Models for Tax Reform

Apr 17, 2012 | Taxes

Continuing on our Tax Week theme, this blog will focus on the various models there are for tax reform. Obviously, there are an almost unlimited number of ways to reform the tax code, but we will lay out the major "styles" of tax reform.

The tax reforms we will mention range from largely staying within the current structure to dramatically simplifying the current system to dramatically altering its structure.

  • '86-Style Reform (Lower the Rates, Broaden the Base): In 1986, Democrats and Republicans came together to enact a comprehensive tax reform package. The package combined reductions in rates and simplifications of the code with cuts to various "tax expenditures" such as the deduction for credit card interest and the investment tax credit. It also taxed capital gains as ordinary income. The most recently incarnated of that style of reform is the Wyden-Coats legislation introduced last year, which consolidates six rates to three, reduces them somewhat, reduces a number of tax expenditures, and raises rates on capital gains.
  • Zero Plan-Style Reform: The Fiscal Commission's Zero Plan is the 1986-style reform on steroids. Instead of identifying several tax expenditures to eliminates, this reform cuts out all tax expenditures and uses the money to substantially lower rates and deficits. Under this framework, the Commission then allowed tax expenditures to be "added back," but only if they were paid for with higher rates. For example, the Commission's illustrative tax plan brought rates down to 12%, 22%, and 28% (above the 8%, 14%, and 23% of the pure Zero Plan) and kept some form of many major tax expenditures (for example, the mortgage interest deduction was turned into a 12% credit). This style generally taxes capital gains and dividends as ordinary income, but it could maintain preferential rates in exchange for higher rates.
  • National Sales Tax (FairTax): Many economists believe that moving to a consumption tax would help promote economic growth by favoring savings and investment. Some tax reforms would replace some or all of the current system with a sales tax. The most prominent of this type of reform recently, the FairTax, would replace nearly all federal taxes with a 30 percent retail sales tax. In addition, it would give rebates to all households based on the projected consumption of a poverty-level family, adjusted for family size. This system is designed to be revenue-neutral. A similar but alternative approach would be to instead replace the income tax with a Value Added Tax (VAT), which is like a sales tax except that it is collected at every point along the supply chain.
  • Flat Tax (Hall-Rabushka): Consumption taxes need not be imposed at the point of sale. One alternative, associated with economists Robert Hall and Alvin Rabushka, is something called a flat tax. The flat tax would charge a single rate (perhaps 20 percent) on all corporate and individual income, but would exempt savings and investments. Since income by definition equals the sum of consumption and savings, exempting savings from taxation leads to a consumption tax.
  • Progressive Consumption Tax (X Tax): One critique of consumption taxes is that they are regressive -- both because they tend to have a "flat" rate structure and because lower-income individuals spend a larger proportion of their income than higher-income individuals. One solution, generally associated with the late Princeton economist David Bradford, is to enact a progressive consumption tax -- what Bradford called an "X tax." As in the example above, this tax would exempt net savings and so focus on consumption. However, a progressive rate structure would ensure that higher income individuals pay at higher rates than they would in a flat tax.
  • Partial Replacement VAT (Graetz Plan): Another approach for taxing consumption in a progressive way is to combined a new consumption tax with a more progressive version of the existing income tax. This is the approach taken by by Yale professor Michael Graetz in his plan to combine a new VAT with lowering corporate and individual tax rates, as well as an exemption from the income tax for families making less than $100,000 from the income tax, and a rebate for low-income individuals. Some versions of this proposal would go further by eliminating or reducing many tax expenditures as well. A variant on this type of reform would replace or reduce payroll taxes in exchange for a VAT.
  • New Revenue Sources: The reform models discussed above pick one of two tax bases: income or consumption (or some combination of both, as the current system is). Other reforms could involve alternate sources of revenue either as a supplement to the existing system, as a partial replacement, or as a full replacement. New revenue could come from a carbon tax, a financial transactions tax, or other sources.
  • Partial Reform: Of course, for as many comprehensive tax reforms as there are, there are many more plans which would partially reform the tax system by reforming tax expenditures or changing rates in isolation. These efforts can take on many forms, but most notably this label could describe the proposals in the President's budget (or other Democratic budgets), which reduce or eliminate some tax expenditures and allow some of the 2001/2003/2010 tax cuts to expire. Such reforms can help meet revenue or distributional goals without uprooting the current system.

These reforms are by no means an exhaustive list of possibilities, but these are some of the more common types of reform that you will see and hear about. Regardless of the form it takes, we know that reform has to happen. The current code is simply not cutting it.