Overview

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

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The number of policymakers in Washington, D.C., who want to replace the current federal income tax system with a radically different system seems to grow by the hour. The policymakers have heard their constituents complain about how complex and burdensome the current system is, and many, though not all, agree that a completely new system is needed. They advocate some form of flat tax a value-added tax or a retail sales tax or a combination of these.

The call from all points on the political spectrum for eliminating or radically changing the federal income tax has grown increasingly loud in the wake of the 1994 Republican takeover of both chambers of Congress. Although the Democrats (House Minority Leader Richard Gephardt, D-Missouri, in particular) have begun to describe their own vision for tax restructuring, the debate so far has focused on various forms of a consumption tax (that is, on proposals that would eliminate any tax on investment income). Any such proposal would change profoundly the U.S. tax system and affect virtually every taxpayer. Can the fairness goals and anti-abuse concerns that created much of today's tax complexity be effectively addressed in a far simpler system on which policymakers can agree?

House Majority Leader Richard Armey, R-Texas, has introduced a flat tax proposal; House Ways and Means Committee Chairman Bill Archer, R-Texas, has spoken in favor of a broad-based consumption tax; and Rep. Gephardt has proposed a comprehensive income tax approach. In the Senate, Majority Leader Bob Dole, R-Kansas, (together with House Speaker Newt Gingrich, R-Georgia) has appointed former Housing and Urban Development Secretary Jack Kemp as chair of the National Commission on Tax Reform and Economic Growth to develop a tax reform proposal for the Republican leadership.

The Clinton administration so far seems to be taking a wait-and-see approach to the issue of fundamental tax reform. The administration has welcomed but not endorsed the Gephardt proposal to retain a reformed income tax, and internal meetings are continuing to develop options, including combinations of income and consumption taxes, for the president.

Through November 1996, tax-restructuring discussions are likely to be general and largely political. Even if the winner of the presidential election makes tax reform one of the top issues, it will be several years before any new proposal could actually take effect. Neither the current administration nor a new administration could develop a proposal before spring 1997. Congress would probably take at least as much time to consider a new proposal as it did to work on the Tax Reform Act of 1986-sixteen months-so that enactment of actual legislation would be unlikely before fall 1998. Because Congress would want to allow time for transition, it is unlikely that any newly-restructured tax system would become fully effective until 1999 or even 2000.

Although implementation may be years in the future, individuals and businesses already are beginning to conduct their own analyses of the effects of the various proposals. Input from the affected taxpayers will lead to significant changes in the proposals as the political debate progresses. Because the tax system influences the well-being of all sectors of the economy and because the proposals are so sweeping in their scope, the debate will spur a huge collective learning process throughout the United States. Taxpayers will intensely study the implications for international as well as domestic transactions. The complexity of the issues will test the ability of tax experts to provide the clear and thoughtful analysis that will be required for a productive public discussion of tax reform.

A Brief History on Tax Reform

For the past two decades, tax reform has been a nearly constant feature of our political life. In 1975 and 1976, Congress enacted major reform legislation intended to restore or preserve fairness by closing loopholes, restraining tax shelters, and adjusting (lowering) individual rates. In 1981, in the early months of his administration, President Reagan pushed a sweeping tax change through Congress.

The 1981 legislation lowered rates (placing the top income tax rate at 50 percent), provided indexing so that inflation would not result in greater tax burdens, and introduced substantial business investment incentives.

In 1982 and 1984, Congress adopted substantial tax increases as part of its budget efforts. These tax bills consisted largely of efforts to broaden the tax base by eliminating or restricting various deductions or by forcing early recognition of income.

When Democratic presidential candidate Walter Mondale attempted to use tax reform as a campaign issue in 1984, President Reagan countered with instructions to his Treasury Department to prepare a study on tax reform. The resulting study, released in November 1984, became the foundation of the Tax Reform Act of 1986. The 1986 Act lowered rates for the highest-income taxpayers to 28 percent and dramatically broadened the tax base through such measures as elimination of the deductions for state sales taxes and personal interest and limitations on the deduction of losses from passive investments.

In 1988, taxes again played a substantial role in the presidential campaign, with Vice President George Bush repeating his famous "read my lips" pledge as Democrats argued that a tax increase was inevitable. The 1990 budget compromise included an increase in the top individual rate to 31 percent.

In 1992, candidate Bill Clinton campaigned on a platform that promised greater tax fairness and fiscal discipline through an increase in top individual and corporate tax rates, expansion of the earned income tax credit, and various reforms. Early in his presidency, President Clinton pushed these changes through Congress as part of the 1993 budget.

What has been the result of these two decades of nearly constant tax change?

In 1975, top individual income tax rates were 70 percent on investment income and 50 percent on earned income. Capital gains were effectively subject to a top rate of 35 percent. At the same time, a much broader array of tax planning strategies allowed high-income taxpayers to shelter substantial portions of their income. Today, the top individual income tax rate is 39.6 percent, capital gains are subject to a top rate of 28 percent, and tax-shelter opportunities have been reduced.

In 1975, the top corporate tax rate was 48 percent. Accelerated depreciation and the investment tax credit were significant devices to mitigate that burden. Today, the top corporate rate is 35 percent, and many former planning strategies have been eliminated.

Thus, the last two decades have had substantial effects on the burdens for particular taxpayers and on the ways in which individuals pay taxes; payroll taxes are now a greater percentage of total receipts, while income taxes bring in a lower share. As shown in the following table, the federal government collected about the same share of national output in taxes in 1994 as it did in 1974.

Federal Receipts As a Percentage of Gross Domestic Product
Type of Tax	1974	1994
Individual income tax	8.5	8.2
Corporate income tax	2.8	2.1
Social security taxes	5.3	7.0
Excise taxes	1.2	0.8
Other taxes	1.0	0.9
Total federal taxes	18.8	19.0

This publication is designed to familiarize you with the current suggested approaches for radically restructuring the U.S. tax system. The Consumption Tax Proposals section describes various consumption tax proposals, including: (1) House Majority Leader Richard Armey's flat tax; (2) the suggestion by Sen. Richard Lugar, R-Indiana, for a national retail sales tax; and (3) the value-added personal consumption tax.

These proposals seek to restructure our current tax system while maintaining the same level of government receipts; the exception is the Armey plan, which is designed to also provide a $40 billion tax cut paid for by spending cuts. Although some of these plans undoubtedly will fall by the wayside as the debate about tax reform unfolds over the next few years, they do shed light on tax issues that policymakers are moving to address. Regardless of the outcome of congressional action, we believe this publication will continue to provide value to businesses and individuals who want to understand how the issues at the core of fundamental tax reform might affect them.

The section on Alternatives to a Consumption Tax briefly describes potential Democratic alternatives to the consumption tax approach. These include Rep. Gephardt's "flatter" income tax and the simplification reform of the current system advocated by top Treasury officials.

The section on Consumption Tax Issues Briefs continues the analysis of consumption tax plans with a series of issues briefs. These briefs attempt to illuminate some of the political possibilities and difficulties surrounding fundamental change, as well as some of the major economic issues.

Lastly, the section on Is the Sacrifice Too Great? looks at the ultimate issue: which individuals, businesses, and geographic regions may be most affected as a result of fundamental tax reform; and it places their concerns in the context of some of the issues identified in 'Consumption Tax Issues Briefs'.

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