any proposed alternatives to the current system, a return-free tax 
system may be difficult to implement. 

* Enforcing the tax code: Perhaps the government's most challenging 
role in administering the tax system is detecting and penalizing 
taxpayer noncompliance. Under the current system, withholding and 
information reporting are important enforcement tools that generally 
increase compliance rates. However, they are not sufficient by 
themselves, and IRS devotes considerable resources to collecting taxes 
owed but not remitted. 

* Providing taxpayer assistance: In order to reduce compliance burden 
and increase compliance rates, tax administrators generally provide 
assistance to taxpayers by such means as publishing forms and answering 
questions. 

A tax change proposal may reduce the cost of some administrative tasks 
but raise others. Compared to the current personal income tax, 
consumption taxes like an NRST or a VAT reduce the number of filers 
because only businesses file. As a result, they reduce processing costs 
and eliminate the compliance burden on individual taxpayers. However, 
other aspects of enforcement costs may increase because administrators 
would no longer be able to rely on withholding and information returns 
as enforcement tools. 

The way the tax system is structured by Congress can affect how it is 
administered, and this can affect compliance. For example, taxes 
withheld from employees and taxes that have information reporting 
requirements have lower income misreporting rates than other taxes. As 
figure 15 shows, taxes on wage and salary income, which is subject to 
both withholding and information reporting, have the lowest rate of 
misreported income; whereas taxes on income from such sources as self- 
employment (nonfarm proprietor income) have the highest rate of 
misreported income. 

Figure 15: Taxpayer Noncompliance Categorized by Amount of Withholding 
and Information Reporting, 1992: 

[See PDF for image] 

[End of figure] 

Regardless of the amount of withholding and third-party information 
reporting required, other government enforcement activities are likely 
to be needed under any proposed tax system in order to ensure that 
taxpayers comply with the tax code. Proposals that simplify the tax 
code and administrative efforts to aid honest taxpayers in complying 
with the tax laws could increase compliance; however, under any system, 
costly enforcement efforts, perhaps including face-to-face audits of 
taxpayers, will likely always be needed to help detect and penalize 
dishonest taxpayers. 

Measuring administrative costs is difficult. Budgetary costs are easily 
measured: IRS's budget in fiscal year 2004 was $10.2 billion. However, 
as discussed earlier, the costs of other parties in tax administration 
are harder to determine. Compliance burden estimates range from $100 
billion to $200 billion. Despite the uncertainty, the range of 
estimates indicates that compliance burden is likely to considerably 
outweigh IRS's budgetary costs. 

Changes in the technology of tax administration and in the tax code may 
have had offsetting and, as yet, unmeasured effects on the costs of tax 
administration. On the one hand, recent innovations in computer 
software and electronic financial transactions have made it easier to 
administer the tax code. On the other hand, since the last major tax 
reform initiative in 1986, the number of special rates, credits, 
deductions, and other provisions in the tax code have increased. This 
added complexity has made the tax code more difficult to administer. 

Trade-offs between Equity, Economic Efficiency, and Simplicity, 
Transparency, and Administrability: 

While the concept of administrability is closely linked to the concepts 
of simplicity and transparency, they are not always the same. For 
example, a national retail sales tax would be a relatively simple form 
of taxation for taxpayers to understand. At the same time, a national 
retail sales tax could present administrative difficulties because it 
would be difficult to distinguish between similar commodities that are 
tax exempt and those that are not, and to distinguish retail sales, 
which are taxed, from sales to other companies, which are not taxed. 

Similarly, just because a tax is administrable does not necessarily 
mean it would be transparent. For example, although payroll taxes are 
fairly easy to administer, who pays them in an economic sense is not 
necessarily transparent. As we discussed earlier, many economists agree 
that employees bear the entire burden (both the employer and employee 
share) of payroll taxes, making the incidence of payroll taxes 
nontransparent. 

Improving the simplicity, transparency, and administrability of the tax 
system may affect the equity and efficiency of the tax system. 
Simplified, transparent, and administrable tax codes are generally 
thought to enhance efficiency because (1) taxpayers can redirect 
resources that would have been used to comply with the tax code to 
other, more productive purposes and (2) these tax systems have fewer 
incentives that distort decision making about work, savings, and 
investment. However, proposals to simplify the tax system may reduce 
equity because many tax provisions that are complex and difficult to 
comply with are also designed to promote fairness. 

Key Questions: 

1. What impact is the tax proposal likely to have on the compliance 
burden that taxpayers face?

* Will more or fewer taxpayers be required to fill out tax forms and 
file them with IRS?

* What information will taxpayers be required to provide on the tax 
forms?

* Does the proposal contain any estimates of its effect on compliance 
burden?

2. Will taxpayers' planning responsibilities (record keeping, research, 
etc.) likely increase or decrease in comparison to those under the 
current tax system?

3. Is the proposed tax system transparent?

* Can taxpayers identify their tax liability easily?

* Can taxpayers understand the logic behind the tax that they are 
paying?

* Do taxpayers know what their true tax burden is (i.e., do they 
understand the incidence of the tax system)?

* Do taxpayers understand the incidence of the tax system in terms of 
the tax burdens of other taxpayers?

* Are taxpayers aware of the extent of compliance by others?

4. How would the tax system be administered?

* What would be the role of taxpayers, employers, information return 
providers, and the IRS under the proposal?

* Does the proposal contain estimates of its effect on budgetary costs?

* Does the proposal contain any information about how administrative 
costs would be shared?

5. What would be the proposal's impact on IRS?

* How would IRS functions of processing, compliance, collections, and 
taxpayer assistance be affected?

* What enforcement tools (e.g., withholding and information reporting) 
would be added or taken away from tax administrators?

* Does the proposal contain information about its likely effect on 
compliance?

6. Are there trade-offs between the simplicity, transparency, and 
administrability of the proposed tax system?

7. Under the tax proposal, have efforts to enhance the simplicity, 
transparency, and administrability of the tax system resulted in trade- 
offs with respect to the equity and efficiency of the proposal?

[End of section]

Section 3 Transitioning to a Different Tax System: 

[End of section]

Transition rules are sometimes proposed when switching to an 
alternative tax system. The rules are often intended to compensate 
certain people or entities whose losses are determined to be 
inequitable. However, not all tax experts agree that transition rules 
are appropriate when implementing changes to the tax code. Since 
transition rules are short-term tax policies, they should be judged by 
the same criteria for a good tax system that we discussed earlier. Many 
of the same trade-offs between the criteria that exist when considering 
tax reform proposals are also relevant when considering how to move 
from the current tax system to an alternative tax system. (See fig. 16.)

Figure 16: Transition Issues Overview: 

[See PDF for image] 

[End of figure] 

Deciding if Transition Relief Is Necessary: 

Changes to the tax code can create winners and losers. Taxpayers' 
losses, which are more often discussed in debates than gains resulting 
from tax policy changes, may be more obvious when tax changes increase 
government revenues or if the changes are designed to be revenue 
neutral. However, even tax decreases can create losers depending on 
whether the tax burden is redistributed, spending cuts are made, or the 
tax burden on future generations is increased. Deciding if transition 
relief is necessary involves how to trade off between equity, 
efficiency, simplicity, transparency, and administrability. 

Decisions about whether to tax previously accumulated savings when 
switching to a consumption tax provide an example of the trade-offs 
that need to be considered when determining if transition relief is 
merited. Some argue that switching from the current tax system to a 
consumption tax would merit some transition relief for equity reasons 
because accumulated savings, which may have already been taxed once 
under the income tax system, would be subject to a second tax when used 
for consumption purposes. In other words, those who had saved 
previously would be taxed higher than those just beginning to save. 
Proponents for transition relief argue that taxpayers who accumulated 
savings have an implicit contract with the government that savings 
would not be taxed when withdrawn. The notion that taxpayers rely on 
the continued existence of government policy when they make economic 
decisions is one of the key equity justifications for offering 
transition relief. 

However, not everyone agrees that transition relief is justifiable 
based on equity grounds. Opponents of transition relief argue that 
taxpayers knowingly accept the risk that government policy may change 
when they make decisions, such as how much to save, and therefore do 
not need to be compensated for any losses that result from switching to 
an alternative tax system. 

There are also trade-offs between equity and efficiency that should be 
considered when thinking about transition relief. The efficiency gains 
that could be realized by switching to a consumption tax could be 
negated if the government offered transition relief to taxpayers. 
Taxing accumulated savings is economically efficient because doing so 
does not distort work or savings behavior--taxpayers cannot avoid 
paying the tax by changing their behavior to work or save less. 
Offering transition relief would reduce the revenue gain from taxing 
accumulated savings, thereby requiring higher consumption tax rates. 

Finally, developing and implementing transition rules could add a 
significant amount of complexity to the tax system--a characteristic of 
the tax system that the switch to an alternative tax system was likely 
intended to reduce. The new complexity would be temporary, phasing out 
with the transition rules. 

Identifying Affected Parties: 

Identifying winners and losers, the amount of gains and losses, and 
effective mitigation policies is complicated by the different ways tax 
changes can affect taxpayers. Tax law changes, by definition, affect 
taxpayers' future liabilities. In some cases, those future tax changes 
are capitalized into the prices of marketable assets. For example, 
changes in the tax treatment of owner-occupied housing have the 
potential to affect current housing prices. In other cases, such as 
wealth accumulated in a savings account, tax law changes might affect 
the value of the wealth but do not change the price of a marketable 
asset. In still other cases, the after-tax return to future behavior, 
such as hours worked, is altered. Regardless of how taxpayers feel the 
impact of a tax change, the impact on their ability to consume over 
time is the same (assuming everything else is constant). 

Revenue Effects of Transition Relief: 

If transition relief is provided to compensate taxpayers for financial 
losses due to changes in the tax code, then revenues equivalent to 
these losses will need to be found from other sources, assuming the 
proposal is revenue neutral. One alternative source of revenue would be 
to tax those who have received windfall gains from the policy changes. 
However, debates about transition relief typically center around how to 
handle taxpayers who are likely to suffer windfall losses and not on 
how to impose special taxes on those who experience windfall gains. 

Policy Tools for Implementing Transition Rules: 

The two most commonly discussed policy tools for transitioning to an 
alternative tax system are grandfather clauses and phase-in rules. 

* Grandfather clauses: Grandfather clauses are typically used to exempt 
people who would be subject to a new rule from the provisions of that 
rule. Grandfather clauses are generally used to exempt current assets 
or investments from new tax rules in order to protect taxpayers who 
purchased those assets from being penalized by unexpected changes to 
the tax system. One problem with grandfather clauses is that over time 
they can lead to unequal tax treatment of similar assets. 

* Phase-in periods for new laws: Another form of transition relief 
would be to phase in new legislation over a period of time in order to 
reduce the effects that new tax laws would have on taxpayers. 

* Combination of grandfather clauses and phase-in periods: It would 
also be possible to develop transition rules that allow for certain 
assets/investments to be grandfathered and others subject to phased-in 
tax laws. One possible variant previously outlined by the Treasury 
Department would be to apply new tax laws immediately to all new assets 
but phase in the tax laws on existing assets. 

Key Questions: 

1. Does the proposal include transition rules?

* If so, what are they?

* What gains and losses are the rules intended to mitigate?

* Who bears these gains or losses?

2. What are the expected revenue effects of the transition rules?

* If the proposal is intended to be revenue neutral, what additional 
revenue sources will be used during the transition period?

3. How will the transition rules affect the equity of the tax system as 
a whole?

* Why were some taxpayers selected for transition relief but not others?

* Who will pay for the transition relief?

4. How will the transition rules affect the overall efficiency of the 
tax system?

* Do the transition rules have efficiency costs that offset some of the 
gains from changing the tax system?

* Do estimates of these efficiency costs exist?

5. How will the transition rules affect the overall simplicity, 
transparency, and administrability of the tax system?

[End of section]

Appendixes: 

Appendix I: Key Questions: 

Section I: Revenue Needs--Taxes Exist to Fund Government: 

1. What current taxes would the proposal change?

* Does the proposal change personal income taxes, social insurance 
taxes, corporate income taxes, and/or estate and gift taxes?

2. What is the nature of the proposed change to the tax system?

* Does the proposal change the tax base from income to consumption?

* Does the proposal include tax expenditures?

* Does the proposal change the tax rates?

* Does the proposal change the collection points for the tax?

3. How will the proposed change affect total revenues?

* Are proposed changes to the tax code likely to be revenue neutral?

* If not, will they generate more or less revenue than the current tax 
laws?

4. What effect would the proposal have on the nation's projected 
budgets and long-term fiscal outlook?

* Does the proposal take into consideration the sizable long-term 
fiscal gap that the country faces?

5. What tax expenditures are included in the proposal, and what tax 
expenditures, if any, have been removed from the current tax system?

* Are the social and economic goals of the tax expenditures likely to 
be achieved and worth the cost in lost revenue?

* When the total costs of a program are considered, would it be less 
costly to implement the program as a tax expenditure or as a spending 
program?

6. If the proposal changes the tax base, the tax rates, or the 
collection points, how would these changes alter the amount of revenue 
that the government is able to collect?

7. What implications, if any, would the proposal have on the ability of 
state and local governments to collect tax revenues?

* Would the proposal tax the same base that many states rely on?

* Would the proposal allow many states to continue to rely on the 
federal tax base as a starting point for determining state taxes?

Section II: Criteria for a Good Tax System: 

Equity: 

1. How is a taxpayer's ability to pay broadly defined: 

* Income?

* Consumption?

* A broader definition of overall wealth?

2. What factors other than income, such as medical expenses, number of 
dependents, and so forth, does the proposal account for when 
considering a taxpayer's ability to pay taxes?

3. Will taxpayers with equal ability to pay taxes pay the same amount?

* If not, what provisions of the proposal do not adhere to the 
principle of horizontal equity?

4. How will the tax system tax people with differing ability to pay?

* Are the statutory tax rates progressive, proportional, or regressive?

* Are the average effective tax rates progressive, proportional, or 
regressive (accounting for credits, deductions, and other tax 
expenditures)?

5. Are there any components of the tax proposal that are justified on 
the benefits received principle?

* If so, what mechanisms are in place to determine that taxpayers who 
pay taxes for a particular government program are the same taxpayers 
who benefit from the provisions of that program?

6. Does the proposal change the distribution of taxes (i.e., is the 
proposal distributionally neutral)?

* If not, who will be paying more in taxes and who will be paying less?

* If so, what features of the proposal are in place to ensure that it 
will remain distributionally neutral?

7. What type of distributional analysis was done?

* What time period is covered? For example does the distributional 
analysis measure the lifetime or annual effects of the tax system?

* How is ability to pay (income, consumption, or wealth) measured?

* What is the unit of analysis (individuals, households, or taxpaying 
units, etc.)?

* What assumptions are made about tax incidence (e.g., who is assumed 
to pay the corporate income tax)?

* What taxes are covered in the distributional analyses?

* What measures (e.g., tax rates, share of tax liability) are being 
used to calculate the distribution of tax burden?

Efficiency: 

1. Does the proposal tax income, spending, assets, and investments 
differentially?

* Which types of income, spending, assets, and investments are tax 
preferred?

* Which decisions are likely to be distorted?

2. What social goals, if any, is the tax proposal trying to promote?

* Is there an efficiency justification for the goal, or is the goal 
justified on other grounds, such as equity?

3. Do estimates of the cost of achieving the goal include efficiency 
costs?

4. What are the trade-offs between equity, efficiency, and the other 
criteria?

5. Is the tax proposal accompanied by estimates of the efficiency gains 
or losses to be realized by the new tax system?

* Is the tax proposal accompanied by estimates of economic activity 
(e.g., change in labor supply or change in gross domestic product 
(GDP)) that will be encouraged or discouraged by the new tax system?

* Is the proposal accompanied by estimates of the efficiency loss or 
gain associated with these changes in economic activity?

6. How does the tax change affect leisure versus work decisions?

7. How does the tax change affect savings versus consumption decisions?

8. How does the tax system affect decisions about foreign versus 
domestic investment?

9. How does the tax change affect choices between different types of 
investments and different types of consumption?

10. Is the tax proposal likely to increase economic growth?

* Is the growth achieved through a onetime rearranging of resources?

* Is the growth achieved through a permanent increase in the rate of 
growth?

* Does the tax proposal contain estimates of its effect on growth 
(often measured by changes in GDP) and estimates of the costs of 
achieving the growth (such as reduced leisure time)?

11. In addition to efficiency effects, will the proposal have other 
economic effects by increasing or reducing the deficit?

Simplicity, Transparency, and Administrability: 

1. What impact is the tax proposal likely to have on the compliance 
burden that taxpayers face?

* Will more or fewer taxpayers be required to fill out tax forms and 
file them with the Internal Revenue Service (IRS)?

* What information will taxpayers be required to provide on the tax 
forms?

* Does the proposal contain any estimates of its effect on compliance 
burden?

2. Will taxpayers' planning responsibilities (record keeping, research, 
etc.) likely increase or decrease in comparison to those under the 
current tax system?

3. Is the proposed tax system transparent?

* Can taxpayers identify their tax liability easily?

* Can taxpayers understand the logic behind the tax that they are 
paying?

* Do taxpayers know what their true tax burden is (i.e., do they 
understand the incidence of the tax system)?

* Do taxpayers understand the incidence of the tax system in terms of 
the tax burdens of other taxpayers?

* Are taxpayers aware of the extent of compliance by others?

4. How would the tax system be administered?

* What would be the role of taxpayers, employers, information return 
providers, and the IRS under the proposal?

* Does the proposal contain estimates of its effect on budgetary costs?

* Does the proposal contain any information about how administrative 
costs would be shared?

5. What would be the proposal's impact on IRS?

* How would IRS functions of processing, compliance, collections, and 
taxpayer assistance be affected?

* What enforcement tools (e.g., withholding and information reporting) 
would be added or taken away from tax administrators?

* Does the proposal contain information about its likely effect on 
compliance?

6. Are there trade-offs between the simplicity, transparency, and 
administrability of the proposed tax system?

7. Under the tax proposal, have efforts to enhance the simplicity, 
transparency, and administrability of the tax system resulted in trade- 
offs with respect to the equity and efficiency of the proposal?

Section III: Transitioning to a Different Tax System: 

1. Does the proposal include transition rules?

* If so, what are they?

* What gains and losses are the rules intended to mitigate?

* Who bears these gains or losses?

2. What are the expected revenue effects of the transition rules?

* If the proposal is intended to be revenue neutral, what additional 
revenue sources will be used during the transition period?

3. How will the transition rules affect the equity of the tax system as 
a whole?

* Why were some taxpayers selected for transition relief but not others?

* Who will pay for the transition relief?

4. How will the transition rules affect the overall efficiency of the 
tax system?

* Do the transition rules have efficiency costs that offset some of the 
gains from changing the tax system?

* Do estimates of these efficiency costs exist?

5. How will the transition rules affect the overall simplicity, 
transparency, and administrability of the tax system?

[End of section]

Appendix II: Selected Bibliography and Related Reports: 

Government Accountability Office: 

Government Performance and Accountability: Tax Expenditures Represent a 
Substantial Federal Commitment and Need to Be Reexamined. [Hyperlink, 
http://www.gao.gov/cgi-bin/getrpt?GAO-05-690] (Forthcoming). 

Tax Policy: Summary of Estimates of the Costs of the Federal Tax 
System. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-878] 
(Forthcoming). 

Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal 
Sustainability but Will Require a Variety of Strategies. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-527T] Washington, 
D.C.: April 14, 2005. 

21ST Century Challenges: Reexamining the Base of the Federal 
Government. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-325SP] Washington, 
D.C.: February 1, 2005. 

Federal Debt: Answers to Frequently Asked Questions--An Update. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-485SP] Washington, 
D.C.: August 12, 2004. 

The Honorable David M. Walker, Comptroller General of the United 
States. Truth and Transparency: The Federal Government's Financial 
Condition and Fiscal Outlook. Address to the National Press Club. 
September 17, 2003. 

Alternative Minimum Tax: An Overview of Its Rationale and Impact on 
Individual Taxpayers. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-00-180] 
Washington, D.C.: August 15, 2000. 

Tax Administration: Potential Impact of Alternative Taxes on Taxpayers 
and Administrators. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-98-37] 
Washington, D.C.: January 14, 1998. 

Congressional Budget Office: 

Statement of Douglas Holtz-Eakin, Director. The Economic Costs of Long- 
Term Federal Obligations. Washington, D.C.: February 16, 2005. 

Effective Tax Rates: Comparing Annual and Multiyear Measures. 
Washington, D.C.: January 2005. 

Effective Federal Tax Rates Under Current Law, 2001 to 2014. 
Washington, D.C.: August 2004. 

Revenue and Tax Policy Brief: The Alternative Minimum Tax, No. 4. 
Washington, D.C.: April 15, 2004. 

Effective Federal Tax Rates, 1997 to 2000. Washington, D.C.: August 
2003. 

Options to Cut Taxes. Washington, D.C.: June 2000. 

The Incidence of the Corporate Income Tax. Washington, D.C.: March 
1996. 

Library of Congress, Congressional Research Service: 

Esenwein, Gregg A. and Jane G. Gravelle. The Flat Tax, Value-Added Tax, 
and National Retail Sales Tax: Overview of the Issues. CRS Report 
RL32603. Washington, D.C.: December 14, 2004. 

Esenwein, Gregg A. The Alternative Minimum Tax for Individuals. CRS 
Report RL30149. Washington, D.C.: November 15, 2004. 

Labonte, Marc. The Size and Role of Government: Economic Issues. CRS 
Report RL32162. Washington, D.C.: March 22, 2005. 

Luckey, John R. Federal Estate, Gift, and Generation-Skipping Taxes: A 
Description of Current Law. CRS Report 95-416. Washington, D.C.: 
January 5, 2005. 

Other Selected Sources: 

Aaron, Henry J. and William G. Gale. Economic Effects of Fundamental 
Tax Reform. Washington, D.C.: Brookings Institution Press, 1996. 

Cai, Jinyong and Jagadeesh Gokhale. "The Welfare Loss From a Capital 
Income Tax." Federal Reserve Bank of Cleveland Economic Review, vol. 
33, no. 1 (1997). 

Cronin, Julie-Anne. U.S. Treasury Distributional Analysis Methodology, 
Office of Tax Analysis Paper 85. Washington, D.C.: U.S. Department of 
the Treasury, September 1999. 

Feldstein, Martin, "Tax Avoidance and the Deadweight Loss of the Income 
Tax." The Review of Economics and Statistics, vol. 81, no. 4 (1999): 
674-680. 

Gravelle, Jane G., "The Corporate Tax: Where Has It Been and Where Is 
It Going?" National Tax Journal, vol. 57, no. 4 (2004): 903-23. 

Joint Committee on Taxation, Methodology and Issues in Measuring 
Changes in the Distribution of Tax Burdens. JCT Report JCS-7-93. 
Washington, D.C.: June 1993. 

Mikesell, John L. Fiscal Administration: Analysis and Application for 
the Public Sector, 5TH Edition. Fort Worth, Tex.: Harcourt Brace 
Publishers, 1999. 

[End of section]

Appendix III: Glossary: 

Ability to Pay Principle; A concept of tax fairness that states that 
people with different amounts of wealth, income, or other levels of 
well-being should pay tax at different rates. Wealth includes assets 
such as houses, cars, stocks, bonds, and savings accounts. Income 
includes wages, interest, dividends, and other payments. 

Adjusted Gross Income (AGI); All income subject to taxation under the 
individual income tax after subtracting certain deductions, such as 
certain contributions for individual retirement accounts, and alimony 
payments. Personal exemptions and the standard or itemized deductions 
are also subtracted from AGI to determine taxable income. 

Alternative Minimum Tax (AMT); A separate tax system that applies to 
both individual and corporate taxpayers. It parallels the income tax 
system but with different rules for determining taxable income, 
different tax rates for computing tax liability, and different rules 
for allowing the use of tax credits. 

Average Tax Rates; The total amount of tax a taxpayer pays divided by 
some measure of his or her income. In the current tax system, average 
tax rates are sometimes presented as the amount of tax a taxpayer pays 
divided by his or her taxable income. Average effective tax rates 
differ in that they are developed using a broader measure of total 
income than taxable income. 

Benefits Received Principle; A concept of tax fairness that states that 
people should pay taxes in proportion to the benefits they receive from 
government goods and services. 

Capital Gains; A capital asset's selling price less its initial 
purchase price. Investments that have been sold at a profit are called 
realized capital gains. Investments that have not yet been sold, but 
would yield a profit if they were sold have unrealized capital gains. 

Collection Point; The individual or business that actually remits 
payment of taxes to the government. 

Compliance Burden; The time and resources, including out-of-pocket 
costs, that taxpayers spend each year in order to comply with the tax 
laws. Compliance burden is often cited as a measure of the overall 
simplicity of the tax code. 

Consumption Tax Base; A tax base where people pay taxes on goods and 
services that they purchase, or consume, effectively excluding savings 
and investment from the tax base. Capital assets are usually fully 
expensed when purchased under a consumption tax rather than depreciated 
over time, as is the case under an income tax. 

Corporate Income Taxes; Taxes paid by corporations on net income, or 
the difference between corporate revenues and corporate business 
expenses. 

Credit; An amount that offsets or reduces tax liability. When the 
allowable credit amount exceeds the tax liability, and the difference 
is paid to the taxpayer, the credit is considered refundable. 

Deduction; An amount that is subtracted from the tax base before tax 
liability is calculated. Deductions claimed before and after the 
adjusted gross income line on the Form 1040 are sometimes called "above 
the line" and "below the line" deductions, respectively. 

Deficit; The amount by which the government's spending exceeds its 
revenues for a given period, usually a fiscal year. 

Defined Contribution Pension Plans; A type of retirement plan that 
establishes individual accounts for employees to which the employer, 
participants, or both make periodic contributions. Employees bear the 
investment risk and often control, at least in part, how their 
individual account assets are invested. 

Discretionary Spending; Outlays controlled by appropriation acts, other 
than those that fund mandatory programs. 

Distortion; Changes in behavior, such as how much to work, what to 
consume, and where to invest, due to taxes, government benefits, or 
monopolies. 

Distributional Analysis; An analytical tool used by government agencies 
and other analysts to identify how different tax proposals or tax 
systems would affect different groups of taxpayers with differing 
ability to pay taxes, usually measured by income. 

Dividend Income; A taxable payment made by a company to its 
shareholders, often quarterly, out of the company's retained earnings. 
Dividends are usually given out in the form of cash, but can also be 
given out as stock or other property. 

Economic Incidence; The person or group of people that actually bear 
the burden of a tax regardless of who remits payment to the government. 
For example, even though businesses remit tax sales tax payments to the 
government, individuals who purchase items may bear the actual burden 
of the tax. 

Effective Tax Rates; The amount of tax that a taxpayer pays to the 
government expressed as a percentage of some overall measure of total 
income. 

Efficiency Costs; A reduction in economic well-being caused by 
distortions, or changes in behavior due to taxes, government benefits, 
monopolies, and other forces that interfere in the market. Efficiency 
costs can take the form of lost output or consumption opportunities. 

Employer-Provided Health Care; Insurance plans offered by employers to 
employees where the employer pays all or a portion of an employee's 
health insurance costs. Employer-provided health care payments are not 
counted as nonwage income, and therefore these payments are not subject 
to taxation. 

Entitlement; Programs that require the payment of benefits to persons, 
state or local governments, or other entities if specific criteria 
established in the authorizing law are met. 

Estate and Gift Taxes; Assets an individual owns at the time of his or 
her death or gifts made during the course of his or her life may be 
subject to transfer taxes, sometimes referred to as estate and gift 
taxes. Estate and gift taxes are more likely to affect wealthier 
individuals, and most citizens are unaffected by estate and gift taxes. 

Excise Taxes; A tax on the sale or use of specific products or 
transactions. 

Exemption; A part of a person's income on which no tax is imposed. It 
is the amount that taxpayers can claim for themselves, their spouses, 
and eligible dependents. There are two types of exemptions--personal 
and dependency. Each exemption reduces the income subject to tax. The 
exemption amount is a set amount that changes from year to year. 

Externality; A benefit or cost that is not captured or paid by the 
individuals or firms creating them. 

Flat Tax; A type of tax reform proposal that, in most cases would 
change the tax base to a consumption tax base and impose a single, or 
flat, tax rate on individuals and businesses. Most flat tax proposals 
would not really be "flat" because they grant exemptions for at least 
some earnings. 

Grandfather Clause; Provisions that are typically used to exempt people 
who would be subject to a new rule from the provisions of that rule. 
Thus, in the case of tax law changes, only people who engage in certain 
activities after a tax law change will be affected by changes to the 
tax treatment of that activity. 

Gross Domestic Product (GDP); The value of all final goods and services 
produced within the borders of a country such as the United States 
during a given period. The components of GDP are consumption 
expenditures (both personal and government), gross investment (both 
private and government) and net exports. 

Horizontal Equity; The concept that people with the same ability to pay 
should be taxed at the same rate. 

Income Tax Base; A tax base where individuals are taxed on the basis of 
income, or both the goods and services they consume as well as their 
savings and investments. Under an income tax, capital assets are 
usually depreciated over time rather than being fully expensed at the 
time they are purchased, as would be the case under a consumption tax. 

Individual Retirement Accounts; Investment accounts that allow people 
to save a certain amount of income each year and, in most cases, deduct 
the savings from taxable income, with the savings and interest tax 
deferred until the person retires. 

Mandatory Spending; Also known as "direct spending." Mandatory spending 
includes outlays for entitlements (for example, food stamps, Medicare, 
and veterans' pension programs), interest payments on the public debt 
and nonentitlements such as payments to the states from Forest Service 
receipts. By defining eligibility and setting the benefit or payment 
rules, the Congress controls spending for these programs indirectly 
rather than through appropriations acts. 

Marginal Tax Rates; Tax rate that taxpayers pay on the next dollar of 
income that is earned. Marginal tax rates can be presented as both 
marginal statutory rates and marginal effective rates. 

Medicaid; A federal program that states administer to help pay medical 
costs for low income citizens. Each state in which applicants for the 
program reside establishes criteria for financial need. Medicaid 
supplements Medicare to pay for some of the costs that Medicare does 
not cover. 

Medicare; A federal entitlement program that delivers medical care to 
eligible workers, spouses of workers, and retired workers when they 
reach age 65. 

Net Tax Gap; The difference between taxes legally owed to the 
government and taxes actually paid to the government, less collected 
enforcement revenue. 

Payroll Taxes; Often synonymous with social insurance taxes. However, 
in some cases the term "payroll taxes" may be used more generally to 
include all tax withholding. For the purposes of this report, payroll 
taxes are synonymous with social insurance taxes. 

Personal Income Taxes; Taxes on income earned by individuals, including 
income from wages, interest, and nonwage income. 

Phase-in Rule; A rule that allows for a new tax provision to be 
implemented gradually rather than immediately upon enactment of a new 
tax law. Phase-in rules help mitigate windfall losses during the 
transition to a new set of tax laws. 

Progressive Tax Rates; A tax rate structure where tax liability as a 
percentage of income increases as income increases. 

Proportional Tax Rates; A tax rate structure where taxpayers pay the 
same percentage of income, regardless of their income. 

Regressive Tax Rates; A tax rate structure where tax liability is a 
smaller percentage of a taxpayer's income as income increases. 

Retail Sales Tax; A tax levied on the sale price of a good and 
collected by the seller of the good. 

Revenue Neutral; A term applied to tax bills or proposals are designed 
to raise the same amount of revenue as the system that is being 
replaced. 

Social Insurance Taxes; Tax payments to the federal government for 
Social Security, Medicare, and unemployment compensation. While 
employees and employers pay equal amounts in social insurance taxes, 
economists generally agree that employees bear the entire burden of 
social insurance taxes in the form of reduced wages. 

Spillovers; See externality. 

Standard Deduction; A deduction that reduces income subject to tax and 
varies depending on filing status, age, blindness, and dependency. The 
standard deduction is taken instead of itemizing deductions. 

Statutory Incidence; The party, usually an individual or a business, 
that is legally required to pay a tax to the government. 

Statutory Tax Rate; Tax rates as written into law. 

Tax Burden; See economic incidence. 

Tax-Exempt Bonds; Bonds issued by state and local governments for 
public projects on which interest that is earned is exempt from federal 
income tax. 

Tax Expenditures; A revenue loss attributable to a provision of the 
federal tax laws that grants special tax relief that encourages certain 
kinds of behavior by taxpayers or to aid taxpayers in special 
circumstances. The Congressional Budget and Impoundment Act of 1974 
lists six types of tax expenditures: exclusions, exemptions, 
deductions, credits, preferential tax rates, and deferrals. 

Tax Incidence; See economic incidence. 

Tax Liability; The amount of tax that a taxpayer is legally required to 
pay to the government at a given time. 

Tax Preferences; See tax expenditures. 

Taxable Income; Income subject to tax that is used to determine tax 
liability. In the case of the federal income tax, taxable income is 
equal to a taxpayer's adjusted gross income less personal deductions 
and exemptions. 

Third-Party Information Reporting; Information reported to IRS by third 
parties, such as banks or employers, that allows IRS to verify that 
information reported by taxpayers on their tax returns is accurate. 

Value-Added Tax; A tax levied at each stage of production or 
distribution on the value added to the product during that stage of 
production. Value-added taxes are now commonly used in many Western 
European countries as a source of revenue. 

Vertical Equity; The concept that people with differing ability to pay 
taxes should pay different rates of taxes or different percentages of 
their incomes in taxes. 

Voluntary Compliance; A system of compliance that relies on individual 
citizens to report their income freely and voluntarily, calculate their 
tax liability correctly, and file a tax return on time. 

Windfall Gain; A sudden and usually unexpected gain for a taxpayer or 
group of taxpayers owing to changes to the tax system. 

Windfall Loss; A sudden and usually unexpected loss for a taxpayer or 
group of taxpayers owing to a change in the tax system. Transition 
rules are often proposed to mitigate the effects of windfall losses.  

[End of section]

FOOTNOTES

[1] Summing outlay equivalent estimates is controversial because doing 
so does not take into account possible interactions among tax 
expenditures. In addition, there are several ways to define and measure 
tax expenditures. The size of a tax preference can change over time. 
For example, accelerated depreciation of machinery and equipment drops 
out of the list of the top 10 tax expenditures in 2006. Moreover, what 
is considered a tax expenditure depends on the tax base. Some 
provisions of the tax code that are considered tax expenditures under 
an income tax base would not be considered tax expenditures under a 
consumption tax base. For further information on how tax expenditures 
are defined and measured, see GAO, Government Performance and 
Accountability: Tax Expenditures Represent a Substantial Federal 
Commitment and Need to Be Reexamined, GAO-05-690 (forthcoming). 

[2] GAO, 21ST Century Challenges: Reexamining the Base of the Federal 
Government, GAO-05-325SP (Washington, D.C.: February 2005). 

[3] Martin Feldstein, "Tax Avoidance and the Deadweight Loss of the 
Income Tax," The Review of Economics and Statistics, vol. 81, no. 4 
(1999). 

[4] Jinyong Cai and Jagadeesh Gokhale, "The Welfare Loss From a Capital 
Income Tax," Federal Reserve Bank of Cleveland Economic Review, vol. 
33, no. 1 (1997). 

[5] It is difficult to measure the amount of time that taxpayers spend 
planning and preparing their returns because, among other reasons, when 
surveyed, taxpayers may overstate or understate the amount of time that 
they spent depending on how straightforward or complicated their 
returns were (i.e., how frustrating the experience was). Additionally, 
there is no consensus among researchers regarding the appropriate 
monetary value to be assigned to each hour of time spent on tax 
compliance activities. 

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