Federal income tax reform is at the forefront once again. With baby boomers approaching retirement, the 2001 and 2003 tax cuts set to expire, and the alternative minimum tax continuing to affect millions more middle-income taxpayers, the tax reform debate is heating up. In light of the current climate, it is no surprise that President Bush has made tax reform a priority of his Administration’s second term.

In January 2005, the President created the President’s Advisory Panel on Federal Tax Reform and charged it with recommending options to make the Internal Revenue Code simpler, fairer, and more pro-growth. The Panel’s recommendations, released November 1, 2005, include voiding most tax deductions and lowering tax rates to make the U.S. tax system simpler and more efficient.

The first of the two outlined proposals pushes for major simplification of the current income tax system, while the second recommends changes for businesses that lead to an indirect tax on consumption. Access the Panel’s final report.

Two weeks prior, the AICPA released a report Understanding Tax Reform: A Guide to 21st Century Alternatives, in an effort to serve as a resource in the tax reform debate. The report offers an unbiased review of tax reform proposals and discusses the issues and alternatives for reform. It is intended to foster informed discussion among policymakers by providing balanced information and analysis.

The 2005 report builds on the success of Flat Taxes and Consumption Taxes: A Guide to the Debate, released by the AICPA in 1995. Highly regarded by tax experts, the 1995 report offered a comprehensive and evenhanded analysis of tax alternatives. The current research further develops key issues uncovered in 1995 and provides expanded coverage of new alternatives being considered in the 2005 debate. The report provides a timely, unbiased resource to those engaged or interested in tax reform. Both the 1995 and 2005 reports are available online.

The 2005 report outlines three approaches to tax reform that are central to the current debate: bottom-up, fundamental and a hybrid methodology.

“Bottom-up” is an incremental approach that would modify the current income tax system without changing the system’s fundamental character as an income tax.
“Bottom-up” proposals address economic growth by creating incentives for capital formation, accelerating depreciation, eliminating double taxation of corporate profits, and increasing tax-preferred savings options.

Fundamental tax reform, on the other hand, would replace the entire current tax system (or major parts of it) with a new system – with a consumption tax being the most frequently proposed substitute. The most dramatic manifestations of this approach would significantly reduce tax filing by most individuals. The report examines the five major consumption tax alternatives: a retail sales tax; a credit-invoice value-added tax (VAT); a subtraction method VAT; “the flat tax” (a single-rate consumption tax); and a personal consumption tax.

A consumption tax system is considered simpler and more conducive to economic growth, while income taxes are viewed as more progressive. These general observations may not hold true for specific proposals. Both types of tax systems have valuable characteristics, and that may be why the hybrid approach to reform – one that encompasses both an income and consumption tax – is receiving greater consideration. The report outlines current hybrid proposals.

In fact, our current income tax is better characterized as a hybrid income-consumption tax than as a “pure” income tax. This is because many forms of investment are subject to reduced tax rates (capital gains, dividends), a zero tax rate (state and municipal bond interest), or deferred tax rates (retirement plans, certain important features of life insurance contracts).

If delivered appropriately, each of the tax reform approaches discussed in the report has the ability to yield positive results. Simplification and reducing impediments to economic growth and international competitiveness are key components to the consideration of any proposal. Reforms should also address increasing domestic savings and reducing the tax compliance gap. In addition, the difficulty of measuring income and determining whether tax provisions should have a more neutral affect on individual and business decision-making must also be considered.

With this report, the AICPA does not take a position on the “best possible solution” to reform, but supports an in-depth debate of the issues, taking into account the goals of enacting “good tax policy.” Policymakers are encouraged to use the AICPA’s Tax Policy Concept Statement #1: Guiding Principles for Good Tax Policy to evaluate competing reform proposals for simplicity, fairness, consistency, transparency and economic efficiency, and other important measures. Education and discussion between policymakers and the public are essential to make this tax reform effort rational, thoughtful and lasting.

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