Simplifying Federal Taxes: The Advantages of Consumption-Based Taxation
by Chris R. Edwards on 02/12/2002
35 Pages
The 2001 $1.35 trillion tax cut reduced income tax rates and modestly liberalized the tax rules for retirement saving plans. However, the new tax law did not slow the progression of the tax code toward increasing levels of complexity. In fact, the law made 441 changes to the tax code and created a complicated series of phase-in periods for tax changes. Meanwhile, the congressional Joint Committee on Taxation (JCT) released a 1,300-page study cataloging the excessive complexity of federal taxes but providing only limited proposals for reform.
Minor simplification reforms will not be enough. The tax system is caught in a spiral of continual change and nonstop growth in rules. Since the mid-1980s there have been 7,000 federal tax code changes and a 74 percent increase in the number of pages of tax rules. Complying with federal tax requirements wastes 6 billion hours each year as families and businesses fill out tax forms, keep records, and learn tax rules.
The key factor that causes rising income tax complexity is the inherent difficulty of measuring the tax base. The “Haig-Simons” measure of income favored by many academic theorists is economically damaging and too impractical to use in the real world. As a result, policymakers have fallen back on ad hoc and inconsistent rules to define the income tax base. Income may be taxed when earned, when realized, or when received. Some income is not taxed, some is taxed once, and some is taxed multiple times. Such inconsistencies intensify the tax code’s complexity and create instability as policymakers gyrate between different definitions of the tax base. In addition, the lack of a consistently defined tax base increases the use of the tax code for special-interest tax breaks, thus further adding to the system’s complexity.
The complexity and inefficiency of the individual and corporate income taxes have led to great interest in replacing them with a consumption-based tax. The leading consumption-based tax proposals, including the national retail sales tax and the Hall-Rabushka flat tax, could dramatically simplify federal taxation. Those tax systems would eliminate many of the most complex aspects of federal taxation, including depreciation accounting and capital gains taxation.
Businesses bear the biggest brunt of tax complexity costs under the income tax. For example, there has been chronic confusion over the capitalization of assets. The current asset classification system is very out of date; it is based in part on a 1958 Treasury study. As a result, the treatment of new technologies, such as computers, is often wrong and results in those assets being overtaxed. Even up-to-date depreciation schedules would be wrong because inflation makes it extremely difficult to measure depreciation accurately.
The flat tax would eliminate the complexity of depreciation and amortization, and the nonstop battles over capitalization. All business purchases would be treated the same way and immediately deducted. Congress has already recognized the excessive complexity and inefficiency of depreciation accounting—but only for small businesses. The flat tax would give all businesses a huge simplicity benefit that only very small businesses enjoy today.
Americans interested in saving a portion of their current income to support themselves in later years face an enormously complex array of tax rules. All this complexity is an artifact of the income tax. Consumption taxes would exempt personal saving from taxation. Not only would this be massively simpler, it would free Congress from picking and choosing which forms of saving should be specially favored. It would be much simpler, fairer, and more efficient for individuals themselves, not the federal government, to choose the form and purpose of their saving.
Imposing the federal tax on income was a historic mistake: no simple, efficient, and stable measure of income has been found in nine decades of the income tax. It is time to recognize this mistake and replace the income tax with a consumption-based alternative.
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