AFTER A SERIES of changes in tax rates and a variety of new complications in the Internal Revenue Code, the time is ripe for a basic overhaul of the Federal government's revenue system. Tinkering with individual rates or "loopholes" is not a satisfactory answer. This article attempts to move the process along by analyzing the four major alternative approaches to fundamental tax reform. Rather than promoting any single view, what follows focuses on the defining characteristics of each.
Tax reforms come in many shapes and varieties. Two main motivating factors for reform are present: to increase economic growth by encouraging savings and investment and to simplify the burdens of tax preparation.
Shifting the tax base to consumption. The most basic change in the nation's revenue structure would be to introduce a new form of Federal tax, one levied on consumption instead of income. For years, economists have debated the respective merits of income and consumption as the basis for taxation. The U.S. uses consumption taxation to a far lesser degree than most other developed Western nations.
In recent years, the traditional preference for income-based taxation has eroded. A poll of macroeconomists at 15 universities reported that 63% favored "a fundamental reform of the American tax system towards a consumption tax," with 37% opposed. Tax experts have devised--and criticized--a variety of specific consumption-based taxes. No consensus, however, has been reached on the details. It is likely that two interrelated clusters of issues--the general desirability of a tax on consumption and the specific form that it should take--will receive increased public attention in the years ahead.
Many analysts believe that taxing people on the portion of society's output that they consume is fairer than taxing them on what they contribute by working and investing. In the 19th century, economist John Stuart Mill made this point in advocating the exemption of savings as part of a "just" income tax system. In the 1940s, American economist Irving Fisher argued that the income tax involved double taxation of savings and distorted the choice of individuals in favor of consumption. Thus, not only is the income tax unjust, it encourages consumption and leisure at the expense of thrift and enterprise.
The Treasury proposed a "spendings tax" in 1942 as a temporary wartime measure to curb inflation. The proposal quickly was rejected by Congress. A major argument against the expenditure tax--then and now--is that the exemption of savings would favor the rich since they are better able to save large portions of their income. Some believe this would lead to greater concentrations of wealth in the hands of a few. Proponents of an expenditure tax respond that it can be made as steeply progressive as desired. Moreover, the trend in income taxation since 1980 has been away from progressivity and toward a flatter, more proportional revenue structure.
Another objection to the consumption base is that it would favor the miser over the spendthrift, even when both have similar spending power or ability to pay. The response offered to this argument is that consumption uses up the resources available to the nation, while saving adds to these resources. Moreover, the fundamental way for an individual to minimize consumption tax liabilities is to consume less: the incentives to work, save, and invest are unimpaired. By contrast, the basic way to minimize the income tax is to earn less, which dampens incentives to work, save, and invest--with deleterious effects on economic growth and living standards.
In practice, much of the impact of shifting to a consumption tax base would depend on how the tax was structured. The two major categories of alternatives are expenditure (or income) taxes levied on the portion of income not saved (which conceptually is the same as consumption) and sales or value-added taxes collected on individual purchases. …