D e l o i t t e   &   T o u c h e   LLP

Next  |  Previous  |  Table of Contents  |  Home  |  Site Search

ALTERNATIVES TO A CONSUMPTION TAX

Introduction

The Gephardt 10-Percent Tax

Simplification Measures

Introduction

The proposals to replace the federal income tax with a consumption tax are receiving most of the attention in Washington and in the nation's editorial pages. Other ideas for improving the current system without radically taking apart the income tax are being discussed, however, usually along one of two lines.

Proponents of the first line of argument point out the potentially regressive nature of some consumption tax proposals and the potential damage of such a change to working class families who "earn" their money through labor as opposed to "speculating" in the stock market. In addition, they believe that consumption taxes are unfair because income is a better way of measuring "ability to pay" than consumption. Proponents of the second line of argument agree that a radical change to a consumption tax is too risky because (1) it may not bring in the revenue the government needs and depends on, and (2) it is uncertain how the change would affect the value of existing assets, wage and price levels, interest rates, and other important economic variables. Click here for more detailed discussion on these issues.

The Gephardt 10-Percent Tax

House Minority Leader Richard Gephardt, D-Missouri, has offered a tax-reform proposal that is designed to build on the Tax Reform Act of 1986 by further broadening the personal income tax base and by lowering and flattening the tax rate schedule. The Gephardt proposal essentially reflects a political choice to defend the concept of progressive income taxation and the existing separate tax on corporate-source income against the more radical ideas proposed by flat-tax and consumption-tax advocates; it does not defend every aspect of the status quo.

The Gephardt proposal for the personal income tax, which is not yet in legislative form, would repeal essentially all credits, special tax rates, exclusions, and deductions. The only deductions still allowed would be those for ordinary and necessary business expenses, home mortgage interest, alimony, half of self-employment taxes, investment interest, and employee business expenses. Gephardt also would retain the earned income tax credit.

Fringe benefits and employer pension contributions would be taxed as income to the employee, but earnings on pension funds and IRAs would continue to be deferred until the funds are withdrawn. The exclusion for the inside buildup of life insurance would continue.

Gephardt would use the revenue generated by this broadening of the income tax base to lower and flatten tax rates by amounts that he claims would leave total personal income tax revenue unchanged. There would be a tax rate of 10 percent for the first $40,200 of taxable income of a married couple (in excess of a personal exemption of $2,750 and a standard deduction of $8,350). As a result, about 75 percent of taxpayers essentially would pay a 10-percent flat rate income tax. The standard deduction for heads of household would be $7,350; for single taxpayers it would be $5,000. Tax rates would increase to a top rate of 34 percent for taxable incomes in excess of $264,450.

Gephardt's proposed tax rates are as follows:

Tax Rates Under the Gephardt Proposal

Taxable Income ($)

The following example shows how a married couple with two dependent children would fare under the Gephardt plan. Similar to the Consumption Tax example, the assumed levels of capital gains, interest income, dividend income, and itemized deductions are based on Internal Revenue Service prior years' tax return data. The taxpayers also are assumed to receive no fringe benefits or employer pension plan contributions. The home mortgage interest deduction is assumed to account for approximately 45 percent of the total of itemized deductions.

Example:

Total Income                           $75,000

Salary                                     $69,488

Capital Gains                          $2,600

Dividends and Interest             $2,912

Itemized Deductions                $15,800

Under the Gephardt proposal: This couple's taxable income is calculated as:

Note: Because the taxable income in this example is more than $40,200 (but less than $97,150), a 10-percent tax will be assessed on the first $40,200, with a 20-percent tax on the amount in excess $40,200.

The actual tax is calculated as:

$4,020, plus 20 percent of $8,300 = tax of $5,680

[that is, $48,500 minus $40,200] = $5,680

As previously noted, under present law, the couple's tax liability would be $8,706; this compares to the $5,680 under the Gephardt plan.

Gephardt not only rejects the exemption of investment income from tax proposed under the consumption tax plans, but he also proposes to eliminate the current 28 percent maximum capital gains rate, making capital gains taxable at the same rate as ordinary income.

Gephardt has indicated that he believes his tax structure would allow the Internal Revenue Service to implement a return-free income tax system for half of U.S. taxpayers and would permit significant cuts in the IRS itself.

Gephardt has not offered a specific proposal for corporations other than indicating that he wants to raise $50 billion per year by eliminating corporate tax preferences. He wants to use the proceeds to reduce taxes on small businesses.

To deal with the concern that tax reform would be followed by restoration of high tax rates (as has happened since 1986), Gephardt proposes that tax rate increases would have to be approved in a national referendum.

Simplification Measures

As the presidential race heats up, political observers continue to watch for signs that President Clinton will join the growing ranks of fundamental tax reform proponents. To date, the president has resisted the temptation to introduce his own plan. Instead, he appears to be following a variation of President Reagan's 1984 strategy by allowing Treasury Department officials to support other, less dramatic routes. This strategy lets the president champion change without taking on the burden of defending a specific proposal. This could change quickly depending on the political climate confronting the president during the campaign.

Treasury Secretary Robert Rubin, Assistant Treasury Secretary for Tax Policy Leslie Samuels, and Internal Revenue Commissioner Margaret Richardson all have discussed the dangers of replacing the income tax system. However, these same administration officials have said they support developing measures that would simplify the current system.

Samuels has been the Treasury Department's most vocal opponent of replacing the income tax system with a consumption-based model. Without giving specifics, Samuels, in testimony before the House Ways and Means Committee on June 7, 1995, said, "A simpler tax system would have lower compliance costs for individuals and businesses and lower administrative costs for the government."

"We are actively working on proposals relating to complexity and efficiency with respect to the current tax system," Samuels said. The Treasury Department is developing ways to reform the complicated alternative minimum tax system for individuals, Samuels added. Treasury also is developing proposals to revamp the definition of dependent and searching for ways to increase the number of taxpayers who use the simplified forms 1040EZ and 1040A. Treasury officials are sure to continue moving in this direction, but it is unclear whether their actions will do anything more than whet the appetites of congressional reformers who believe a full-scale replacement of the income tax system is necessary.

"We should think long and hard before we attempt to completely repeal the income tax," Samuels told the American Bar Association's tax section on May 20, 1995. "We will collect $1.3 trillion in income taxes this year, making us the envy of the world. We are dealing with the world's largest and most complex economy, and so far we are dealing with theoretical and highly idealized reform proposals versus practical application," Samuels added.

Next  |  Previous  |  Table of Contents  |  Home  |  Site Search

Copyright © 1996 Deloitte & Touche LLP. All rights reserved Copyright and Legal Information.
For feedback or suggestions contact the webmaster@dtonline.com