Prospects for Federal Tax Reform in the 109th Congress
Rachelle B. Bernstein
Vice President, Tax Counsel
National Retail Federation

President Bush has made federal tax reform a priority in his second term. In his executive order establishing a bi-partisan advisory panel on federal tax reform, the President asked the panel to provide revenue neutral policy options that would meet his goals of simplification, progressivity (recognizing the importance of home ownership and charity), and economic growth and job creation. The panel has been asked to make its recommendations to the Treasury Department by July 31.

To date, the House of Representatives has demonstrated more interest in fundamental tax reform than the Senate. The proposal that has garnered most attention in the House is a proposal to replace federal income, payroll and estate and gift taxes with a national retail sales tax. This proposal, introduced as H.R. 25 by Rep. John Linder (R-GA), has more than 50 co-sponsors in the House, including House Majority Leader Tom DeLay (R-TX).

It appears that the tax-writing committees of Congress do not expect to act on tax reform until they receive the President’s recommendations, although Ways and Means Committee Chairman Bill Thomas (R-CA) has expressed some interest in combining tax reform with social security reform. In particular, Thomas has expressed interest in adopting a VAT in addition to the income tax as a way to fund social security and pension reform. Social Security Subcommittee Chairman Jim McCrery (R-LA) shares this interest. Thomas has said that he would like his Committee to mark-up social security reform legislation in June.

The President’s Advisory Panel on Federal Tax Reform

The President’s Advisory Panel is chaired by former Senator Connie Mack (R-FL) and co-chaired by former Senator John Breaux (D-LA). The panel includes a number of noted economists and academics. The panel divided its work into two stages – examination of the existing tax system and alternatives for reform. They held nine hearings in conjunction with these two stages.

The Advisory Panel heard from 27 witnesses regarding options for reform and is now seeking comments about the potential benefits and problems with the reform proposals they received. The options can probably be divided into (1) proposals for complete replacement of the income tax system with various types of consumption tax systems, (2) proposals to create a dual tax system – by adding a consumption tax to the income tax and making reforms to the current income tax, and (3) reforms of the income tax.

Consumption Tax as a Replacement for the Income Tax

The first set of options, replacing the income tax with a consumption tax, includes proposals for a National Retail Sales Tax, a Flat Tax, a Value Added Tax, and a consumed income tax . All consumption tax proposals will depress consumer spending and harm the retail industry.
Consumption taxes are highly regressive, and, therefore, do not meet the President’s criteria of being fair to all. Because lower-income households tend to spend a higher portion of their income, they would pay a higher tax relative to income level than would upper income households. A recent NRF study of H.R. 25, Linder’s proposal for a national retail sales tax, found that if that bill were enacted, families with income less than $18,000 a year would get a tax cut, and families with income over $100,000 would get a tax cut. However, families with incomes between $18,000 and $100,000 a year would have a tax increase. Families earning between $18,000 and $35,000 a year would have the largest tax increase because most families in this income category must use all of their earnings for living expenditures and have no ability to save, regardless of the tax incentive to do so.

The transition from an income tax system to a consumption tax system will cause the economy to decline for several years, and therefore, does not meet the President’s criteria of being pro-growth. A study performed for the NRF’s Foundation by PricewaterhouseCoopers (PwC) in 2000 found that following enactment of a national retail sales tax the economy would decline for three years, employment would decline for four years, and consumer spending would decline for eight years. Although the study showed that the economy would begin to grow in the fourth year, it found that the increase in economic growth over the ten-year modeling period was relatively modest compared to disruptions to the economy during the transition years and questioned whether the gain was worth the pain. The 2000 PwC study found that following enactment of a flat tax, the economy would decline for 5 years, employment would decline for 5 years, and consumer spending would decline for 6 years. Economic growth in years 6 through 10 would be even more modest than under the national retail sales tax.

Consumption Tax as an Addition to the Income Tax

Several witnesses that appeared before the advisory panel suggested that a VAT be enacted as an add-on to the current income tax system, as a means to finance social security, pay for repeal of the alternative minimum tax and other income tax reforms, and fund other governmental priorities. This model is similar to that used in many European countries.

Adding a VAT in addition to the income tax will lead to a higher overall level of taxes as a percent of GDP, which will not foster economic growth. An early NRF study of an add on VAT found that GNP would decline for four years after enactment and consumer spending would decline even longer. Obviously, projections change depending on how the VAT is designed, but it appears clear that for several years the economy would decline compared to where it otherwise would be.

According to a recent study by Dan Mitchell of the Heritage Foundation, the best evidence that a VAT will lead to substantial growth in the level of taxation comes from the European example. In the mid-1960’s, before any European country adopted a VAT, the burden of government in Europe was only slightly higher than it was in the United States. In Europe tax revenues were about 30% of GDP, while in the United States tax revenues were about 27% of GDP. The VAT proved to be a very easy tax to raise because it is built into the price of goods and hidden from consumers. Forty years later, taxes in Europe amount to approximately 41% of GDP, while taxes in the United States remain at about 27% of GDP. The European experience demonstrates that the VAT is a very easy tax to increase to fund increased government spending.

Adding a consumption tax to the income tax adds more regressivity to the tax system and does not meet the fairness requirement. Adding a consumption tax to the income tax also will increase complexity. Small businesses have enough trouble meeting the burdens of collecting and remitting payroll and income tax withholdings. To also impose on these businesses the burden of collecting and remitting a VAT or national retail sales tax will greatly increase their compliance burdens. Finally, enacting a consumption tax on the federal level will impinge on the revenue base that has heretofore been reserved for the states and will make it difficult for the states to meet their funding needs.

Reform of the Income Tax

Although much of the focus of reform options presented to the Advisory Panel was on new tax systems, the Panel also heard from advocates of reform of the current income tax. In fact, the President has made clear that he wants a plan for reform of the income tax to be one of the options recommended by the Panel. One of the major reasons that income tax reform witnesses recommended that option is because the transition to a new system could have a detrimental impact on the economy for many years. Witnesses, as well as members of the panel, were also fearful of adopting a new type of tax – like a national retail sales tax – that has not been adopted by any other country. Income tax reform advocates were also concerned with the regressive nature of consumption taxes and the particularly unfair impact on senior citizens.

Witnesses advocated simplifying the current system by repealing the alternative minimum tax, lowering tax rates and broadening the tax base. Many felt that reforms could be made to the income tax to ameliorate the bias against savings and investment, without creating the complication and transition problems of moving toward a consumption tax.