Evaluation of Fundamental Tax Reform Proposals

1
Evaluation of Fundamental Tax Reform Proposals
May 17, 2005

• Presidents Advisory Panel on Federal Tax Reform
• Leslie B. Samuels
• Cleary Gottlieb Steen Hamilton LLP

2
Evaluation of Fundamental Tax Reform Proposals

• The United States has the most complex economy
  and the most complex tax system. How can we do
  better?

3
Look at Proposals in a Real World Way

• Fundamental Tax Reform such as RST, VAT, Flat
  Tax that substantially changes the existing tax
  system should be evaluated using criteria that
  can easily be understood and explained to the
  public.
• Who will be winners and losers?
• The current hybrid tax system imperfect as it
  is has been created by Congress over a long
  period and is the creature of the political
  process.
• Any new system will also be a product of the give
  and take of the legislative and political
  process.
• Judging the feasibility and impact of fundamental
  tax reforms proposals should be made in the
  context of the reality of the legislative and
  political process and not on the basis of a
  theoretical model.
• No other industrialized country has made a switch
  to a full consumption tax system.
• We have no real world experiences to guide us.
• Since there is a significant risk of getting it
  wrong, the proponents of fundamental tax reform
  have the burden of showing that the reform is
  clearly worthwhile.

4
First, Do No Harm

• The current tax system has important incentives
  to encourage social and economic objectives that
  affect the everyday life of millions of families.
  These include
• Health care coverage provided by employers
• Retirement savings provided by employers
• Charitable giving
• Child care
• Education
• Owner occupied housing
• In judging any alternative tax system, the first
  question is how the new system will deal with the
  social and economic objectives that are now built
  into the existing system.
• Will a new system reduce employer provided health
  insurance?
• Will a new system reduce employer provided
  retirement savings opportunities?
• Will a new system have a significant effect on
  the value of homes?

5
First, Do No Harm (contd)

• How certain are, and what is the possible
  magnitude of, adverse social and economic
  consequences of a new tax system?
• Who are the winners and losers?
• How certain are the social and economic benefits
  of a new tax system, and what is the possible
  magnitude of the benefits?
• The data on whether a consumption tax will
  encourage savings is mixed and the amount of new
  savings could be small.

6
Transition Issues The Elephant in the Room

• What are the expected consequences of a
  transition to a consumption-based system?
• What are the consequences of the so-called
  stealth tax on existing wealth and savings and
  on existing business investments and capital
  structures?
• Who will be the intended and unintended winners
  and losers? What happens to the elderly? What
  happens to businesses with substantial
  investments or borrowings?
• Will attempts to soften the transitional
  dislocations create major complexity and
  uncertainty?

7
Consequences to Sectors of the Economy

• How will a new consumption-based tax system
  affect different business sectors?
• Financial Services and Financial Markets
• The taxation of financial institutions banks,
  credit unions, investment firms and insurance
  companies is extremely difficult in a
  consumption tax system.
• How are financial intermediation services
  imbedded in interest rates taxed?
• What will be the effect on the financial markets
  of moving to a new system?
• International
• The international tax provisions of the existing
  tax system are still very complex. Need for
  guidance, simplification and training IRS agents.
• How will a new system coordinate with our trading
  partners to avoid excessive taxation?
• State and local fiscal consequences and
  integration with a new federal system.

8
Judge New System vs. Improved Tax System

• First look at a possible revised and simplified
  tax system
• Review all taxes individual and corporate income
  taxes employment taxes and excise taxes
• Review proposals to solve AMT problem
• Estimate winners and losers
• Then, compare a new, real world consumption-based
  tax system (not a theoretical model) against a
  possible revised income tax system
• Estimate winners and losers
• Review impact on state and local governments

9
Conclusions

• In the real world of our complex economy and
  society, any proposal to completely eliminate the
  income tax in favor of a consumption-based tax is
  not a responsible approach and should be soundly
  rejected by the commission.
• Any proposal to combine a revised income tax with
  a credit invoice VAT is a distant second to a
  reformed income tax because it is possible to get
  the worst of the two tax systems.
• The Commission should focus primarily on
  reforming the existing system.