the president’s - the washington post the report on tax reform options: simplification,...

The President’s Economic REcovERy AdvisoRy BoARd

Board Members

PaulA.Volcker,Chairman

AnnaBurger

JohnDoerr

WilliamH.Donaldson

MartinFeldstein

RogerW.Ferguson

MarkT.Gallogly

JeffreyR.Immelt

MonicaLozano

JimOwens

CharlesPhillips

PennyPritzker

DavidSwensen

RichardL.Trumka

LauraD’AndreaTyson

RobertWolf

AustanGoolsbee,StaffDirectorandChiefEconomist

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PREFACEWhatfollowsisareportofthePresident’sEconomicRecoveryAdvisoryBoard(PERAB)onop-tionsforchangesinthecurrenttaxsystemtoachievethreebroadgoals:simplifyingthetaxsystem,improvingtaxpayercompliancewithexistingtaxlaws,andreformingthecorporatetaxsystem.

TheBoardwasaskedtoconsidervariousoptionsforachievingthesegoalsbutwasaskedtoexcludeoptionsthatwouldraisetaxesforfamilieswithincomeslessthan$250,000ayear.Weinterpretedthismandatenottomeanthateveryoptionweconsideredmustavoidataxincreaseonsuchfami-lies,butratherthattheoptionstakentogethershouldberevenueneutralforeachincomeclasswithannualincomeslessthan$250,000.Asimilarprincipleofrevenueneutralitywasusedinthe1986taxreformlegislationinwhichchangesthatraisedrevenuewerecombinedwithcutsinpersonalincometaxrates.Thespecificchangesweconsideredcaneitherraiseorlowerrevenue.Werealizethatrevenueneutralitybyincomeclassmightresultinincreasesordecreasesintaxliabilityforsub-groupsorindividualtaxpayerswithineachincomeclass–thatis,revenueneutralitymightresultin“winners”and“losers.”WehopethattheAdministrationandtheCongresswillselectchangesthataredesirableontheirmeritsandnotworryaboutthedistributionaleffectsofeachofthemin-dividually.TheentirepackageofoptionsselectedshouldbeevaluatedbytheTreasuryortheJointCommitteeonTaxation(JCT)toseewhatimpactithasontaxliabilitybyincomeclass.If,asseemslikely,thepackageraisestaxesforsomeincomegroupsandlowersthemforothers,thiscouldbeoffsetbyadjustmentstothestandarddeduction,taxratesorotherprovisions.Ofcourse,eveniftheratesareadjustedtoberevenueneutralineachincomeclass,therewillbeindividualtaxpayerswhogainandlose.Wedidnottrytoholdalltaxpayersharmlessintheoptionsweevaluated,andwewerenotaskedtodosobythePresident.Itwouldbeimpossibletodosowithoutsubstantialcostsintermsoflostrevenues.

TheBoardgatheredinformationfrombusinessleaders,policymakers,academics,individualciti-zens,laborleaders,andmanyothers.Ourfindingsaretheresultofmonthsofinputfrommanypeople, andwe thank them for their advice. Inaddition,over theyears therehavebeenmanyreportsontaxreformoptionsbybothgovernmentagenciesandprivateentities. Therehasalsobeensubstantialacademicresearchontheseissues.Wehavebenefitedgreatlyfromstudyingthesepreviousreportsandmaterials.

TheBoardwasnotaskedtorecommendamajoroverarchingtaxreform,suchasthe1986taxre-form,thetaxplansproposedbythe2005TaxReformPanel,orproposalsforintroducingavalue-addedtaxinadditiontoorinlieuofthecurrentincometaxsystem. Wereceivedmanysuggestionsforbroadtaxreform,andsomemembersofthePERABbelievethatsuchreformwillbeanessentialcomponentofastrategytoreducethelong-termdeficitofthefederalgovernment. Butconsistentwithourlimitedmandate,wedidnotevaluatecompetingproposalsforoverarchingtaxreforminthisreport.

Finally,itisimportanttoemphasizeattheoutsetthatthePERABisanoutsideadvisorypanelandisnotpartoftheObamaAdministration.Wehaveheardtheviewsofexpertsinthegovernmentinthesamewaythatwehaveheardtheviewsofoutsideexpertsandinterestgroups.Wehaveat-temptedtodistilltheseviewsinthisreporttoprovideanoverviewoftheadvantagesanddisadvan-

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tagesoftaxreformoptionsthatachievethethreegoalsofourmandate:taxsimplification,greatertaxcompliance,andcorporate taxreform.Ourreport ismeant toprovidehelpfuladvice to theAdministrationasitconsidersoptionsfortaxreforminthefuture. ThereportdoesnotrepresentAdministrationpolicy.

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TABLE OF CONTENTS

I. LIST OF FIGURES AND TABLES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

II. SIMPLIFICATION OPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

a. Option Group A: Simplification for Families . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

i. Option 1: Consolidate Family Credits and Simplify Eligibility Rules . . . . . . . . . . . 6

1. Consolidate Family Benefits into a Work Credit and a Family Credit . . . 8

2. Combine the EITC, Child Tax Credit, and the Child Dependent Exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

3. Consolidate the Child Tax Credit and Dependent Exemption, and Repeal (or Reduce) Some Education Credits . . . . . . . . . . . . . . . . . . . 10

ii. Option 2: Simplify and Consolidate Tax Incentives for Education . . . . . . . . . . . . 10

iii. Option 3: Simplify the “Kiddie Tax” (Taxation of Dependents). . . . . . . . . . . . . . . . 15

iv. Option 4: Simplify Rules for Low-Income Credits, Filing Status, and Divorced Parents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

1. Harmonize the EITC and Additional Child Tax Credit. . . . . . . . . . . . . . . . . 17

2. Simplify Filing Status Determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

3. Eliminate the “Household Maintenance Test” for “Estranged” Spouses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

4. Simplify the EITC for Childless Workers . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

5. Clarify Child Waivers in the Event of Divorce or Separation . . . . . . . . . . 22

b. Option Group B: Simplifying Savings and Retirement Incentives. . . . . . . . . . . . . . . . . . . . 23

i. Option 1: Consolidate Retirement Accounts and Harmonize Statutory Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

ii. Option 2: Integrate IRA and 401(k)-type Contribution Limits and Disallow Nondeductible Contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

iii. Option 3: Consolidate and Segregate Non-Retirement Savings . . . . . . . . . . . . . 29

iv. Option 4: Clarify and Improve Saving Incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

1. Make the Saver’s Credit a Match . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

2. Expand Automatic Enrollment in Retirement Savings Plans . . . . . . . . . 31

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v. Option 5: Reduce Retirement Account Leakage . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

vi. Option 6: Simplify Rules for Employers Sponsoring Plans . . . . . . . . . . . . . . . . . . 32

vii. Option 7: Simplify Disbursements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

viii. Option 8: Simplify Taxation of Social Security Benefits . . . . . . . . . . . . . . . . . . . . . 34

c. Option Group C: Simplify Taxation of Capital Gains. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

i. Option 1: Harmonize Rules and Tax Rates for Long-Term Capital Gains . . . . . 37

1. Harmonize 25 and 28 Percent Rates on Capital Gains . . . . . . . . . . . . . . 37

2. Simplify Capital Gains Taxes on Mutual Funds . . . . . . . . . . . . . . . . . . . . . . 38

3. Small Business Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

ii. Option 2: Simplify Capital Gains Tax Rate Structure . . . . . . . . . . . . . . . . . . . . . . . . 39

iii. Option 3: Limit or Repeal Section 1031 Like-Kind Exchanges . . . . . . . . . . . . . . 40

iv. Option 4: Capital Gains on Principal Residences . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

d. Option Group D: Simplifying Tax Filing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

i. Option 1: The Simple Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

ii. Option 2: Data Retrieval. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

iii. Option 3: Raise the Standard Deduction and Reduce the Benefit of Itemized Deductions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

e. Option Group E: Simplification for Small Businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

i. Option 1: Expand Simplified Cash Accounting to More Businesses. . . . . . . . . . 48

ii. Option 2: Simplified Home Office Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

iii. Option 3: Simplify Recordkeeping for Cell Phones, PDAs, and Other Devices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

f. Option Group F: The AMT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

i. Option 1: Eliminate the AMT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

ii. Option 2: Modify and Simplify the AMT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

III. COMPLIANCE OPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

a. Background on Compliance and the Tax Gap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

b. General Approaches to Improve Voluntary Compliance and Reduce the Tax Gap . . . . 56

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c. Option 1: Dedicate More Resources to Enforcement and Enhance Enforcement Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

d. Option 2: Increase Information Reporting and Source Withholding . . . . . . . . . . . . . . . . . 59

e. Option 3: Small Business Bank Account Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

f. Option 4: Clarifying the Definition of a Contractor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

g. Option 5: Clarify and Harmonize Employment Tax Rules for Businesses and the Self-Employed (SECA Conformity) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

h. Option 6: Voluntary Disclosure Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

i. Option 7: Examine Multiple Tax Years During Certain Audits . . . . . . . . . . . . . . . . . . . . . . . 63

j. Option 8: Extend Holding Period for Capital Gains Exclusion on Primary Residences. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

IV. CORPORATE TAX REFORM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

a. Overview of the Corporate System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

b. Option Group A: Reducing Marginal Corporate Tax Rates. . . . . . . . . . . . . . . . . . . . . . . . . . 69

i. Option 1: Reduce the Statutory Corporate Rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

ii. Option 2: Increase Incentives for New Investment/Direct Expensing . . . . . . . . 71

c. Option Group B: Broadening the Corporate Tax Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72

i. Option 1: Provide More Level Treatment of Debt and Equity Financing . . . . . . 72

ii. Option 2: Review the Boundary Between Corporate and Non-Corporate Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

iii. Option 3: Eliminate or Reduce Tax Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

1. Eliminating the Domestic Production Deduction. . . . . . . . . . . . . . . . . . . . . 78

2. Eliminate or Reduce Accelerated Depreciation . . . . . . . . . . . . . . . . . . . . . 78

3. Eliminate Other Tax Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

A. Special Employee Stock Ownership Plan (ESOP) Rules . . . . . . . . . 79

B. Exemption of Credit Union Income from Tax . . . . . . . . . . . . . . . . . . . . 79

C. Low-Income Housing Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

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V. ADDRESSING INTERNATIONAL CORPORATE TAX ISSUES . . . . . . . . . . . . . . . . . . . . . . . . 81

a. The Current U.S. Approach to International Corporate Taxation. . . . . . . . . . . . . . . . . . . . . 82

b. Box 1: The Foreign Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

c. Economic Effects of the Current U.S. Approach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

i. Effects on the Location of the Economic Activities of U.S. Multinationals . . . . 85

ii. Effects on the Costs of U.S. Companies and their Foreign and Domestic Competitors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

iii. Erosion of the Business Tax Base through Transfer Pricing and Expense Location . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87

iv. The Costs of Administering and Complying with the Current U.S. System . . . 88

v. Option 1: Move to a Territorial System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

vi. Option 2: Move to a Worldwide System with a Lower Corporate Tax Rate. . . . 91

vii. Option 3: Limit or End Deferral with the Current Corporate Tax Rate . . . . . . . . 93

viii. Option 4: Retain the Current System but Lower the Corporate Tax Rate . . . . 94

VI. ACKNOWLEDGMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

VII. APPENDIX. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

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I. LIST OF FIGURES AND TABLES

Figure 1: Family–Related Tax Credits per Family Taxpayer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Table 1: Comparison of Provisions Relating to Families with Children . . . . . . . . . . . . . . . . . . . . . . 7

Table 2: Summary of Education Provisions, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Figure 2: The Process for Claiming the EITC and Additional Child Credit . . . . . . . . . . . . . . . . . 18

Table 3: Employer-Sponsored Retirement Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Figure 3: Retirement Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Table 4: Taxation of Social Security Benefits (Single Taxpayer) . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

Table 5: The Gross Tax Gap, by Type of Tax, Tax Year 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

Table 6: Individual Income Tax Underreporting Gap and Net Misreporting Percentage, by Visibility Groups, Tax Year 2001. . . . . . . . . . . . . . . . . 54

Table 7: Marginal Effective Tax Rates on New Investment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

Figure 4: Top Statutory Corporate Tax Rates U.S. and OECD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

Table 8: Shares of Total Business Returns, Receipts and Net Income, 1980-2007 . . . . . . . . . 74

Table 9: Special Tax Provisions Substantially Narrow the Business Tax Base . . . . . . . . . . . . . . 76


II. SIMPLIFICATION OPTIONSThetaxcodeiscomplex.Thiscomplexityimposessignificantcostsonaffectedtaxpayersandisre-flectedintheamountoftimeandmoneythatpeoplespendeachyeartoprepareandfiletheirtaxes.Taxpayersandbusinessesspend7.6billionhoursandincursignificantout-of-pocketexpenseseachyearcomplyingwithfederalincometaxfilingrequirements. Inmonetaryterms,thesecostsareroughlyequivalenttoatleastonepercentofGDPannually(orabout$140billionin2008).Thesecostsaremorethan12timestheIRSbudgetandamounttoabout10centsperdollarofincometaxreceipts.TheIRSestimatedthatfor2008,taxpayersfilingForm1040spentanaverageof21.4hoursonfederaltax-relatedmatters.Mosttaxpayers—about60percent—nowpaytaxpreparerstofillouttheirreturns,andatleast26percentusetaxsoftware.Speciallytargetedprovisionsnowrequirelow-incometaxpayers,SocialSecurityrecipients,individualssubjecttotheAlternativeMinimumTax(AMT),andmanyothergroupstocalculatetheirincomesmultiplewaysandmultipletimes.Theburdenofthiscomplexityfallsespeciallyheavilyonlower-incomefamiliesandonhouseholdswithcomplicatedlivingarrangements.Familiesclaimingachild-relatedcreditareabout40per-centmorelikelytouseapaidpreparer,andmorethan70percentoflow-incomerecipientsoftheEarnedIncomeTaxCredit(EITC)usedapaidpreparertodotheirtaxes.Forbusinessesandtheselfemployed,thecomplianceburdenisparticularlyhigh,andbecausethisburdenhasalargefixedcomponent,thesecostsareregressive.Thecomplexityofthetaxcodeispartlytheresultofthefactthatnewprovisionshavebeenaddedoneatatimetoachieveaparticularpolicygoal,butwithinadequateattentiontohowtheyinteractwithexistingprovisions. Thisresultsinduplicativeandoverlappingprovisions,multipledefini-tionsofconceptslikeincomeanddependentchildren,differencesinphaseouts,anddifferencesinthetimingofexpiringprovisions.Between1987and2009,theinstructionbookletssenttotax-payersfortheForm1040increasedinlengthfrom14pagesto44pagesoftext.Thetaxcodehasbecomemorecomplexandmoreunstableoverthelasttwodecades,inpartbecauselegislatorshaveincreasinglyusedtargetedtaxprovisionstoachievesocialpolicyobjectivesnormallyachievedbyspendingprograms.Therehavebeenmorethan15,000changestothetaxcodesince1986,andacurrentJCTpamphletlists42pagesofexpiringprovisions.Thecomplexityresultsinerrorsandmistakesthatadverselyaffecttaxcomplianceandaddtoad-ministrativeandenforcementcosts.InternalRevenueService(IRS)studiessuggestthatnon-com-plianceishigheramongfilersfacedwithcomplexeligibilityrulesandrecordkeepingrequirements.Forexample,anIRSstudysuggestedthatbetween23and28percentofEITCpaymentsinfiscalyear2006wereincorrect.Similarly,theGovernmentAccountabilityOffice(GAO)estimatedthatfortaxyear2005,19 percentofeligibletaxfilersfailedtoclaimeitheratuitiondeductionorataxcreditforwhichtheywereeligible.ThecomplexityofthesystemalsomakesitharderfortheIRStodoitsjobbyincreasingthedifficultyofidentifyingnon-compliantandimproperbehavior.

Beyondthesedirectcoststhatcanbemeasuredintime,money,andrevenuelosttononcompli-ance,thecomplexityofthetaxsystemisatremendoussourceoffrustrationtoAmericantaxpayers,reducesthesystem’stransparency,andunderminestrustinitsfairness.

Thetaskforcereceivedmanydifferentideasfortaxsimplification.Inthisreport,wegrouptheseideasintoafewbroadcategories:SimplificationforFamilies;SimplifyingSavingsandRetirement


Incentives;SimplifyTaxationofCapitalGains;SimplifyTaxFiling;SimplificationforSmallBusi-nesses;andtheAMT.

a. Option Group A: Simplification for FamiliesInourpublicmeetings, in conversationswith taxexperts, and through submissions from indi-vidualtaxpayers,taxprovisionsrelatedtofamiliesandchildrenwereamongthemostcitedsourcesofcomplexityinthetaxcode.Thetaxcodeprovidesnumerouscreditsanddeductionsthatreducetaxesforfamilieswithchildrenandforchild-relatedexpenseslikedaycareandeducationcosts.Thereisalsoaspecialratestructureforunmarriedindividualswithfamilyresponsibilities.Cur-rently,morethan50milliontaxpayerswithchildrenclaimatleastoneofthesechild-relatedtaxbenefits;mostfamilieswithchildrenreceiveatleasttwoandfrequentlythreeormore.

Each of these child-related provisions has different eligibility rules, many of which are difficulttointerpretorenforceandsomeofwhichweheardcriticizedasunfairandarbitrary.Confusionabouttherulesforthesebenefitscontributestomistakesandnoncompliance.Inaddition,havingmanydifferentbenefitsoftenrequiresparentstomakemultiplecalculationstocomputeeachcreditamount,eitherbecausethecreditsaredeterminedonaspecificdefinitionofearningsoranalterna-tivemeasureofincome,orbecauseabenefitphasesoutincertainincomeranges.Someprovisionscanbecalculatedinalternativeways,requiringparentstotrydifferentcalculationstopickthemostadvantageousone.Thesystemalsorequireschildren(ortheirparents)tofilemillionsofreturnsthatraiselittlerevenue.

Togetanideaofwhythisisaproblem,taketheexampleofamiddle-classfamilywithteenagechil-drenaged16and19,theeldestastudentwholivesawayatcollegeandissupportedbytheparents.Thefamilyhastypicalmiddle-classincome,averybasicfamilystructure,andonlywageincome.Undercurrentlaw,thefamilyiseligibletoclaimdependentexemptionsforbothchildren,allowingtheparentsadeductionagainsttheirtaxableincome.Becausetheyhaveonechildunder17theyarealsoeligibleforthe$1,000childtaxcredit.Thecollegestudentistoooldforthechildcredit,buttheparentsmaybeabletoclaimoneofanumberofeducationcreditsforthestudentdependingontheamountoftheireducationalexpenditures.

Despitethesimplicityofthissituation,theprocessforclaimingthebenefitsforwhichthisfamilymaybeeligibleisnon-trivial. Theinstructionsforclaimingthedependentexemptionincludeamulti-partchecklistandmorethantwopagesofinstructions.Adependentchildmustnormallybe18oryoungerandresidewiththeparents,butanexceptionappliesforastudentlivingawayatschool.(However,justbecausetheolderchildisacollegestudentforthepurposesofthedepen-dentexemptiondoesnotnecessarilymakehimeligibleforeducationcredits,whicharegovernedbyothereligibilityandrecordkeepingrequirements.)Beforecalculatingthechildtaxcreditfortheyoungerchild,theparentsmustreadthroughaneligibilitytestintendedtoscreenouttaxpayersincertainraresituations.Likethevastmajorityoffamilies,thesesituationsdonotapplytothefamilyinthissimpleexample,sotheycanskiptothenext(andforthemfinal)step:a10-line,two-pageworksheetneededtocalculatethesizeofthechildtaxcredit.Inthistheyarefortunate—afamilywithlessincomeormorechildrenmayneedtocalculateanalternativedefinitionofincomeandfile


anadditionaltwo-page,13-lineformfortheadditionalchildtaxcredit,andafamilywithhigherincomemayhavetocalculateareducedbenefit.

Because theparents in this examplepay tuition for thecollege student, the familywould likelyqualifyforatleastthreedifferenteducationbenefitsbutmustchooseonlyone.Makingthischoicewillrequiretheparentstoconsultanadditionalpublication,makethreeseparatecalculationstofindthemostadvantageousbenefit,andthenfileadditionalformstoclaimthecredit.

Becausebothchildrenareclaimedasdependentsbytheirparents,theymaybesubjecttothe“kid-dietax,”requiringthecollegestudenttofileaseparatedependentreturnevenifthestudentearnsaslittleas$950.Ifthechildrenhavehighenoughincomes,theymaybetaxedattheparents’taxrate,requiringparentsandchildrentocoordinatetheirfilings.

Ascomplicatedasthesestepsare,thisfamilyhasitrelativelyeasy. Athigherincomelevels,thechild taxcredit,dependentexemption,andeducationcreditsallphaseout (indifferent incomeranges), requiring additional calculations for each credit or deduction, and raising effective taxratesonfamilyincome.Atlowerincomelevels,thesituationisarguablymorecomplex.ParentsmustmakecalculationsbasedondifferentdefinitionsofincometoclaimbenefitsliketheEITC(arefundableworkcreditwhosevalueistiedtothenumberofchildren)ortheadditionalchildtaxcredit—calculationsthatcanrequiremorethan100linesonworksheetsinsomecases.Itislittlewonderthatthevastmajorityofthepoorestfamiliesmustpayataxpreparertoclaimtheseben-efits.Ontopofthis,manyfamily-relatedtaxprovisionsarepredicatedonfamilyrelationships,theresidenceofthechild,andexpendituresmadebytaxpayerstosupportthechildandmaintainthechild’shousehold. Theserulesaredifficulttounderstandandfollow,particularlyforfamiliesincomplicatedlivingsituations—householdsthatincludeextendedfamilyandmultiplegenerations,orthatareheadedbyanunmarried,separated,ordivorcedparent.

Whileexplainingthecomplexitiesofthecurrentfamilyandchildtaxprovisionstous,expertsem-phasizedthattheyexistforgoodreasons:topromoteequityandtoembodytheprinciplethattaxburdensshouldreflectdifferencesamongfamiliesintheirabilitytopay;todefrayemployment-re-latedchild-careexpenses;toencouragehighereducation;andtoprovideincentivestowork.Somelevelofcomplexityisrequiredtotargetthesegoalsappropriately.Moreover,thephase-outsofeligibilityforcreditsandthelimitationsofeligibilityoftenreflectfiscalrestraintortheprincipleof“verticaleq-uity”—theideathatfamilieswithgreaterabilitytopayshouldshoulderalargershareofthetaxburden.

Thus,therearetradeoffsbetweensimplifyingexistingfamilyandchildtaxprovisionsandachievingtheseothergoalsoftaxpolicy.Thedistributionalandincentiveeffectsofproposedsimplificationmeasuresmustbeconsidered.Butthecaseforsimplificationhasbecomestrongerovertheyearsasaresultofthegrowingnumberoffamily-relatedprovisionsandtheirapplicabilitytoagrowingnumberofmiddle-classtaxpayers.

Expertsalsotoldusthatanotherdifficultyisthatmeaningfulsimplificationoffamilyanddepen-dentprovisionswouldeitherbecostly in termsof foregone taxrevenuesorwouldcreate losersamongcertainlowerandmiddle-incomehouseholds.Thisdifficultyreflectsthegenerosityofcur-rentprovisionsforlower-andmiddle-incomehouseholdsandtheoverlappingofprovisionsthatbenefitslightlydifferentgroupsofhouseholds.Thescheduledexpirationofportionsoftheseprovi-


sionsin2011mayprovideanopportunitytoreviewandconsolidatetheremainingfamilyandde-pendentprovisionswhileensuringthatthevastmajorityoflower-andmiddle-incomehouseholdsremainatleastaswelloffastheywouldbeaftertheprovisionsexpired.

Belowweoutlinefouroptionsforsimplifyingthetaxtreatmentoffamilies.Some(butnotall)oftheoptionscompriseseveralproposals.

i. Option 1: Consolidate Family Credits and Simplify Eligibility Rules

Recurrentcriticismsofthepresentfamily-relatedcreditsanddeductionsarethattherearetoomanydifferentcreditsandthatfiguringouthowtoclaimeachbenefitisdifficultandtimeconsuming.

Familiesoftenreceivemultiplebenefitsinasingleyear.In2005,morethan80percentoffamiliesclaimingoneoftheEITC,ChildTaxCredit,ordependentexemptionclaimedmorethanoneandalmost30 percentclaimedallthree.Figure1illustratestheaveragenumberofchild-relatedcred-itsandexemptionsclaimedpertaxpayerwithchildrenatdifferentlevelsofincome.Asthefigureshows,taxpayersearningcloseto$25,000receive,onaverage,aboutthreedifferentcredits.Asin-comerisesthesecreditsphaseoutandtaxpayersbecomeineligibleforcertainbenefits.BecauseoftheexpansionoftheEITCandthechildtaxcreditundertheAmericanRecoveryandReinvestmentAct(ARRA),thenumberoftaxpayersreceivingmultiplecreditshasincreased.

Figure 1: Family–Related Tax Credits per Family Taxpayer

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

0 20 40 60 100 140 180

Dependent Exemption Education Credits Child Tax Credit EITC

Cre

dit

s cl

aim

ed p

er t

axp

ayer

wit

h c

hild

ren

Source: Statistics of Income Public Use File (2005).

Adjusted Gross Income ($ thousands)

Source:StatisticsofIncomePublicUseFile(2005).

This isburdensomebecauseeachcreditordeduction isgovernedbyslightlydifferenteligibilityrulesandbenefitcalculations.Table1providesadescriptionofthelargestchild-relatedbenefitsandacomparisonofrulesthatgoverneachone.Asthetableshows,eachbenefitisreduced(phasedout)inadifferentrangeandatadifferentrate.Manyofthecreditsrequiremultiple,sometimesdozensoflinesofcalculations,andeachdefinesaneligiblechildusingadifferentcombinationofage,residency,andrelationshiprequirements.


Tabl

e 1

: Com

paris

on o

f P

rovi

sion

s R

elat

ing

to F

amili

es w

ith C

hild

ren

D

epen

den

t E

xem

pti

on

Ch

ild T

ax C

red

itE

arn

ed In

com

e Ta

x C

red

itC

hild

an

d D

epen

den

t C

are

Tax

Cre

dit

Hea

d o

f H

ou

seh

old

F

ilin

g S

tatu

sE

du

cati

on

Cre

dit

s

Tax

ben

efit

(200

9)D

educ

tion

of $

3,6

50

fo

r ea

ch d

epen

dent

.

Cre

dit o

f $

1,0

00

pe

r ch

ild. P

artia

lly

refu

ndab

le.

Cre

dit u

p to

$3

,04

3

for

one

child

, $5

,02

8

for

two

child

ren,

and

$

5,6

57 f

or m

ore

than

two

child

ren.

R

efun

dabl

e.

Cre

dit o

f up

to 3

5%

of

up

to $

3,0

00

of

wor

k-re

late

d ex

pens

es

for

one

child

, $6

,00

0 if

m

ore

than

one

.

Mor

e fa

vora

ble

rate

sc

hedu

le a

nd h

ighe

r st

anda

rd d

educ

tion

than

for

oth

er

unm

arrie

d ta

xpay

ers.

$2

,50

0 f

or A

mer

ican

O

ppor

tuni

ty T

ax C

redi

t (A

OTC

); $

2,0

00

for

Li

fetim

e Le

arni

ng

Cre

dit (

LLC

); an

d ot

hers

. AO

TC p

artia

lly

refu

ndab

le.

Ph

ase-

Ou

t Th

resh

old

(Jo

int

File

rs)

Ove

r $

25

0,0

00

Ove

r $

11

0,0

00

Ove

r $

21

,42

0P

hase

s-do

wn

in 1

6

step

s fr

om $

15

,00

0 to

$

43

,00

0.

NA

Ove

r $

16

0,0

00

for

the

AO

TC. O

ver

$1

00

,00

0

for

LLC

.

Ph

ase-

Ou

t R

ate

(Jo

int

File

rs)

2.9

7 p

erce

nt p

er

exem

ptio

n5

per

cent

21

.06

per

cent

Cre

dit f

alls

fro

m 3

5

perc

ent o

f ex

pens

es

to 2

0 p

erce

nt o

f ex

pens

es in

pha

se-o

ut

rang

e.

NA

12

.5 p

erce

nt p

er

stud

ent f

or th

e m

axim

um A

OTC

cre

dit.

1

0 p

erce

nt f

or L

LC.

Max

imu

m L

ines

to

C

alcu

late

Cre

dit

10

64

40

34

NA

42

Ag

e R

equ

irem

ent

Und

er 1

9 o

r un

der

24

an

d a

stud

ent;

any

age

if pe

rman

ently

and

to

tally

dis

able

d.

Und

er 1

7.

Und

er 1

9 o

r un

der

24

an

d a

stud

ent;

any

age

if pe

rman

ently

and

to

tally

dis

able

d.

Und

er 1

3; a

ny a

ge

if un

able

to c

are

for

him

self

or h

erse

lf.

Und

er 1

9 o

r un

der

24

an

d a

stud

ent;

any

age

if pe

rman

ently

and

to

tally

dis

able

d.

Und

er 1

9 o

r un

der

24

and

a s

tude

nt; a

ny

age

if pe

rman

ently

an

d to

tally

dis

able

d;

your

self

or y

our

spou

se a

t any

age

.

Res

iden

cy

req

uir

emen

t

Qua

lifyi

ng c

hild

mus

t liv

e w

ith ta

xpay

er

for

over

one

hal

f of

the

year

. Oth

er

non-

qual

ifyin

g ch

ild

rela

tives

mus

t liv

e w

ith

the

taxp

ayer

for

the

entir

e ye

ar. E

xcep

tion

for

stud

ents

at s

choo

l.

Exc

eptio

n fo

r di

vorc

ed

pare

nts.

Sam

e as

dep

ende

nt

exem

ptio

n.

Chi

ld m

ust l

ive

with

ta

xpay

er f

or o

ver

one

half

of th

e ye

ar.

Mus

t liv

e w

ith th

e ta

xpay

er f

or th

e pe

riod

durin

g w

hich

th

e ex

pens

es w

ere

incu

rred

. E

xcep

tion

for

divo

rced

par

ents

.

Qua

lifyi

ng c

hild

mus

t liv

e w

ith th

e ta

xpay

er

for

over

one

hal

f of

th

e ye

ar.

Sam

e as

dep

ende

nt

exem

ptio

n.


Allof thesedifferencesrequireparentstoconsultpagesof instructions,multiplechecklists,andoccasionally to turn to alternative publications to determine whether their child or dependentqualifiesforacreditordeduction. Moreover,becauseeligibilityrulesforcreditsaresimilarbutnotidentical,manyofthesetaxformsandchecklistsaskforsimilaror,insomecases,exactlythesameinformation.Forexample,aparentclaimingthedependentexemption,thechildtaxcredit,EITC,anddependentcarecreditmustreportthesamechild’snameandSocialSecuritynumberfourtimes,andmayhavetocalculateandreporttheirearningsonfourdifferentforms.Becausethephase-outsofthesecreditsarealldifferent,eachcreditmayneedtobecalculatedseparately.Incertaincases,thebenefitamountmustbecalculatedusingalternativemeasuresofincome.Forexample,thedependentexemptionanddependentcarecreditphaseoutasadjustedgrossincome(AGI)increases,butthechildtaxcreditphasesoutwithamodifiedversionofAGI;theEITC,addi-tionalchildtaxcredit,anddependentandchildcarecreditsuseearningsintheircalculations—andthedefinitionof“earnings”isnoteventhesamefortheEITCandadditionalchildtaxcredit.

Manyfamilieswillnotreceivethesamesetofbenefitsfromyeartoyear.Manyfamilieswithtran-sitorily lowincomebecauseofunemployment,maternity leave,or illnesswillbeeligiblefortheEITCforonlyoneyear.Childrenwillageoutofthedependentandchildcarecreditat13andthechildtaxcreditat17.Theywillbecomenewlyeligibleforeducationbenefitsat18or19butmaynotreceivethesameeducationcreditforeachyearofschool.Thislackofconsistencyrequiresparentstolearnnewruleseachyearandreducesthefamiliarityoftaxpayerswiththebenefitsforwhichtheyareeligible.

Consolidating taxbenefits for familieswouldreduce thenumberofcreditsanddeductionsandstandardizeeligibilityrules,eliminatingmuchofthecomplexity,computationalburden,taxpayerconfusion,anddifficultieswithenforcementinthecurrentsystem.Aconsolidationthatreducedthenumberofcreditsneednotreducetaxbenefits;benefitamountscouldbeadjustedtomaintainthecurrentlevelanddistributionofsuchbenefits.Asnotedabove,mostparentsreceivemultiplecredits.Moreover,mostofthedifferencesineligibilityforfamilyandchildcreditsdependonfam-ilyincomeandtheagesofchildren,suggestingthatsomecreditscouldbecombinedbyadjustingageorincomeeligibilityrules.Consolidatingcreditsmaytakeanynumberofpermutations,butsomegeneralprinciplesapply.Thissectionprovidesthreeexamplesofconsolidationstoillustratepotentialoptionswiththeprosandconsofeach.

1. Consolidate Family Benefits into a Work Credit and a Family Credit

The proposal and its advantages: Theexpertsweheardfromrepeatedlyreferencedanoptionadvocatedbythe2005TaxReformPan-elandmodifiedinapolicypaperfromtheCenteronBudgetandPolicyPrioritiesbyJasonFurman.In the 2005 Panel’s option, the dependent exemption, standard deduction, and child tax creditwereconsolidatedintoa“FamilyCredit”availabletoalltaxpayers,andtheEITCwasreplacedbya“WorkCredit.”Thedependentcarecreditwaseliminated,andspecifictaxbenefitsforhigheredu-cationwerereplacedwithasimilarlygenerousextendedfamilycreditforfulltimestudentsunderage22.Thevalueofthesenewcreditswascalibratedtomirrorthelevelanddistributionofbenefitsavailabletofamiliesundercurrentlaw.


Advocatesofthissystempointtonumeroussimplifications.Thisoptionreplacesanarrayoftaxbenefitswithtworelativelysimplecredits,eliminatinganumberofoverlappingprovisions.TheFamilyCreditwouldprovideauniformtaxbenefitthatdoesnotphaseoutwithincome,eliminat-ingthephase-outcalculationsofthepersonalanddependentexemptions,thechildtaxcredit,andthedependentandchildcarecredit.TheWorkCreditwouldreplacetheEITCandtherefundableportionofthechildtaxcredit,andwouldmaintainworkincentives.Calculatingbenefitswouldbesimplifiedbecauseduplicativecomputationsofincomeandearningswouldbeeliminated.Replac-ingmultipleeducationbenefitswithafixedbenefitforfamilieswithfulltimestudentswouldmain-tainthesubsidytopursuehighereducation,butwithoutthecomplexitiesassociatedwithclaimingeducationbenefitsandrequirementstomaintainrecordsforqualifyingexpenses.Withonlytwocredits,anumberofstepsinthetaxfilingprocesswouldbeeliminated.Additionally,withfewercredits,theabilityoftaxpayerstogamethesystembyshiftingdependentsbetweenunmarriedpar-entsortootherrelativestoachievelargertaxbenefitswouldbereduced,improvingcompliance.

Disadvantages:Inordertosimplifythecalculationofbenefits,theFamilyCreditproposedbythe2005TaxReformPanelwouldnotphaseoutwithincome,asdoesthechildtaxcreditandotherbenefitsundercur-rentlaw. Intheabsenceofphase-outs,theproposalwouldsignificantlyincreasethecostofthecreditandloserevenuerelativetocurrent law. Somenon-standardstudents—olderstudentsorpart-timestudents—couldloseeducationcredits.Inaddition,thevalueoffamily-relatedbenefits,particularly refundablecredits like theadditionalchild taxcreditand theEITC,have increasedsince2005,makingthedistributionoffamily-relatedbenefitsmorevariableacrossincomegroups.Withonlyonephase-outofbenefitsintheWorkCredit,the2005Panel’srecommendationwouldnotreplicatethecurrentprogressivityoffamilybenefits.Intheabsenceofotherchangestothetaxsystem,twooreventhreephase-outswouldbeneededtoapproximatethephase-outsoftheEITC,thechildtaxcredit,educationbenefits,andthepersonalexemption,andachievetheprogressivityofthecurrentsystem.

Movingfromsixtypesoffamilybenefitstotwowouldalsoreducetheabilitytousethetaxcodetotargetbenefitstospecificgroups.Thecurrentsystemreflectsadesiretoprovidegreaterbenefitstoyoungerchildren,totaxpayerswithhighereducationexpensesorchild-careexpenses,tofamiliesincertainlivingarrangements,andtotaxpayersbasedontheirmaritalstatus.Consolidatingcred-itswouldresultinthesedifferentgroupsfacingmoresimilartaxburdens.

2. Combine the EITC, Child Tax Credit, and the Child Dependent Exemption

The proposal and its advantages: Thesethreeprovisionswouldbecombinedintoasinglefamilybenefitwithharmonizedeligibilityrequirements,andthecreditwouldberefundablefortaxpayerswith(uniformlydefined)earnedincome. Thisoptionwouldreducethecomplexityof family-relatedbenefitsbyeliminatingtwoprovisions(andtheirassociatedinstructions,checklists,andworksheets).MultiplecomputationsfortheadditionalchildtaxcreditandEITCwouldbeeliminated,andothereligibilityruleswouldbeharmonized,streamliningthefilingprocess.


Disadvantages:Becausethephase-outsforeachofthesecreditsdiffersubstantiallyundercurrentlaw,amorecom-plicatedphase-outschedulewouldberequiredtomaintainthecurrentdistributionofbenefits.Theage-eligibilityrulesofthedependentexemptionandchildcreditdiffer.Hence,extendingtheben-efitsofthechildtaxcredittohigher-incomechildrenwouldeitherreducetaxrevenuesorrequireareductionintaxbenefitsforchildrenunderage17.Thedependentexemption(orasimilarben-efit)wouldberequiredfornon-childdependents,likeelderlyparents,limitingthesimplificationbenefits.Harmonizingrulesacrossthesecreditscouldraisetaxesforcertaingroups—forexample,applyingtheEITCeligibilityrulestothecombinedcreditwouldeliminatechild-relatedbenefitsfornon-U.S.residentsandfornon-custodialparents.

3. Consolidate the Child Tax Credit and Dependent Exemption, and Repeal (or Reduce) Some Education Credits

The proposal and its advantages: This option would apply the same age tests used for the dependent exemption to the child taxcredit,allowingfamilieswithchildrenunderage24whoarefull-timestudentstoreceivethechildtaxcredit.Theeducationcreditsavailabletothisgroupwouldthenbereducedorrepealed,buttheLifetimeLearningCredit(LLC)wouldbeofferedtotaxpayerswhocannotbeclaimedasdepen-dents.Inadditiontotheadvantagesofthepreviousoption,additionalsimplificationwouldarisebyreplacingthemultitudeofeducationbenefitswithasimpleflatcredit,eliminatingthird-partyreportingfromuniversitiesandburdensomerecordkeepingforexpenseslikebooksandsupplies.Complianceandenforcementofthesecreditswouldimproveandtaxpayerswouldnolongerneedtomakemultiplecalculationstolearnwhicheducationcredittotake.

Disadvantages:Again,dependingonthevalueoftheconsolidatedcreditandthequalifiedexpensesofstudents,somefamiliesmayreceivelargerorsmallercredits.

ii. Option 2: Simplify and Consolidate Tax Incentives for Education

Thetaxsystemincludesatleast18differentprovisionsbenefitingtaxpayerswitheducationalex-penses(seeTable2).Someprovisionsreducethecostofeducationdirectly,includingtheAmeri-canOpportunityTaxCredit(AOTC),theLLC,thetuitionandfeesdeduction,andthestudentloaninterestdeduction.Otherprovisionsencouragesavingforfutureexpenseswithsavingsbondsorthroughtax-preferredaccounts(thesearediscussedingreaterdetailinthesectionundersavingsincentives).


Tabl

e 2

: S

umm

ary

of E

duca

tion

Pro

visi

ons,

20

09

Ty

pe

of

Ben

efit

Qu

alif

yin

g E

xpen

ses

Elig

ible

Ind

ivid

ual

sM

axim

um

An

nu

al A

mo

un

t In

com

e Li

mit

s

(sin

gle

/jo

int

file

rs)

Am

eric

an O

pp

ort

un

ity

Cre

dit

(ef

fect

ive

thro

ug

h 2

010)

Per

stu

dent

cre

dit a

gain

st

tax

Tuiti

on, r

equi

red

fees

, non

-ac

adem

ic fe

es, b

ooks

, su

pplie

s, e

quip

men

t

Taxp

ayer

, spo

use

or

depe

nden

t in

first

4

year

s of

hig

her

educ

atio

n pu

rsui

ng d

egre

e en

rolle

d at

leas

t hal

f-tim

e

$2

,50

0: 1

00

% o

f th

e fir

st

$2

,00

0 a

nd 2

5%

of

the

next

$2

,00

0 (

inde

xed

for

infla

tion)

Pha

se-o

ut b

egin

s at

$

80

,00

0/$

16

0,0

00

Ho

pe

Sch

ola

rsh

ip

Cre

dit

Per

stu

dent

cre

dit a

gain

st

tax

Tuiti

on a

nd r

equi

red

fees

Taxp

ayer

, spo

use

or

depe

nden

t in

first

2

year

s of

hig

her

educ

atio

n pu

rsui

ng d

egre

e en

rolle

d at

leas

t hal

f-tim

e

$1

,80

0: 1

00

% o

f th

e fir

st

$1

,20

0 a

nd 5

0%

of

the

next

$1

,20

0 (

inde

xed

for

infla

tion)

Pha

se-o

ut b

egin

s at

$

50

,00

0/$

10

0,0

00

Life

tim

e Le

arn

ing

C

red

it

Per

taxp

ayer

cre

dit

agai

nst t

ax

Tuiti

on a

nd r

equi

red

fees

Taxp

ayer

, spo

use

or

depe

nden

t in

post

-se

cond

ary

or p

rofe

ssio

nal

educ

atio

n

$2

,00

0: 2

0%

of

the

1st

$

10

,00

0 to

tal a

cros

s al

l elig

ible

stu

dent

s in

ho

useh

old

(not

inde

xed

for

infla

tion)

Pha

se-o

ut b

egin

s at

$

50

,00

0/$

10

0,0

00

Stu

den

t lo

an in

tere

st

ded

uct

ion

A

bove

-the

-line

ded

uctio

n

Tuiti

on, r

equi

red

fees

, no

n-ac

adem

ic fe

es,

book

s, s

uppl

ies

and

equi

pmen

t, ro

om a

nd

boar

d

Taxp

ayer

, spo

use,

or

depe

nden

t$

2,5

00

Pha

se-o

ut o

ver

$5

5,0

00

-$

70,0

00

($

11

0,0

00

-$

14

0,0

00

join

t file

rs)

mod

ified

AG

I.

Ed

uca

tio

n

exp

ense

s d

edu

ctio

n

(e

ffec

tive

th

rou

gh

20

09)

Abo

ve-t

he-li

ne d

educ

tion

Tuiti

on a

nd r

equi

red

fees

Taxp

ayer

, spo

use

or

depe

nden

t rec

eivi

ng

high

er e

duca

tion

$4

,00

0 o

r $

2,0

00

sub

ject

to

inco

me

limits

Ded

uctio

n lim

ited

to

$4

,00

0 if

mod

ified

AG

I is

less

than

$6

5,0

00

($

13

0,0

00

join

t); a

nd to

$

2,0

00

if m

odifi

ed A

GI

is le

ss th

an $

80

,00

0

($1

60

,00

0 jo

int)

,

Dep

end

ent

exem

pti

on

fo

r ch

ildre

n a

ged

19 t

hro

ug

h 2

3

Per

sona

l exe

mpt

ion

dedu

ctio

n fo

r de

pend

ent

stud

ents

age

d 1

9 th

roug

h 2

3

NA

Stu

dent

enr

olle

d fu

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ly c

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divi

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inco

me

limits


Tabl

e 2

: S

umm

ary

of E

duca

tion

Pro

visi

ons,

20

09

(con

tinue

d)

Ty

pe

of

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efit

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alif

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xpen

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axim

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nu

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mo

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mit

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gle

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lusi

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gro

ss

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me

for

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n of

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st

uden

t loa

ns

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row

er w

ho w

orks

for

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cert

ain

perio

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e in

ce

rtai

n pr

ofes

sion

sN

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Bu

sin

ess

exp

ense

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edu

ctio

n

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miz

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educ

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t bus

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k re

late

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expe

nses

incl

udin

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ansp

orta

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child

care

Taxp

ayer

or

spou

seN

one

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rall

limita

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on

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ized

ded

uctio

ns

may

app

ly to

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lusi

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inco

me

for

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d fe

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, non

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ic fe

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quip

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e ca

ndid

ate

Non

eN

one

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ion

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lusi

on f

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ss

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for

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on

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nTu

ition

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ee o

f co

llege

, sp

ouse

or

depe

nden

t; gr

adua

te s

tude

ntN

one

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e

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itio

nal

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d R

oth

IR

As

Exc

eptio

n fr

om 1

0%

ad

ditio

nal t

ax o

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rly

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ribut

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on, r

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, non

-ac

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ic fe

es, b

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, su

pplie

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quip

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t, ro

om

and

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d, s

peci

al n

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Taxp

ayer

, spo

use,

chi

ld

or g

rand

child

(en

rolle

d at

le

ast h

alf-

time

for

room

an

d bo

ard)

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eN

one

Qu

alifi

ed T

uit

ion

P

lan

(Q

TP)

or

529

Pla

n

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gro

ss

inco

me

for

dist

ribut

ions

fr

om Q

TP a

ccou

nts

Tuiti

on, r

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ic fe

es, b

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pplie

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quip

men

t, ro

om

and

boar

d, s

peci

al n

eeds

, an

d co

mpu

ter

tech

nolo

gy*

(*AR

RA

add

ition

)

Any

pos

t-se

cond

ary

stud

ent (

enro

lled

at le

ast

half-

time

for

room

and

bo

ard

)

Non

eN

one

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verd

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du

cati

on

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avin

gs

Acc

ou

nt

E

xclu

sion

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m g

ross

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t, ro

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and

boar

d, a

nd s

peci

al

need

s

Any

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ludi

ng

prim

ary

and

seco

ndar

y (e

nrol

led

at le

ast h

alf-

time

for

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boa

rd)

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trib

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ns li

mite

d to

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0 p

er y

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pien

t

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se-o

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f el

igib

ility

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ntrib

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st

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and

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Taxp

ayer

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t N

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m $

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t ta

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clu

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xclu

sion

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on p

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duca

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Non

e


ThepurposesofthedifferentcreditsandprovisionsdescribedinTable2aretoencourageeduca-tionalinvestmentandtohelpreducethecostofhighereducation.However,theexpertsweheardfromarguedthatthecurrentmultiplicityofcreditsis,atbest,aninefficientwaytoachievethosegoals.First,thecurrentsystemobscuresthetaxbenefitofeducationalinvestmentsuntilaftertheyaremade.Thisreducesthevisibilityoftheincentivesandmakestheseprovisionslesseffectiveatpromotingeducationalinvestment.Moreover,taxcreditshaveuptoa10-monthlagbetweenwhentuitionorothercostsareincurredandwhenthecreditisawarded,somethingthatposesintolerablefinancinghardshipsonthosewithoutsubstantialincomeorotherresources.Asecondconcernisthatthetaxbenefitsforwhichastudentattendingcollegeiseligiblearedifficulttounderstand.Forexample,severaloftheeducationbenefitsaremutuallyexclusive—aparent(orstudent)mayclaimonlyoneofthedeductionfor“tuitionandfees,”theLLC,ortheAOTCforaparticularstudent.Thus taxpayersmustevaluatemultipleprovisionsandmakealternativecalculations—oftenwellaftereducationalexpendituresaremade—tofigureouttheireligibilityfordifferenttaxcreditsandtheamountsforwhichtheyareeligible.Thus,theincentivesinthesecreditsareneithertranspar-entenoughnor timelyenough toencourageeducation formany taxpayers. ExpertscontrastedthesebenefitswiththeprogramofPellGrants,whichtargetlower-incomegroupsandareawardedconcurrentlywithapplicationandadmissiontocollege.ManyarguedthatPellGrantsaremorehelpfultothepoorandtomiddle-incomehouseholdsthanrefundablecredits,andthatincreas-ingeducationalfundingforthesegroupsmaybebetterdonethroughimprovedPellGrantsthanthroughthetaxsystem.

Anotherconcernisthatthecreditsandotherprovisionsarethemselvescomplexandconfusing,makingithardfortaxpayerstoclaimthebenefitsproperly.Thepublicationthatdiscusseseduca-tionbenefitsoffers11definitionsofa“qualifyingexpense”anda“qualifyinginstitution”foratotalof12education-relatedtaxprovisions.Inmanycases,thesealternativedefinitionsimplysubstan-tivedifferencesinwhatqualifiesforataxbreak:taxpayerscannotclaimmostcreditsforcostsofroomandboard,butmayusefundsfromaneducationsavingsaccountordeductinterestfromastudentloantopayforthosecosts.Similarly,theAOTCisavailableforastudentpursuingadegreeinthefirstfouryearsofpost-secondaryeducation,whiletheLLCisavailableforanunlimitednum-berofyearsandtonon-degreestudents.TaxpayersmaytakemultipleAOTCsformultiplestudentsbutonlyoneLCCindependentlyofthenumberofstudents;theymaybeunawarethattheycantaketheAOTCforonestudentandtheLLCforanother.Thesystemissufficientlycomplicatedthatmanytaxpayersfailtoclaimeducationbenefitstowhichtheyareentitled.TheGAOreportedthat19percentofeligibletaxfilersin2005didnotclaimeitheratuitiondeductionorataxcreditthatcouldhavereducedtaxliabilitybyanaverageof$219,probablyduetothecomplexityofthetaxprovisions.Taxpayersmayalsoerroneouslyclaimtaxbenefitstowhichtheyarenotentitledormaynotclaimthecreditwhichwouldbemostadvantageoustothem.

Finally,thesystemimposessizablecomplianceandrecordkeepingburdensonstudents,parents,andeducational institutions. Collegesanduniversitiesmustdocumentenrollmentand tuition,andtaxpayersmustdocumentandmaintainrecordsofpaymentsforqualifiedtuitionandfeesand


othernon-reportedexpenses, likebooksandsupplies.1 Administeringthesebenefits isdifficultbecausetheIRScannotevaluatemanyclaimswithoutanintrusiveaudit.

Overall,thesystemofeducationtaxbenefitswouldbemoreeffectiveiftheincentivesweremoretransparentandtimely,andbenefitswereeasiertoclaimandenforce.

The proposal and its advantages: Replacing the large number of subsidies that exist to help taxpayers pay for current educationexpenseswithoneortwoalternativeswouldeliminatemultiple,redundantdefinitions,pagesofinstructionsandworksheets, andwouldreduce theneed for individuals tocompute their taxesmultiple times. Taxpayers would know in advance which credit they are eligible for and whatamounttheywouldreceive,increasingthetransparencyofthetaxcodeandthesalienceofincen-tives. Harmonizingthedefinitionofqualifiededucationalexpenseswouldhelpfamiliesunder-standwhichexpensesaredeductibleandwhicharenot.Fromanadministrativeperspective,itisimportanttorecognizethatcomplianceandadministrationareeasierforqualifiedexpensesliketuitionforwhichthereisgoodthird-partyreporting,andmoredifficultforexpensesthatarehardfortheIRStodocumentlikeexpensesforbooks,orexpensesthatmightbeconsideredabusive,likerentforaluxurycondo.

Some experts suggested modest changes like allowing the tuition and fees deduction, which isredundantformostfamilies,toexpirewhilesimplifyingandnarrowingthedefinitionofqualifiedexpensesforcertainbenefits.Amorebroad-reachingreformwouldconsolidateeducationcreditswithotherfamily-andchild-relatedcredits.Forexample,oneproposalwouldextendeligibilityforthechildtaxcredittoanytaxpayerclaimingadependentexemptionforafulltimestudentuptoage23,whileeliminatingorreducingcertaineducationcredits.Thisproposalcouldreplacehard-to-administerandunderstandeducationcreditswiththerelativelysimplechildtaxcreditrequiringlittlerecordkeepingorcomplianceeffort.

Theliteratureonbehavioraleconomicsemphasizesthatthepresentationofincentivesoftenaffectsthechoices individualsmake. Recent researchshows that simplyfillingout federal studentaidformsatthetimetaxpayersfiletheirreturnswouldinfluencethelikelihoodthattheyenrollthem-selvesortheirchildreninschool.Thisresearchsuggeststhatabetterintegrationofstudentaidpro-visionswiththetaxsystemandamorevisiblepreviewofthetaxbenefitsavailabletostudentscouldencourageenrollmentwithoutrequiringincreasesinthevalueofgovernment-providedsubsidies.

Disadvantages:Aconcernwithaconsolidationofcreditsisthatthecurrentvariationincreditsandeligibilityrulesreflectsthevariationintypesofstudentsandtypesofeducationalinvestments. TheAOTCandLLCprovideoverlappingcoveragetomostcollegestudentsandmostchoosetheAOTCbecauseofitsmoregenerousbenefits.However,aconsolidationthateliminatedtheLLCwouldeitherdepriveabout7millionpart-timestudentsfromtheseeducationbenefitsorextendmorecostlybenefitstothislargegroup.Similarly,aproposaltoreplacecertaineducationcreditswithanextendedchildtaxcreditwouldneedtoaddressbenefitsforthealmost7millionstudentsovertheageof25.Har-

1 Universitiescanreporteithertuitionbilledortuitionpaid,whichmayleadtoconfusiononthepartofthetax-payeranderrorsintheamountsofdeductionstheyclaim.


monizingrulesregardingqualifiedexpenseswouldalsorequiredifficulttradeoffs.Partofthecom-plexity,recordkeeping,andadministrativeburdenarisesfromhard-to-documentexpensesrelatedtobooks,supplies,androomandboard.Eliminatingtheseexpenseswouldsimplifythecreditandimprovecompliance,butwouldprovideequaltreatmenttotaxpayerswithunequalexpenditures.

iii. Option 3: Simplify the “Kiddie Tax” (Taxation of Dependents)

Currentlawrequiresapproximately10milliondependentstofiletaxeseachyeartoreportrelativelysmallamountsoftax.This“kiddietax,”enactedtopreventparentsfromreducingtheirfamily’staxliabilitiesbyshiftinginvestmentincometotheirchildren,includesrulesthatcanrequireadepen-denttofileareturnwithaslittleas$950ofinvestmentincome.Ifinvestmentincomeexceedsasecondthresholdof$1,900,theincomeistaxedatratesthatdependontheincomeofsiblingsandparents.Thetaxgenerallyappliestochildrenunderage18,full-timestudentsage19to24whocanbeclaimedasdependents—eveniftheyarenotclaimed—andtoelderlyordisableddependents.Abouthalfofkiddietaxfilersarecollegestudentsandabout40percentarebetweenage14and 18.In2005,5.7milliondependentfilers(outof9.9million)paidlessthan$50intaxes,andmostofthose5.7millionowednotaxesandfiledonlytogetarefund.

Inadditiontostringentfilingrequirements,thetaxcalculationitselfisparticularlycomplex.Inthemostbasiccaseofdependentsreceivingonlyinvestmentincome,thefirst$950isexemptbasedonaspecialstandarddeductionfordependentfilers,thenext$950istaxedatthedependent’staxrate,andadditionalincomeistaxedattheparents’taxrate,ifhigher.Ifthedependenthasearnedin-come,sayfromasummerjob,thestandarddeductionismorecomplexanddependsonthecombi-nationofearnedandinvestmentincome.Inmostsituations,thedependent’sstandarddeductionislessthanthestandarddeductionforothersinglefilers.Ifaparenthasmorethanonechildsubjecttothekiddietax,anevenmorecomplicatedprovisionrequiresaddinguptheinvestmentincomeofallthechildrenandtheparentsandthenallocatingtheresultingadditionaltaxamongthechil-dren’staxreturns.Navigatingtheserulesrequiresa28-pageIRSbookletthatincludesworksheetstocalculatethedependent’staxableincomeandtaxliability.

Theinterdependencebetweenadependent’staxreturnandthatofsiblingsandparentscancreatesignificant issues incertainsituations. First, thisrequirescoordinationamongfamilymemberswhenfilingtaxes,whichmaybedifficultwhenstudentsareawayatcollegeorwhenfamilydisputesmakeitdifficulttoobtaintherequiredinformationaboutparents’returns.Additionally,interde-pendencerequiresspecialrulestodealwithamendedreturnsandtheAMT.Theseprovisionsap-plytoindividualswhocouldbeclaimedasdependentsofanothertaxpayerregardlessofwhethertheyareactually claimedornot. Thus, aparentdoesnot escape thecomplexity simplybynotclaimingadependent.Collegestudentswhocouldbeclaimedasdependentsshouldbefilingtheirreturnsasdependentfilersandmayneedtocoordinatetheirreturnswiththoseoftheirparentsandsiblingsiftheyaresubjecttothekiddietax.Inmanyinstances,thekiddietaxcouldbeconsideredtobeataxonafamily’slackofsophistication.Thatistypicallythesituationwhenfamiliesdonotunderstandorusethespecialtaxprovisionsthatprovidefavorabletaxtreatmentforfundssetasideforthedependent’seducation.


The proposals and their advantages: Theburdenofthekiddietaxarisesbecauseofthelowfilingthresholdthatrequirestaxpayerstofilemillionsofreturnsthatgeneratelittlemoney,becauseofthefactthatmillionsmustfileforrefundsdespiteowingnotaxes,andbecausethecomputationoftherequiredtaxisitselfcomplicated.Thefilingburdencouldbereducedbyraisingthestandarddeductionfordependentsandbyimprov-ingrulesforwithholdingsothatfewerdependentworkershadtaxeswithheldonsmallamountsofincome.Providingasafeharborwithholdingexemptionforyoungfilers(lessthanage18,forexample)wherebyindividualsandemployerswerenotpenalizedforimposingzerowithholdingwouldreducethenumberofdependentsrequiredtofilejusttoreceivearefund. Becausethesetaxpayers owe little in taxes, the compliance issues and revenue consequences would be small.Similarly,raisingthestandarddeductionfordependentscouldreducetheburdenoffilingsignifi-cantlyatarelativelysmallrevenuecost;doublingthe$950standarddeductionto$1,900makesasinglethresholdatthecurrentkiddietaxlevelandmakes300,000dependentreturnsnon-taxable.

Therearealsoseveraladvantagestosimplifyingthetaxcalculationfordependentswhomustfile.First,eliminatinganyinteractioninthecalculationofthetaxratebetweenthedependent’sincomeandsiblings’incomewouldreducethenumberofcomputationsrequiredatrelativelysmallrevenuecost.Theadditionalstepofeliminatinginteractionswithaparent’staxratewouldprovidegreatersimplification,butpolicymakerswouldneedtochoosewhichtaxratetoapplytoadependent’sinvestmentincometoensurethatparentswerenotavoidingtaxesbytransferringassetstotheirchildren.Oneoptionwouldtaxadependent’sordinaryincomeandamodestamountofinvest-mentincomeatthetaxratefordependentsandthentaxanyremaininginvestmentincomeatthemaximumrate.Anotheroptionwouldusetheratescheduleforfiduciaryreturns,whichhasnar-rowertaxbrackets.

Disadvantages:Raisingthefilingthresholdorincreasingtheamountofincometaxedatthedependentratecouldincreaseparents’incentivetoshelterinvestmentincomeastheirchildren’s,sincethetaxrateforchildrenisgenerallylowerthanthatoftheparents.Simplificationthatappliedthetoptaxratetothedependent’sincomeoverathresholdtodiscouragesuchshelteringcouldraisetaxratesonde-pendentswithrelativelymodestamountsofincome.Taxinginvestmentincomeofdependentsatthemaximumratecouldbeviewedaspunitiveasitwouldmeantaxingthatincomeataratehigherthantheparents’rateinmostcases.

iv. Option 4: Simplify Rules for Low-Income Credits, Filing Status, and Divorced Parents

Anumberofexpertscitedtherulesthatapplytolow-incomeprovisionsliketheEITC,thechildtaxcredit,andheadofhouseholdfilingstatus,asparticularlycomplex,inconsistent,difficulttointer-pretandtoenforce,andinequitable.Theseprovisionsproviderefundablecreditsforlow-incomehouseholdsandreducethetaxburdenforfamilieswithchildren.

Some of the complexity associated with claiming these credits is illustrated in Figure 2, whichshowstheactualchecklists,worksheets,andformsalow-incomeparentmustnavigatetoclaimand


calculatetheEITCandtherefundablechildtaxcredit.Additionalcomplexityarisesfromthevaria-tionindefinitionsandeligibilitycriteriaforthedifferentprograms.Becausetheeligibilitycriteriaaffectonlyaverysmallsubsetoftaxpayersformanyoftheseprovisions,theadditionalcomplexityprovideslittlebenefitintermsofrevenuecollection.

Anadditionalcostofthecomplexityoftheseprovisionsisincreasednoncompliance.AccordingtotheIRS,errorsinclaimingtaxcreditsanddeductionsincludingthosedescribedabovecontrib-uted$32billiontothetaxgapin2001.InitsmostrecentstudyofEITCnoncompliance,theIRSestimatedthattheEITCover-claimratewasabout27percent.Whilecomplexityisoftencitedasareasontaxpayersoverclaimcredits,otherstudiespointoutthatbetween15and25 percentofap-parentlyeligibleindividualsdonotclaimtheEITC,possiblyduetothecomplexityoftheeligibilityrulesandthecreditcomputation.Hence,thecomplexityoftheseprovisionsalsoresultsintaxpay-ersforgoingthebenefitstheyareprovidedbylaw.

1. Harmonize the EITC and Additional Child Tax Credit

Figure2showstheactualformsataxpayerclaimingboththeEITCandtheadditionalchildtaxcreditmayneedtofiletoclaimthesebenefits(andthefigureexcludesotherformsforotherbenefitssuchaparentwouldlikelyclaim).MuchofthecomplexityillustratedinthefigurearisesbecauseofdifferencesbetweentheEITCandtheadditionalchildtaxcreditthatrequiretaxpayerstoassesseligibilityunderdifferentrulesandtocalculatebenefitsindifferentways.Forexample,boththeEITCandtheChildTaxCreditarepredicatedonearnedincome.However,thedefinitionofearnedincomediffersbetweenthetwocredits,andfamilieswiththreeormorechildrencanchooseamongalternativedefinitionsofearningsforthechildtaxcredit.Thislatterprovisionalonerequiresoveronemillionfamiliestocomputetheircreditstwiceinordertomaximizetaxsavings.


Figure 2: The Process for Claiming the EITC and Additional Child Credit Figure 2: The Process for Claiming the EITC and Additional Child Credit

Form 1040 Instructions: Lines 64a and 64b – Earned Income Credit (EIC) (Steps 1-2)

Form 1040 Instructions: Lines 64a and 64b – EIC (Steps 3-4)


Schedule EIC – Earned Income Credit

Form 1040 Instructions: Worksheet A – EIC – Lines 64a and 64b

Form 1040 Instructions: Worksheet B – EIC– Lines 64a and 64b (Parts 1-4) Form 1040 Instructions:

Worksheet B – EIC– Lines 64a and 64b (Parts 5-7)

Form 8812 – Additional Child Tax Credit

Form 8812 Instructions: Earned Income Chart – Line 4a

Pub. 972: 1040 and 1040NR Filers – Earned Income Worksheet

Pub. 972: Child Tax Credit Worksheet (Part 1)

Pub 972: Child Tax Credit Worksheet (Part 2)

Form 1040 Instructions: Child Tax Credit Worksheet – Line 51 (Part 1)


Figure 2: The Process for Claiming the EITC and Additional Child Credit

Form 1040 Instructions: Lines 64a and 64b – Earned Income Credit (EIC) (Steps 1-2)



Schedule EIC – Earned Income Credit

Form 1040 Instructions: Worksheet A – EIC – Lines 64a and 64b

Form 1040 Instructions: Worksheet B – EIC– Lines 64a and 64b (Parts 1-4) Form 1040 Instructions:

Worksheet B – EIC– Lines 64a and 64b (Parts 5-7)

Form 8812 – Additional Child Tax Credit

Form 8812 Instructions: Earned Income Chart – Line 4a

Pub. 972: 1040 and 1040NR Filers – Earned Income Worksheet

Pub. 972: Child Tax Credit Worksheet (Part 1)

Pub 972: Child Tax Credit Worksheet (Part 2)

Form 1040 Instructions: Child Tax Credit Worksheet – Line 51 (Part 1)


Totargetbenefitstotheneedy,theEITCusesinvestmentincomeasaproxyforwealth,andin2010limitseligibilitytofamilieswithunder$3,100ininvestmentincomefromsourceslikecapitalgains,propertysales,rents,royalties,andnetincomefrompassiveactivities.Thistest,whichisnotap-pliedtotherefundablechildtaxcredit,requiresadditionalinstructionsanda16-lineworksheet.

The proposal and its advantages: Harmonizingtherulesgoverningeligibility,thedefinitionofearnedincome,andthecalculationofbenefitsfortheEITCandthechildtaxcreditwouldeliminatethemultipleschedulesrequiredforfamilieswiththreeormorechildren.Thiscouldpotentiallyhalvethenumberofcalculationsandworksheetsneededtofigurethesecreditsandeliminatepagesofinstructions.

Inaddition,reducingthescopeofthedefinitionofdisqualifiedinvestmentincometoonlythemostcommonincomesourcesreportedonthe1040wouldreducethecomplexityoftheinstructions.Eliminatingthetestentirelywouldprovidefurthersimplification,andwouldreducetheimplicittaxonsavingandassetaccumulationinworkingfamilies. Alternatively,thesametestcouldbeappliedtoboththeEITCandtheadditionalchildtaxcredit.Thiswouldbeasimplificationinthesensethatfamilieswouldfaceconsistentrequirementsforbothcredits.

Disadvantages:Thecomplexityofthesecreditspartiallyreflectsthedesiretotargetbenefitstocertaingroups.Aharmonizationof rules thatadopted theEITCdefinitionofearningsandofqualifyingchildrenwouldreducethesizeoftherefundablechildtaxcreditforcertaingroups,oreliminateitentirelyforsomefamilieswiththreeormorechildren.Forexample,endingmultiplecomputationsforthechildtaxcreditwouldeliminatethechildtaxcreditforafewhundredthousandfamilieswiththreeormorechildrenlivinginPuertoRico,whocurrentlyfilelargelytoreceivethisbenefit.

Eliminatingorsimplifyingthedisqualifiedincometestwouldexpandeligibilitytofamilieswithpotentiallyconsiderableassetsandwealth;withouttheinvestmentincometest,about500,000tax-payerswouldbecomeeligiblefortheEITC.Asimplification(ratherthanelimination)ofthetest,however,wouldexpandeligibilitylessandatasmallerrevenuecost. Alternatively,applyingthedisqualifiedincometesttotheadditionalchildtaxcreditwouldreduceeligibilityforthatcreditandincreaserevenues.

2. Simplify Filing Status Determination

Unmarriedtaxpayerslivingwithdependentsmayqualifytofileasheadofhousehold,afilingstatusthatprovidesa largerstandarddeductionandmoregenerous taxbrackets. Similarly, taxpayerswhoqualifyas“survivingspouses”afterthedeathofaspousemayusethesamestandarddeduc-tionandtaxbracketsappliedtomarriedcouples.Ineithercase,toqualify,ataxpayermustpayoverhalfthecostofmaintainingthehomeinwhichheorsheresideswiththedependentduringtheyear(thehouseholdmaintenancetest).Thistestisburdensomebecauseitrequirestaxpayerstoproduceandretaindocumentationshowingtheirhouseholdexpenditures,andbecauseofthecomplicateddefinitionofwhatisorisnotaqualifyingexpenditure.Therecordkeepingrequire-mentsareafrequentsubjectofenforcementdisputesbecausetheycannotbeverifiedintheabsenceofacumbersomeaudit.


The proposal and its advantages: Eliminatethehouseholdmaintenancetestforunmarriedtaxpayerswhoresidewithandclaimadependent,andallowthemtoclaimheadofhouseholdfilingstatus(orsurvivingspousestatus)withoutregardtowhethertheymaintainthehomeinwhichtheyreside.Alternatively,eliminateheadofhouseholdfilingstatusentirelyandrequirethatunmarriedtaxpayersfilereturnsassinglefilers.Eitherofthesechangeswouldeliminatealengthyworksheetanditsinstructions,andreducerecordkeepingformorethan24millionfilers.Eliminatingheadofhouseholdfilingstatusentirelywouldremoveaseparateratescheduleandstandarddeduction.

Disadvantages:Thisoptionwouldcausemarriagepenaltiestoincreaseunlessspecialruleswereappliedforunmar-riedparentswhoresidetogether.Asinglehomewithmultiplefamiliescouldpotentiallyincludemultipleheadsofhousehold.Ifheadofhouseholdfilingstatuswereeliminated,thestandardde-ductionforhouseholdheadswouldshrinkandsometaxpayerswouldbebumpedintohighertaxbrackets.The2005TaxReformPaneladvocatedeliminatingheadofhouseholdfilingstatus,butsuggestedaddressingthesedistributionalconcernsbyreplacingitwithataxcreditforunmarriedindividualswithfamilyresponsibilities.

3. Eliminate the “Household Maintenance Test” for “Estranged” Spouses

MarriedindividualscannotclaimtheEITCunlesstheyfilejointlyorunlesstheyqualifytofileasheadofhouseholdasan“estranged”or“abandoned”spouse.Toqualifyasanabandonedspouse,ataxpayermustlivewithhisorherchildapartfromhisorherspouse,andmustalsopassthehouse-holdmaintenancetestdescribedabove. Becauseofthecomplexityoftheruleandthedifficultyofmaintainingappropriaterecords,thisrulecontributessignificantlytonon-compliance:almost11percentofEITCoverpaymentsin1999wereduetomarriedtaxpayersfilingassingleorheadofhouseholdwhodidnotmeettherequirements.Manyoftheseclaimswouldnotbeerroneousabsentthehouseholdmaintenancetest.

The proposal and its advantages: Eliminatingthetestwouldreducetherecordkeepingburdenofthisprovisionandimprovecompli-ance.(Analternativeproposalwithasimilareffectwouldallowmarriedtaxpayerswhofilesepa-ratereturnstoclaimtheEITCprovidedtheylivewithachildandapartfromtheirspouse.)ThiswouldalsoimproveequitybyextendingthesametreatmenttoabandonedspouseswhomaybeunabletoprocureadivorceascurrentlyprovidedtodivorcedparentswhoautomaticallyqualifyfortheEITC.Thistreatmentwouldmorecloselyreflectthetreatmentofotherchild-relatedbenefitslikethechildtaxcreditanddependentexemption,whichareavailableindependentlyoflivingar-rangementsandtomarriedtaxpayersfilingseparatereturns.Thecurrenttestcontributestoacci-dentalnoncompliancebecausetaxpayersinthesesituationsappeartoclaimtheEITCerroneously,notrealizingtheyareineligible.


Disadvantages:Eliminatingthetestwouldexpandeligibilitytoabroadergroup.However,therevenuelossislikelytobemodest,inpartbecausemanyineligibletaxpayersalreadytakeuptheEITCmistakenly.

4. Simplify the EITC for Childless Workers

The proposal and its advantages: Therulesthatapplytolow-incomefamiliesincomplicatedlivingsituationsareasourceofaddi-tionalcomplexitywhenclaimingtheEITC.Aworkerthatliveswitha“qualifyingchild”butdoesnotclaimthechildfortheEITCmaynotclaimtheEITCforchildlessworkers.Thismeans,forex-ample,thatanunclethatliveswithhissisterandherchildisnevereligibletoclaimachildlessEITC.Allowingrelativeswhoarenotthechild’sparenttoclaimtheEITCforchildlessworkerseveniftheylivewithaqualifyingchildwouldequalizethetreatmentofsimilarindividualsregardlessoftheirlivingarrangementsandwouldeliminateanerror-provokingregulation.

Disadvantages:ExpandingEITCeligibilitywouldreducerevenues.However,themaximumchildlessEITCis$457and,inpractice,manyindividualsaffectedbytheruleprobablyalreadytakethecrediterroneously,implyingtherevenuelosseswouldbesmall.Someofthetargetingthatmotivatesthecurrentcom-plexitywouldbelost,andthesimplificationgainswouldbeminimizedbecauserulesprohibitingco-residentunmarriedparentsfromreceivingthechildlessEITCwouldberequiredtoreducemar-riagepenalties.

5. Clarify Child Waivers in the Event of Divorce or Separation

Therulespertainingtodivorcedandseparatedparentsareparticularlycomplexanddissimilartotherulesthatapplytootherparents.Divorcedorseparatedparentsareallowedtoexchangetheirrights tocertainchild-relatedbenefits—thedependentexemptionandthechildcredit—butnotothers,liketheEITC.Theserulesburdenalltaxpayerswhoreadinstructionsandfillinchecklists.Theyalsoburdendivorcedfamilies,whomayhavetocomputetheirtaxesunderdifferentscenariostocalculatetheirmaximumtaxsavings.Moreover,thesebenefitsareincreasinglylitigatedinchildsupportordivorcesettlements,resultinginapatchworkofrulingsfromstatecourtsthatnowde-terminewhomayclaimthese federalbenefits. TherulealsoreducesEITCcompliancebecausenoncustodialparentswhoclaimthechildtaxcreditandotherbenefitsmayalsointentionallyorerroneouslyclaimtheEITCaswell.Finally,thissituationmayproducea“divorcesubsidy”bypro-vidingparentswiththeabilitytolowertaxesbyseparating.

The proposal and its advantages: Oneoptiontoaddressthissituationistoeliminatetheabilityofdivorcedorseparatedparentstoexchangetaxbenefits.Thiswouldsimplifytheinstructionsforalmostallchild-relatedbenefitsbyeliminatingthespecialprovisionsfordivorcedparents.Thiswouldalsoimprovehorizontalequitybytreatingpeopleinsimilarcustodialandresidentialsituationsthesameway.


Disadvantages:Adownsidetothisisthatitcouldincreasecomplexityintheinterimifcurrentagreementsweregrandfathered. Suchachangewould increase taxesonnoncustodialparentscurrentlyclaimingchild-relatedbenefitsandwouldreducetaxesoncustodialparents.Theeconomiceffectofsuchachange isuncertain,asparentscouldpresumablyundothisredistributionbymodifyingchildsupportagreements. However,giventhat thedependentexemptionisworthmoretotaxpayersinhighertaxbrackets,theneteffectofsuchachangecouldbetoraiserevenuesintheaggregateifnoncustodialparentsareinhigherbrackets.

b. Option Group B: Simplifying Savings and Retirement Incentives

Morethan20provisionsinthetaxcodeprovideincentivestosaveforretirementandforotherpurposeslikeeducationandmedicalexpenses.Weheardthatindividualscanbeintimidatedandconfusedbothbythesheernumberofaccountstochoosefromandbythefactthateachaccountisgovernedbyadifferentcombinationofrulesregardingeligibility,contributionlimits,andwhenmoneymaybewithdrawn.Weheardconcernsthatthisconfusionreducestake-upofretirementplansbyworkersandthepropensityofemployerstoofferplans,withnegativeeffectsonthegoalofincreasingsaving.Giventhatsavingincentiveprovisionsinthetaxcodearethethird-largesttaxexpenditure—costing$118billionin2008—itisimperativethattheirpublicbenefitsjustifytheircost.

We heard three types of criticisms of the current system. First, many argued that the array ofoptionspresentedtoindividualhouseholds,businesses,andtheiremployeesmakesitdifficulttochooseaplaninthefirstplaceandthecomplicatedrulesmakeithardtounderstandtheincentivestosave,underminingtheireffectiveness.Asecondgrouppointedoutthatformostworkersthechoiceofanemployer-sponsoredsavingplanwasnotthelargestissue—mostemployeesatmediumandlargeemployersareonlyeligibleforoneplan,forexample,a401(k)iftheyworkforaprivateemployerora403(b)iftheyworkforanon-profit. Thisgroupsuggestedthatmostofthecostsofcomplexityariseatsmalleremployersandforemployeeswithmorecomplicatedemploymentsituations. Thisgroupemphasizedadministrativehurdles foremployers sponsoringaplanandinequitiescausedbythedifferentrules;theysuggested“behavioral”interventions(likeautomaticenrollment)toraisesavingswithinthecurrentsystem.Athirdconcernraisedbysomeexpertswasthatthedistributionofbenefitsofthecurrentsetofsavingsincentiveswasnotwellalignedwiththepublicgoalsof increasingsavingsamonggroupswith lowsavingsrates; insteadmostof thebenefitsofsavings-relatedtaxprovisionsaccruetohigher-incomegroupswhoalreadyhavehighpropensitiestosave.AccordingtotheTaxPolicyCenter,about84 percentofthetaxexpenditureforretirementsavingsincentivesaccruestotaxpayersearningmorethan$100,000.

Improvingtheeffectivenessoftaxpreferencesforretirementsavingcouldbeachievedalongmul-tipledimensions. Consolidatingaccountsandharmonizingruleswouldsimplifytheretirementsystemformanyworkersandemployers.Otherrules,likethosegoverningwhenandhowmoneymaybewithdrawnfromaccountscouldalsobechangedtoreducetheburdenontaxpayers.Inad-


dition,incentivestosavecouldbeimprovedwithsimplebehavioralinterventions,likeautomaticenrollmentandofferingtheSaver’sCreditasamatchinsteadofacredit.

Wediscusseightoptionsforsimplifyingsavingsandretirementincentives.

i. Option 1: Consolidate Retirement Accounts and Harmonize Statutory Requirements

Thetaxcodeoffersmorethanadozenvarietiesoftax-favoredretirementsavingaccountsinclud-ingthe401(k),SavingsIncentiveMatchPlanforEmployees(SIMPLE)401(k),Thrift,403(b),gov-ernmental457(b),SalaryReductionSimplifiedEmployeePensionPlan(SARSEP),andSIMPLEIndividualRetirementAccount(IRA)plans.Theseaccountsoftenhavedifferentrulesregardingeligibility,contributionlimits,andwithdrawals.

Table3belowprovidesdetailsonafewrepresentativeemployer-sponsoredretirementplansandsummarizesmanyofthekeyregulationsgoverningtheplans.2Asthetablemakesclear,thereisawidevarietyofrulesacrossplans.Mostplanspenalizeearlywithdrawalsfromretirementaccounts,butsomeretirementplansallowearlywithdrawalswithoutpenalty for“hardship”(usingdiffer-entdefinitionsofhardship)orallowforloans;othersallowearlywithdrawalsformedical,homebuying,oreducationalexpenses;andsomeaccountsdefine“early”asbeforeage59½andsomeasanytimebeforeanemployeeleavesafirm.Therulesforwhenanemployeemay“rollover”contri-butionsfromoneaccounttoanotherhavebeenpartiallyharmonized,buttherearestillcertainac-countswhichcannotberolledintoothers,orcanonlyberolledoverafterawaitingperiod.Ontheemployerside,differentplanshavedifferentrulesforwhichemployeesmustbecovered,withsomerulesfocusingonage,someoncompensation,andsomeonmorecomprehensive“coverage”tests.

2 ThetabledoesnotincludeindividualplanslikeTraditional,non-deductible,orRothIRAs,noreducation-relatedaccountslike529plansorCoverdellplans,normedicalexpensesavingsaccountslikeHealthSavingsAccountsorMedicalSavingsAccounts.


Tabl

e 3

: Em

ploy

er-S

pons

ored

Ret

irem

ent P

lans

P

ayro

ll D

edu

ctio

n I

RA

SE

PS

IMP

LE I

RA

P

lan

SIM

PLE

401

(k)

Saf

e H

arb

or

401(

k)Tr

adit

ion

al

401(

k)40

3(b

)45

7(b

)

Sp

on

sor/

Elig

ible

E

mp

loye

rA

ny e

mpl

oyer

Any

em

ploy

er

Em

ploy

er w

ith

10

0 o

r fe

wer

em

ploy

ees

and

no o

ther

qu

alifi

ed p

lan

Em

ploy

er w

ith

10

0 o

r fe

wer

em

ploy

ees

and

no o

ther

qu

alifi

ed p

lan

Any

em

ploy

er

othe

r th

an a

st

ate

or lo

cal

gove

rnm

ent

Any

em

ploy

er

othe

r th

an a

st

ate

or lo

cal

gove

rnm

ent

Pub

lic

educ

atio

n em

ploy

ers

and

tax-

exem

pt

50

1(c

)(3

) or

gani

zatio

ns

Sta

te a

nd lo

cal

gove

rnm

ents

; non

-ch

urch

tax-

exem

pt

orga

niza

tions

Max

imu

m

Em

plo

yee

Co

ntr

ibu

tio

n$

5,0

00

$

0

$1

1,5

00

$

11

,50

0

$1

6,5

00

$

16

,50

0

$1

6,5

00

$

16

,50

0

Em

plo

yer

Co

ntr

ibu

tio

nN

one

Opt

iona

lR

equi

red

Req

uire

dR

equi

red

Opt

iona

lO

ptio

nal

Opt

iona

l

Max

imu

m

Tota

l E

mp

loye

r +

E

mp

loye

e C

on

trib

uti

on

$

5,0

00

Less

er o

f 2

5

perc

ent o

f co

mpe

nsat

ion

and

$4

9,0

00

.

$1

1,5

00

by

empl

oyee

plu

s 2

or

3 p

erce

nt

mat

ch u

p to

$

24

5,0

00

in

com

pens

atio

n.

$4

9,0

00

or

10

0 p

erce

nt o

f co

mpe

nsat

ion.

$4

9,0

00

or

10

0 p

erce

nt o

f co

mpe

nsat

ion.

$4

9,0

00

or

10

0 p

erce

nt o

f co

mpe

nsat

ion.

$4

9,0

00

or

10

0 p

erce

nt o

f co

mpe

nsat

ion.

$1

6,5

00

or

10

0 p

erce

nt o

f co

mpe

nsat

ion.

Cat

ch-u

p

Co

ntr

ibu

tio

ns

$1

,00

0

$0

$

2,5

00

$

2,5

00

$

5,5

00

$

5,5

00

$5

,50

0;

addi

tiona

l co

ntrib

utio

n of

$

3,0

00

allo

wed

fo

r ce

rtai

n em

ploy

ees

with

m

ore

than

15

ye

ars

of s

ervi

ce.

$5

,50

0; m

ay a

llow

ad

ditio

nal c

atch

-up

cont

ribut

ions

up

to $

28

,00

0 th

ree

year

s pr

ior

to th

e ye

ar o

f no

rmal

re

tirem

ent a

ge.

Wh

en c

an

fun

ds

be

wit

hd

raw

n

wit

ho

ut

pen

alty

?

Sub

ject

to IR

A

rule

s; a

fter

age

5

9 1

/2

Sub

ject

to IR

A

rule

s; a

fter

age

5

9 1

/2

Sub

ject

to IR

A

rule

s; a

fter

age

5

9 1

/2

Sub

ject

to

40

1(k

) ru

les;

af

ter

age

59

1

/2

Sub

ject

to

40

1(k

) ru

les;

af

ter

age

59

1

/2

Sub

ject

to

40

1(k

) ru

les;

af

ter

age

59

1

/2

Aft

er a

ge 5

9

1/2

.

Aft

er s

ever

ance

fr

om e

mpl

oym

ent

or 5

9 1

/2.

Har

dsh

ip

Wit

hd

raw

al

allo

wed

?N

oN

oN

o

Yes,

if

dist

ribut

ion

is n

eces

sary

to

sat

isfy

“im

med

iate

and

he

avy

finan

cial

ne

ed.”

Yes,

if

dist

ribut

ion

is n

eces

sary

to

sat

isfy

“im

med

iate

and

he

avy

finan

cial

ne

ed.”

Yes,

if

dist

ribut

ion

is n

eces

sary

to

sat

isfy

“im

med

iate

and

he

avy

finan

cial

ne

ed.”

Yes,

if

dist

ribut

ion

is n

eces

sary

to

sat

isfy

“im

med

iate

and

he

avy

finan

cial

ne

ed.”

Yes,

for

“u

nfor

esee

able

em

erge

ncy.”

Loan

s al

low

ed?

No

No

No

Yes

Yes

Yes

Yes

Yes


Thecurrentsystemalsoprovidesdifferentcontributionlimitsandeligibilitylimitstodifferentem-ployees,dependingonwheretheywork,whatretirementoptionstheiremployerchoosestopro-vide(ifany),andonindividualcharacteristicsliketheemployee’sage.Taxpayerswhoseemployersofferaretirementplanpaylessintaxes(iftheyortheiremployerscontributetoaqualifiedretire-mentplan)thanthosewhoseemployersdonot. In2010,individualemployeesatfirmsthatdonotsponsorretirementaccountsarelimitedtoIRAcontributionsof$5,000(or$6,000if50yearsorolder). Employeesatfirmsthatofferretirementaccountsmaychoosetodeferupto$16,500($22,000if50yearsorolder),pluswhatevertheiremployerchoosestocontributeuptoacombinedtotalof$49,000. Participants inaSEPmaycontributeupto25percentofcompensationupto$49,000.Employeesatcertaingovernmentalemployerscancontribute(includingmatches)uptoboth403(b)and457plans;theireffectivecontributionlimitis$33,000($44,000if50yearsorold-er).Self-employedindividualsandsmallbusinessownersdirectboththeemployeeandemployercontributionstotheirownplansandhavediscretiontocontributeupto$49,000.Differencesincontributionlimitsandeligibilityrulesleadtoinequitiesintaxburdens.Manyexpertsalsobelievethatsuchdifferencesunderminetheefficiencyofthetaxincentivesforincreasingsavingbecausethemoregenerouslimitsandeligibilityrulesprimarilybenefitindividualswhoalreadysavemorethanaverage.Thus,theseprovisionsmayencouragetheseindividualstoshifttheirsavingtotax-advantagedaccountsratherthantoincreasetheirsaving.However,thecurrentruleswereformedwithcompetingpolicyobjectives inmind. Forexample,offeringhighercontribution limits foremployer-sponsoredplansrelativetoindividualplansprovidesanimportantincentiveforemploy-erstochoosetosponsoraplan.

Administrativeandcompliancecostshavealsobeencitedasadeterrenttoemployersponsorshipofretirementplans.Onlyabouthalfofprivateemployersofferadefinedcontributionretirementplantotheirworkers.Forsmallbusinesses,theadministrativecostsareparticularlylargerelativetothesizeofthebusiness,andlessthan25 percentsponsoranyretirementplan.SIMPLEandsimi-larplansexistlargelytoreducethesecosts.Nevertheless,facedwithmanychoices,smallbusinessownersmayhavetospendconsiderabletimeandenergychoosingthe‘optimal’planforthemselvesandtheirworkers.Smallbusinessownersmayalsodesiretochangethestructureastheirbusinessgrows,creatingfurthercomplications.

Themultiplicityofemployer-sponsoredretirementplansmayalsoburdenemployees.Employeesmayberequiredtoevaluatemultipleaccountsandchooseamongalternativeoptions,discouragingordelayingparticipation.Inthecurrentsystem,anynumberofcommonlifeeventscandisruptaworker’ssavingplan.Marriageordivorce,jobchanges,orchangesinincomeallcanresultinwork-ersbecomingineligiblefortheirpreviousplanorsuddenlyeligibleforanewplan.Often,thesechangesarenotrecognizeduntil tax timetheyearaftersavingscontributionsaremade;special(andunfamiliar)taxprovisionslike“recharacterizations”andnondeductibleTraditionalIRAswerecreatedtoaddressthesetypesofsurprises.Aworkerwhochangesjobsfrequentlymayhavemul-tipleretirementaccountsspreadamongpastemployers,eachholdingonlysmallsumsofmoney.Frequently,workerschangingjobshavetheirretirementcontributionsreturnedtotheminlump-sumdistributionsratherthanrollingthemoverintoanotheraccount.Suchdistributionsreduceretirementsavingsandexposeworkerstounexpectedtaxpenalties.


The proposals and their advantages: Experts suggested consolidating employer-based retirement accounts and simplifying eligibilityandcontributionrules. Consolidatingplansandsimplifyingruleswouldreducecosts forbusi-nessesaswellashelpclarifyincentivesandsimplifysavingforworkers.Afirststepcouldharmo-nizerulesandsimplify tax-preferredsavingsaccountsby imposinguniformrules foreligibility,contributions,andadministration.Forexampleaconsolidatedsetofrulescouldfollowexistingcontributionlimitsandregulationsfor401(k)plans.Particularareaswhereharmonizationmaybedesirableincludetherulesforpenaltiesforhardshipwithdrawals—thedefinitionof“hardship”dif-fersplan-to-planandsomeaccountsdonotallowhardshipwithdrawals—andrulesallowingloansagainstcertainplanbalances.Simplifiedrulesregardingpaperwork,reporting,andlegalliabilitycouldbeappliedtothesmallestemployerstofurtherreducetheiradministrativecosts.

Certainretirementaccountsappearverysimilar—like401(k)s,403(b)s,and457plans—andareinmanywaysredundant.Theyaredistinctbecausetheywerecreatedtoservedifferentemploy-ers—forprofits,non-profits,andgovernments—buttheyservethesamebasicfunctionforeach.Consolidatingsuchplanscouldeliminateextraaccounts, rules,anddocumentation,andwouldsimplifythenumberandvarietyofaccountsforworkerschangingjobsbetweensectors.Forex-ample,asmallgroupofworkers(includingstateuniversityprofessors)whoarecurrentlyeligibleforunusuallyhighcontributionswouldbeheldtothesamecontributionlimitaseveryoneelse.

Amoreaggressiveconsolidationwouldeliminatemoresignificantsourcesofcomplexity.Forex-ample,the2005TaxReformPaneladvancedaplantoconsolidateemployer-baseddefinedcon-tributionplansintoonework-basedaccount(withcurrent-law401(k)limits),allindividualplansintooneindividualaccount,andallspecialpurposesavingsaccountsintooneaccountforsavingsotherthanforretirement.Thisconsolidationwouldhavesweptoutrulesforphase-outs,minimumdistributionsandotherprovisions.Thisplanwasalsopartofabroaderreformintendedtoincreaseopportunitiesfortax-freesavings.Itwouldalsohaveexpandedthesizeofaccountsandeligibilityforaccounts,eliminatingphase-outsandmakingtheaccountsavailabletoalltaxpayers.However,the2005Panelalsorecommendedreducingtaxesoncapitalgainsatthesametime,makingtax-preferredaccountslessdesirableandlimitingtherevenuecostofofferingsuchplans.Overall,thereformsproposedby the2005Panel increasedopportunities for retirement savingandreducedtaxesonsavingingeneral,whilemakinguprevenueelsewhere.

Disadvantages:Themultiplicityofplantypespartiallyreflectsadesiretoofferplanswithreducedadministrativecosts,likeSIMPLEplans,forsmallbusinesses.Consolidationoftheseaccountscouldincreasetheadministrativeburdenonsmallfirms.Muchoftheburdensomecomplexityarisesfromprovisionstolimitthebudgetarycostoftax-preferredvehicles,topromotebroadparticipationinplans(likecoveragetests),andtoensurethattaxsubsidiesavailableforsavingsdonotaccruedisproportion-atelytohigh-incomegroups(likephase-outsand“nondiscrimination”rules).Easingtheseprovi-sionswouldconflictwiththegoalstheyaremeanttoachieve.

Thesimplificationbenefitsofconsolidatingcertainaccountscouldultimatelybemodest.Thethreeplansdescribedaboveareofferedonlybyemployersintheprivatesector,thenon-profitsector,and


thegovernmentsector,respectively;employeesinthosesectorsoftenhavenochoicesandtherulesthatapplyarethesameformostemployeeswithinthosesectors.

Appliedtothecurrenttaxsystem,aplanlikethatinthe2005proposalwouldloseconsiderablerev-enueandwouldsignificantlyexpandtax-preferredsavingsopportunitiestohigher-incomegroups,whoalreadydisproportionatelybenefitfromthem.Therefore,aconsolidationofaccountswouldneedtoaddressboththerevenuecostanddistributionalconsequences,forexample,bylimitingthetaxadvantagesofaccountsforhigher-incomegroupsbyphasingoutthesizeofthedeductionavailableforcontributionsorbyapplyingaflatcredit(ratherthanadeduction)forcontributions.

ii. Option 2: Integrate IRA and 401(k)-type Contribution Limits and Disallow Nondeductible Contributions

Undercurrentlaw,deductiblecontributionstoIRAsarephasedoutforhigher-incomegroupswhilecontributionstoemployerplansarenot,andthephase-outrangediffersbasedonwhetheranem-ployeeiscoveredbyanemployer-sponsoredplan.LargelytoallowindividualswhoareineligibletomakedeductibleIRAcontributions(oftenduetounexpectedincomeorotherrulesdiscoveredattaxtime)toavoidtheadministrativehassleofhavingtotakeoutexcesscontributionsattheendoftheyear,individualsareallowedtomakenondeductiblecontributionstoTraditionalIRAs.Thisrequiresthemtofilesupplementalannualformstotrackthecostbasisoftheassetsinaccounts,andtopaytaxontheincomeearnedintheseaccountsinasingularway.

The proposal and its advantages: OneproposalwouldallowallworkersirrespectiveofincometocontributetoeitherorbothanIRAandanemployer-sponsoredplan.ThecurrentlimitsforcontributionstoIRAsandemployerplanswouldbemaintained($5,000and$16,500,respectively),butthecombinedcontributionswouldbelimitedtothe401(k)limit($16,500).NondeductibleIRAscouldbeeliminatedbecauseincomelimitsoncontributionswouldberemoved.EliminatingnondeductiblecontributionstotraditionalIRAswouldreducethenumberofIRAvehiclesandwouldsimplifyrecordkeepingforparticipat-ingtaxpayers.ComplicatedIRAqualificationandphase-outruleswouldberepealed.Thiswouldalsoencourageadditionalend-of-tax-yearsavingbyworkerswithemployment-basedretirementcoverage.

Disadvantages:TheproposalcouldreducerevenuestotheextentthatincreasingIRAeligibilityresultsingreatertakeup.Moreover,eligibilitywouldbeincreasedprimarilyathigherincomelevels.However,bothconcernsarereducedbythefactthatmosthighincometaxpayersgenerallyalreadyhaveaccesstomoregenerousplans.Anotherdownsideisthatintegratingcontributionsuptoacombinedlimitwoulditselfaddsomecomplexitybyrequiringindividualstotrackcontributionsinmultipleac-countsandensurethatthesumofcontributionsfellbelowthelimit.


iii. Option 3: Consolidate and Segregate Non-Retirement Savings

Overthepast30years,therehasbeenagrowinglistoftax-preferredsavingsvehiclesfornonre-tirementpurposes, includingSection529plans (whoserulesare setby statesandvarywidely),CoverdellIRAs,HealthSavingsAccounts(HSAs),ArcherMedicalSavingsAccounts(MSAs),andFlexibleSavingsAccounts(FSAs). TaxpayerswithIRAsandcertainemployer-sponsoredretire-mentaccountsmayalsowithdrawfundsfromthoseaccountsforeducationandmedicalexpensesorotherpurposes. Anindividualsavingforbothretirementandforotherpurposes facesevenmorechoiceswhendecidingwhichaccountoraccountsprovidethebestalternative.

The proposal and its advantages: Oneproposalwouldconsolidateallthesenon-retirementsavingsprogramsunderasingleinstru-ment.Contributionstothisinstrumentcouldbetax-deductibleuptoalimit,asiscurrentlythecaseforHSAs.Alternatively,contributionscouldbemadewithaftertaxdollars,asiscurrentlythecasefor529andCoverdellplans.Earningswouldaccumulatetax-free,andallqualifieddistribu-tionswouldbeexcludedfromgrossincome.

Segregating non-retirement savings into a consolidated health and education account that wasseparatefromaccountsforretirementsavingswouldsimplifyrulesforbothretirementandnon-retirementaccounts,reduceadministrativecosts,andlimitpre-retirement“leakage”fromretire-mentaccounts.Consolidatingmultipleeducationsavingsplansandmedicalsavingsplanswouldmakethistaxexpendituremoreeffectiveatincreasingsaving.(ThePERABgrouponretirementrecommendssegregatingretirementsavingsaccounts fromtax-advantagedsavingsaccounts forotherpurposesandimposingstrict limitsontheuseoffundsinretirementsavingaccountsfornon-retirementpurposes.)

Analternativeplanwouldconsolidatealleducationsavingsinonetypeofaccount,andallhealthsavingsinanother. Forexample,FSAs(whichareemploymentbased)couldbereplacedwithanewnon-retirementsavingvehiclethathassometaxpreferencesbutdoesnotsubjecttheaccountholdertostringentyear-endforfeiturerequirements.

Disadvantages:Disallowingnon-retirementusesofIRAsoremployerplanscouldreducethedesirabilityofthoseplans,potentiallyreducingparticipation.(However,reductionsinIRAusecouldpresumablyre-sultinincreasesinthesespecialaccounts.)HSAsaredesignedtoimproveincentivesinhealthcarespendingandareintegratedwithspecifichealthinsuranceplans;itwouldnotmakesensetocom-bineHSAdollarswithmoneydestinedforotheruses.Moreover,suchaproposalcouldbecostlydepending on eligibility rules and contribution limits. Mixing savings plans for education andmedicalexpenses,whichcurrentlyhavedisparatetaxtreatmentforcontributionsandvarywithstatelawsorhealthinsuranceparameters,maycreatesignificantwinnersandlosers.

iv. Option 4: Clarify and Improve Saving Incentives

Researchsuggeststhatanumberoftaxprovisionsintendedtoincreasesavingcouldbeimprovedbystrengtheningsavingsincentivesandbyadoptingrulesthatallowforautomaticsaving. One


specificprovisionthatcouldbeimprovedistheSaver’sCredit,acreditthatprovidesasubsidytolow-incomeworkersformakingvoluntarycontributionstoretirementplans,like401(k)sandIRAs(muchlikehigher-incomegroupsreceiveataxsubsidyfortheircontributions).Severalfeaturesofthecredithavemadeitlesseffectivethanitmightotherwisebe.Mostsignificantly,thesavingincentivesprovidedbythecreditarenotvisibleorsalienttotaxpayersbecauseofthedesignandpresentationofthecredit.Researcherssuggesttheopacityoftheincentivesisonereasonthattake-upofthecreditisextremelylow.

Inaddition,arbitrary“cliffs”inthematchingratewithrespecttoincomeandothercomplicationsonthematchformulamakeitdifficulttounderstandanduse.Forexample,atcertainpointsinthescheduleataxpayermayloseupto$1,200increditsforearninganextra$1inincome.

Otherconcernsweheardaboutthecurrentsystemwerethelowparticipationratesandsmallcon-tributionsbyemployeesinsavingsplanssponsoredbytheiremployers.Thereareseveraloptionsforremedyingtheseproblems.

1. Make the Saver’s Credit a Match

ResearchershavedemonstratedthatthedesignoftheSaver’sCreditreducesitsefficacy.Inanex-perimentinvolvingthousandsoflow-incometaxfilersatH&RBlocktaxpreparationoffices,Dufloetal.(2006)showedthatmatchingIRAcontributionsinlieuoftaxcreditscansignificantlyraisetake-upandcontributions.Intheexperiment,increasingtheeffectivefederalSaver’sCreditvaluehadtrivialeffectsonparticipationinIRAs.Incontrast,presentingthecreditasamatch—with-outchangingtheactualvalueofthecredit—actually improvedparticipationsignificantly. Con-tributionstoretirementaccountswerealsolargerwhenthecreditwaspresentedasamatch.Theresearchersconcludedthattaxpayersweremoreresponsivetomatchingincentivesbecausetheyaremoretransparentandeasiertounderstandthansimilarlygeneroustaxcreditsinthecurrentsystem.Inadditiontochangingitsformtoamatch,theSaver’sCreditcouldbemademoregener-ousanduniversal,andthelossinrevenuescouldbeoffsetbyreducingoreliminatingsomeoftheothertaxdeductionsforretirementsavingthatdisproportionatelybenefitthosewithhighincomes.

The proposal and its advantages: DesigningtheSaver’sCredittobemorelikeamatchwouldincreaseitssalienceanditseffectivenessasanincentivetopromotesaving.

AnadditionalimprovementwouldadjustthematchorcreditratetophasedownwithAGIinsteadofabruptlyendingasinthecurrentsystem.Removingthe“cliffs”inthecurrentcreditstructurewouldremovetheveryhigheffectivemarginaltaxratesforthemanysaverswhousethecredit.(TheSaver’sCreditproposalincludedintheFY2011Budgetaddressesthisissue.)

Disadvantages:Administrativehurdleswouldneedtobeaddressedinordertomakeamatchinggrantwork.Forexample,amatchingcreditwouldneedtobedirectlydeposited intotheretirementaccountsofqualifiedtaxpayers,requiringnewproceduresandadministrative infrastructureat theIRSoratfinancial institutions. Specificprovisionswouldneed toaddresshowthecreditwouldapply to


RothversusTraditionalIRAs. Transformingthe“cliffs”inthecreditintoasmootherphase-outwouldreducesomeveryhighmarginaltaxrates,butphase-outscanbedifficulttounderstandandaddcomplexity.Also,dependingonthespecificproposal,thisideacouldaddtothecostoftheprogram.

2. Expand Automatic Enrollment in Retirement Savings Plans

The proposal and its advantages: Underautomaticenrollmentemployersdirectlydepositasmallpercentageofeachpaycheckintoworkers’retirementaccountslike401(k)sorevenintoworkers’IRAs,unlesstheemployeeaffirma-tivelytellstheemployernottodoso.Employeeswouldmaintainfullchoiceoverwhetherandhowmuchtheywanttosavebecausetheycouldchoosetooptoutoftheplanorsaveadifferentamount.Asinthecurrentsystem,employerscouldeasilymatchemployeecontributions.Researchshowsthatautomaticenrollmentboostsparticipationinretirementplanstomorethan90percent,andisparticularlyeffectiveatincreasingtheparticipationoflow-incomeandminorityworkers.

Thepolicyisfeasible,andcouldbetailoredwithappropriatesafeguardstoensurethattheadminis-trativeburdenonsmallemployersisnottoogreat.Indeed,thePresident’sFY2011BudgetincludesaproposaltorequireemployersinbusinessforatleasttwoyearsandwithmorethantenemployeestoofferanautomaticIRAwithregularpayrolldeductionstotheiremployees.(Employerssponsor-ingaqualifiedretirementplan,SEP,orSIMPLEwouldbeexempt.)

Inaddition,otherautomaticfeaturesofaccountscouldbeimplementedtofurtherencouragesav-ing.Forexample,providinganautomaticdefaultinvestmentchoicelikealife-cyclefundorauto-maticescalationofcontributionscouldincreasecontributionsandassetaccumulation,andreducetherisksofpoorinvestmentchoices.Similarly,theautomaticannuitizationofretirementbalancescouldhelpworkersachieveasteadystreamofincomethatisguaranteedforlife.

v. Option 5: Reduce Retirement Account Leakage

A sizable fraction of separated workers who receive lump-sum distributions (particularly smalldistributionsof$5,000orless)fromtheiremployers’retirementplansdonotrollitovertoanotherqualifiedplanorIRA.Someseparatedworkersdonotpaybackoutstanding401(k)loans(inwhichcasetheloanbecomesawithdrawal).Moreover,manyIRAholdersalsotakeearlywithdrawalsforotherexpenses.Thefailuretorollover401(k)fundsorpayback401(k)loans,aswellasthetenden-cytotakeearlywithdrawalsfromIRAs,canreducesavingsthathavebeensetasideforretirement.

The proposals and their advantages: Uponleavingajob,anemployee’splanbalancewouldberequiredtoberetainedintheexistingplanorwouldbeautomaticallytransferredtoanIRAaccountoranaccountwiththeirnewemployer.This“AutomaticRollover”wouldensurethatamountsputasideforretirementcontinuetogrow.

Limitsontax-freeandpenalty-freedistributionsfornon-emergencypurposescouldbetightenedtoreduce“leakage.”Tax-freedistributionsfromindividualaccountscouldbemadeonlyafterage


59½(asundercurrentlawforthemajorityofaccounts),orintheeventofdeathordisability,orforastandarddefinitionof“hardship”suchasthatcurrentlyappliedto401(k)plans.Applyingthemorestringentrulesfor401(k)stoIRAsandotheraccountswouldclosetheexceptionsforearlywithdrawalsforeducation,first-timehomebuyerexpenses,andmedicalexpensesthataremorelenientinIRAs.Earlydistributionswouldbetreatedastaxableincomeandwouldbesubjecttoanadditional10percenttax,similartothepenaltypaidonearlywithdrawalsfromRothIRAsundercurrentlaw.Theseruleswouldensurethataccountssetasideforretirement(andrewardedfordo-ingsowithgeneroustaxbenefits)wouldstillbethereatthetimeofretirement.

Disadvantages:Requiringrolloversorthemaintenanceofaccountsforsmallamountsofmoneywouldraisead-ministrativeburdensonemployersandfinancialintermediaries.LimitingtheabilitytotakeearlydistributionsfromIRAsandotheraccountscoulddiscouragetheuseoftheseaccounts.Moreover,itmaybedifficulttolimitearlywithdrawalsforpopularexpenditureslikeeducationortotrytolimithardshipwithdrawals.

vi. Option 6: Simplify Rules for Employers Sponsoring Plans

Abouthalfofallworkersarenotofferedaretirementplanatwork.Onereasonisthattheadminis-trativeburdensofemployer-sponsoredplansdiscouragesomebusinesses—particularlysmallbusi-nesses—fromadoptingthem.

Muchoftheemployer-sidecomplexityarisesfromprovisionsthatensurethatthebenefitsofsav-ings-relatedtaxexpendituresaredistributedfairlytoworkersatagivenfirmandnotjusttotheownersortohighly-paidexecutives.Forexample,“nondiscriminationrequirements”applyasetof tests that ensure that highly compensated employees do not receive disproportionately highbenefitsrelativetootheremployees.Satisfyingthetestcanrequireemployersandsmallbusiness-estoexaminethecontributionamountsoftheiremployeesthroughouttheyearandadjusttheirown contributions accordingly to avoid penalties. The complexity surrounding these rules hasincreasedbecauseofrelatedprovisionsthatallowemployerscertainexemptionsfromtheoriginalrules.“Cross-testing”allowsalternativemethodsoffulfillingthenondiscriminationrequirementsandhasspawnedanewgenerationofpensionplansengineeredtoallowgreatertax-freesavingsforhighlycompensatedemployees.Similarly,SocialSecurityintegration(or“permitteddisparity”rules)allowsforhighercontributionlimitsforemployeesearningovertheSocialSecuritymaxi-mum($110,000for2010).

The proposal and its advantages: Oneoptionwouldbetosimplifythenondiscriminationtest,forexamplebysimplifyingthedefini-tionofahigh-paidemployeeandtoprovideastandardsafeharbortoavoidtheserequirements.Analternativeproposalwouldrepealnondiscriminationrulesentirelyandrequireallplanstomeetasafeharborstandard.Thisoptionwouldrequireallmediumandlargeemployerplanstohaveminimumcontributionstandardswithnon-electiveand/ormatchingemployercontributions;thecurrentSIMPLE401kplansafeharborrequirementscouldbeapplied tosmallemployers. Thecross-testingandSocialSecurityintegrationrulescouldbeeliminated.


Thesechangeswouldsimplifyplanadministrationandregulationthroughtherepealofthenon-discriminationrules,andreducetheadministrativecostofplanmaintenance. Appropriatesafeharborprovisionscouldbedesignedtoensurecontributionadequacy.Onbalance,thesechangeswouldlikelyincreasetaxrevenueswhiledirectingagreaterportionofthecurrenttaxexpendituretomiddle-classworkers.

Disadvantages:Ifsafeharborrequirementsaretoostringent,thiscoulderodeplansponsorship,especiallyforsmallandmidsizedemployers.

vii. Option 7: Simplify Disbursements

AtaxpayermusttakeMinimumRequiredDistributions(MRDs)frommostretirementaccountsstartingattheageof70½.(TherulesdonotapplytoRothaccounts.)Therulesgoverningthesedistributionsarecomplex—requiringcalculationsinvolvingage-specificsurvivalfactors—andthecalculationsareevenharderforretireeswithmorethanoneaccount.Taxpayerswhofailtocomplywiththeserulesareassessedapenaltyof50percentoftherequireddistribution.

The proposal and its advantages: Eliminatingminimumrequireddistributionsforindividualswithretirementassetsbelowathresh-oldwouldrelievemanytaxpayersfromtheburdenoftheseregulationsatarelativelysmallrev-enuecost.AsFigure3shows,mosthouseholdsheadedbyindividualsoverage70holdrelativelysmallamountsintheirretirementaccounts:about35percentofthesehouseholdswithretirementaccountshave less than$25,000 inretirement-accountassetsandmore thanhalfofhouseholdshavelessthan$50,000.Apolicythatexemptedtaxpayerswithtotalaccountbalancesoflessthan$50,000fromMRDswouldrelievemorethanhalfofthosecurrentlyaffectedbyMRDsfromtherules.Moreover,becausetheaccountsthatwouldbeaffectedbythisproposalarerelativelysmall—theyaccountforonly6percentofretirement-accountassets—therevenuelosseswouldbesmall(about55percentofassetsareheldinaccountslargerthan$500,000).


Figure 3: Retirement Accounts(Individuals Age 70 and Over)

0

10

20

30

40

50

60

0 100,000 200,000 300,000 400,000 500,000

Fraction of Accounts Fraction of Assets

Account Value ($)

Source: Survey of Consumer Finances (2007)

Per

cen

t

Source:SurveyofConsumerFinances(2007).

Disadvantages:This proposal retains the complex rules for about half of taxpayers currently subject to theMRDrules.

viii. Option 8: Simplify Taxation of Social Security Benefits

ThetaxationofSocialSecuritybenefitsisamongthemostdifficultpartofcalculatingincometaxesformostelderlytaxpayers.Determiningtheamountofbenefitssubjecttotaxinvolvesan18-lineworksheetthatrequiresretireestocalculateanalternativemeasureofincomeandthencomparethis“modifiedadjustedgrossincome”(MAGI)toathree-tieredscheduletodeterminetheamountofSocialSecuritybenefits to include in taxable income.Thisphase-in schedule results in steepmarginaltaxrates—ashighas85 percentabovethenormalrate—onordinaryincome,discourag-ingwork,imposinghighratesoftaxationonincomefromretirementaccounts,andencouraginginefficient“taxplanning”toavoidpayingthetax.Theuseofsoftwaretoprepareincometaxreturnseliminatesthecomputationalburden,butitdoesnoteliminatetheproblemstaxpayershaveinpre-dictinghowmuchoftheirbenefitswillbesubjecttotaxationortheirmarginaltaxrate.Becausetheincomethresholdsintheformulaarenotindexedforinflation,moreandmoreSocialSecurityrecipientsaresubjecttotheseprovisionsovertime,andmorepeoplewhowouldordinarilybenon-filershavetofileonthebasisofthistaxalone.

The proposal and its advantages: Simplifying the formula used to calculate the tax on Social Security benefits would reduce thecomplianceburdenonoldertaxpayersandimproveeconomicefficiency.First,replacingthemulti-


tieredphase-inschedulewithasinglephase-inwouldeliminateanumberoflinesontheworksheetandmakethetaxationofbenefitsmoretransparent.Forexample,insteadofthecurrentsystemthatrequiresincludingeitherzero,50,or85 percentofbenefitsintaxableincomedependingondifferent MAGI thresholds, one could specify a single percentage rate—say 40 percent—over asinglethreshold. Suchachangewouldrepresentareturntothepre-1993system. Second,onecouldsimplifythecalculationofMAGI,forexamplebyeliminatingtheinclusionofSocialSecuritybenefitsinMAGIentirely.

Inthisoption,MAGIwouldbedefinedasallnon-SocialSecurityincome(excludingthe50 percentofbenefitscurrentlyincludedinMAGI),theMAGIthresholdforincludingSocialSecuritybenefitsinincomesubjecttotaxationwouldbeloweredto$12,000ofMAGIforasingletaxpayer($24,000marriedfilingjointly),and$0.40ofbenefitswouldbeincludedinAGIforeach$1ofMAGIoverthethreshold. Table4 illustratestheadvantagesanddisadvantagesofsuchachange. Thetableshowstheaveragetaxrates,marginaltaxrates,andamountofSocialSecuritybenefitssubjecttotaxunderthecurrentsystemandunderasimplifiedsystem.Theexampleisintendedtoberoughlyrevenueneutral (basedon2005data),andto illustrate the tradeoffs involved insimplifying theformula.

Table 4: Taxation of Social Security Benefits (Single Taxpayer)Example: (1) (2) (3) (4) (5) (6)

Total Income 20,000 40,000 40,000 40,000 50,000 110,000

Ordinary Income 10,000 15,000 20,000 30,000 35,000 95,000

Social Security Income 10,000 25,000 20,000 10,000 15,000 15,000

Current Law

Benefit Amount Subject To Tax – 1,250 2,500 5,350 11,725 12,750

Marginal Tax Rate on Ordinary Income 10.0% 15.0% 22.5% 27.8% 46.2% 28.0%

Average Tax Rate 0.3% 1.7% 3.9% 8.7% 11.1% 19.3%

Alternative: 40% Phase-In, $12,000 Threshold on Ordinary Income

Benefit Amount Subject To Tax – 1,200 3,200 7,200 9,200 12,750

Marginal Tax Rate on Ordinary Income 10.0% 14.0% 21.0% 21.0% 35.0% 28.0%

Average Tax Rate 0.3% 1.7% 4.1% 9.4% 9.8% 19.3%

ThisproposalwouldsimplifythecalculationofbenefitsbyreducingthecalculationsforMAGI—taxpayersnolongerneedtoincludeafractionofbenefitsinMAGI—andeliminatingthecalcula-tionofmultiplephase-ins—iftaxpayersareaboveathreshold,theyaretaxedonaflatpercentageofbenefitsoverthethreshold,similartothesystemthatexistedpriorto1993.Asisapparent,thealternativesystemresultsinlowermarginaltaxratesonordinaryincomefortaxpayerswithinthephase-inrangeofthecurrentsystem.Thischangereducestheincentivesforinefficienttaxplan-ningandimprovestheincentivestoworkandsave.

Disadvantages:While thiswould lowermarginal taxrates for some taxpayersandoverallaveragemarginal taxrates,somepeoplewouldfallintothephase-inrangesotheywouldfacesomewhathighermarginal


rates.Thispolicywouldcreatewinnersandlosers.Forexample,peoplewithhighSocialSecurityincomebutlownon-SocialSecurityincomewouldpaymoreintaxes.Indeed,individualswiththesametotal income—like those incolumns2-4—wouldbeaffectedslightlydifferently,andsomewouldpayslightlymoreandsomeslightlyless.Tomaintainrevenuewhileloweringthephase-inrateto40 percent,thephase-inthresholdwouldneedtobelower—whilesomelow-incometax-payerswouldpaylessintaxes,otherswouldpaymore.Anadjustmenttotheadditionalstandarddeductionfortaxpayersage65andovercouldbeusedtooffsetthesedistributionaleffects.

c. Option Group C: Simplify Taxation of Capital GainsCapitalgainsaretaxedattheindividuallevelatspecialrateswhichdependonfactorslikethetypeofincomeortypeofasset,theholdingperiodoftheasset,andotheraccountingrules.Long-termcapitalgainsandqualifiedstockdividendsaretaxedseparatelyfromotherincomeatratesof0per-centor15percent.Thecapitalgainsrulesslatedtoreturnin2011include10and20percentbasicratesand8and18percentratesforgainsonassetsheldover5yearsTheAdministration’sBudgetcallsfora20percenttaxrateonlong-runcapitalgainsanddividendsstartingin2011.Inaddi-tion,startingin2013,therecentlyenactedPatientProtectionandAffordableCareActimposesanew3.8percentMedicarecontributiononcapitalgainsandotherinvestmentincomeofmarriedtaxpayerswithAGIover$250,000($200,000forsingletaxpayers).3Thisincreasesthetopstatutoryrateoncapitalgainsto23.8percent.Thecapitalgainsrateofmosthigh-incometaxpayersisalsoaffectedbythe“Pease”3-percentphase-outof itemizeddeductions,whichadds1.19percentagepointstotheeffectiverate.

Thesystemofcapitalgainsalsoincludesspecialratesforcertaintypesofinvestment.Long-termgainsoncollectibles—forexample,gold,jewelry,orart—aretaxedatordinarytaxratesuptoa28percentmaximumrate.Gainsfromthesaleofcertainsmallbusinessstockaretaxedatordinaryratesuptoamaximumof28percentbutwithexclusionsof50,60,75or100percentdependingonwhenthestockwasinitiallyissuedandwhetherthecorporationislocatedinanenterprisezone.Thetaxationofthegainoncertainrealestate(Section1250realproperty)isparticularlycomplex,andproceedsfromasingletransactionmaybetaxedpartiallyatordinaryrates,partiallyas“unre-capturedSection1250gain”subjecttoordinaryratesuptoa25percentmaximum,andpartiallyatthecapitalgainsrate.(Moreover,themaximumrateof25percenton“unrecapturedSection1250gain”appliestotheportionofthegainattributabletodepreciationdeductedatpotentiallyhigherordinarytaxrates.) Inthecaseof“carriedinterest,”capitalgainstreatmentisappliedtocertainincomethatdoesnotrepresentareturnoninvestedcapital.

Becausecapitalgainsaretaxedseparatelyfromotherincome,taxpayersmustcomputethetaxoncapitalgainsanddividendsonanalternativeschedule.Further,becausethereisnotenoughroomonScheduleDforallofthespecialratesandprovisions,manyofthesearenowincludedinseparateschedulesintheinstructions.Havingseparateschedulesincreasestaxpayerburdenandmakesitmoredifficulttocheckwhethertaxpayersareproperlycomputingtheirtaxbecausetheseschedules

3 Thetaxappliestothelesserofthetaxpayer’snetinvestmentincomeandmodifiedAGIinexcessofthe$250,000or$200,000incomethresholds.ThenewdefinitionofmodifiedAGIaddsbackanyforeignincomeexclusioninexcessofanydeductionsandexclusionsdisallowedwithrespecttothatincome.


arenotsenttotheIRS.Thismayincreasethelikelihoodthattaxpayerswillclaimtaxbenefitstowhichtheyarenotentitledandthusincreasenoncompliance.Inadditiontocontributingpagesofinstructionsandworksheets,havingmultipletaxratesfordifferenttypesofcapitalgainsaffectstheafter-taxrateofreturnondifferentassets,distortinginvestmentdecisions.

Anothersourceofcomplexityariseswhenacapitalgainhasoccurredandthuswhentaxesaredue.Anexchangeofproperty,suchasasale,generallyisataxabletransaction—i.e.,youpaythetaxwhenyousellanasset.However,severalprovisionsallowtaxesoncapitalgainsincometobedeferredorforthegaintobecalculateddifferently,addingcomplexityandprovidingincentivesforsociallyunproductivetaxplanning.Forexample,presentlawprovidesthatnogainorlossisrecognizedifpropertyheldforproductiveuseinatradeorbusinessorforinvestmentpurposesisexchangedforlike-kindproperty(aSection1031exchange).Althoughtraditionallike-kindexchangestypi-callyinvolvetwopersonstradingrealpropertywitheachother,thisformofexchangehasgivenwayovertimetoexchangesintermediatedbyathirdpartymarketmaker.MosttransactionsthatoccurunderSection1031onlylooselyresembleanexchangeandinsteadeffectivelyconferrollovertreatmentonawiderangeofbusinesspropertyandinvestments.Rollovertreatmentisconferredonlyifthetaxpayercomplieswithaseriesofcomplicatedrules,andthereismuchuncertaintysur-roundingthesetransactions.

Anotherareaofconcernisthetaxationofcarriedinterest.Themanageror“generalpartner”ofaninvestmentfundtypicallyreceivestwotypesofcompensation:amanagementfeeandapercentageofprofitsgeneratedbytheinvestmentscalleda“carriedinterest.”Themanagementfeeistaxedasordinaryincome,butthecarriedinterestisgenerallytaxedatthelowercapitalgainstaxratetotheextentthattheunderlyinginvestmenthasgeneratedlong-termcapitalgainseligibleforthelowerrate.Manytaxexpertsconsidersomeorallofthecarriedinterestascompensationformanagers’services,andthereforearguethatsomeorallof thiscompensationshouldbetaxedasordinaryearnedincome,asisperformance-basedpayinotherprofessions.

Wediscussfouroptionsforsimplifyingthetaxationofcapitalgains.

i. Option 1: Harmonize Rules and Tax Rates for Long-Term Capital Gains

1. Harmonize 25 and 28 Percent Rates on Capital Gains

Whenataxpayerdeductsdepreciationexpense,thetaxpayer’scostbasisisreducedbytheamountofdepreciationclaimed.Thus,whenthetaxpayerlatergoestoselltheasset,hemayhaveagainasaresultofclaimingthepreviousdeduction.Sincethedepreciationwasdeductedatordinaryincometaxrates,itmakessensethatanygainduetothedeductionshouldbetaxed(“recaptured”)atordinaryrates,andthisishowmostassetsaretreated.However,gainsoncertainrealestatesales(so-calledSection1250gains)aretaxedatordinaryratesonlyupto25percent.Similarly,collect-iblesaretaxedatordinaryrates,butuptoamaximumrateof28percent.


The proposal and its advantages: Sincetheseparatecapitalgainsrateaddscomplexitytoformsandtaxplanningandtherationaleforapreferentialrateisweakinbothcases,onereformoptionwouldbetotaxSection1250recaptureandcollectiblesatordinarytaxrates.Asmallersimplificationwouldusethesamerateforbothprovisions:25percent,28percentoranintermediateratesuchas27percent.

Disadvantages:Realestateheldforinvestment(non-owneroccupied)andcollectiblesinvestorswouldbeadverselyaffectedbyeliminatingorraisingthesepreferentialrates.

2. Simplify Capital Gains Taxes on Mutual Funds

Investorsinmutualfundscurrentlyhavethechoiceofusingseveraldifferentmethodsofcomput-ing theirbasis forpurposesof computingcapital gain. Theycanchoose theaveragecostbasismethod,thefirst-in,first-outmethodorthespecificidentificationofsharesmethod.Specificiden-tificationisthemosttaxpayerfriendlyasitallowssellingthosesharesthathavethehighestcostandthusthelowestcapitalgainfirst.First-in,first-outisgenerallyleasttaxpayerfriendlyastheoldestsharesaremorelikelytohavebeenpurchasedwhenstockpriceswerelower,resultinginalargertaxablegain.Theaveragecostmethodwouldgenerallybeinbetweenthesetwomethods.Withnewreportingofbasisrequirementsineffect,however,thiscreatesthepotentialforconfusionanderrorsiftaxpayersuseadifferentmethodthanusedbythemutualfund.

The proposal and its advantages: Requiringstandardizationusingtheaveragecostmethodforallsharesinaparticularmutualfundaccountwouldprovidethegreatestsimplificationandbeacompromiseamongthemethodsavail-able.Taxpayerswouldstillhavesomeflexibilityasseparateaccountswouldbetreatedseparately.Asatransitionmeasure,thiscouldbemandatoryonlyfornewsharespurchasedafterdateofen-actment(oralternativelystartingatthebeginningofthatcalendaryear).Thisoptionwouldalsohelpimprovecomplianceasovertimeallmutual-fundgaininformationwouldbecomputedandreportedbymutualfunds.

Disadvantages:Somemutualfundinvestorswouldfacehighereffectivetaxratesontheirmutualfundinvestments.

3. Small Business Stock

Thesmallbusinessstockexclusion(Section1202)hasahighlycomplexsetofrequirementsthatmustbemetthroughouttheholdingperiodofashareholderwhohopestobenefitfromtheexclu-sion.Thecomplexrequirementsaredesignedtopreventabuseofthisgenerousprovision.Inad-dition,theSmallBusinessInvestmentActhasbeenrepealed,andtherearenowonlyafewsmallgrandfatheredSpecializedSmallBusinessInvestmentCompanies(SSBICs).BecausecapitalgainstaxrateshavedeclinedsubstantiallyandtheexcludedgainsaretaxedasapreferenceundertheAMT,thereisalmostnobenefitfromtheseexclusions.Boththesmallbusinessstockexclusionand


therolloverofqualifiedsmallbusinessstockgainshavesufferedfromcomplianceissuesbecauseoflimitedreportingrequirementsandenforcementbytheIRS.TheIRSdoesnotreceivethird-partyinformation on eligibility of stock owners of potentially qualified small business stock, makingtheprovisiondifficult toenforce. Therolloverprovisionhasalsobeencriticizedbecauseof theshort6-monthholdingperiod,whichmainlybenefitsinsidersandtradersratherthanlong-terminvestors.Thisprovisionhasbeendescribedasataxbenefitallowingazerocapitalgainstax,butsomesmallbusinessinvestorsdonotre-investtheirgainsinreplacement-qualifiedsmallbusinessstock.ThePresidentproposedazeropercentcapitalgainsrateonequityinvestments(stock)insmallbusinessesanda75percentexclusionwasenactedforinvestmentsin2009and2010aspartofARRA.

The proposal and its advantages: Somesimplificationcouldbeachievedbyallowingthe100percentexclusionforstockpurchasesstartingin2009andchangingtheprior50percentexclusionoffordinaryincometaxratestoa25percentexclusionoffcapitalgainsrates. Thissimplificationwouldretaintheextraincentiveforqualifyingsmallbusinessinvestmentsandresultinsimilareffectivetaxrateswhilegreatlysimplify-ingthetaxcalculations.Thealternativeofrepealingthesespecialsmallbusinessprovisionsforpre-2009investmentswouldstillprovidetheseinvestmentswiththebenefitsofthegeneralpreferentialrateforlong-termcapitalgains.Whateveroptionischosen,improvedreportingisrequiredtohelppreventabuseofthisprovision.

The rollover of gains from qualified small business stock (Section 1044) into an investment inanotherqualifiedsmallbusinessstockcouldberepealedorreformedbylengtheningtheholdingperiodfrom6monthstoatleastoneyear.Theshort6-monthholdingperiodrequirementisincon-sistentwiththe“patientcapital”rationaleforspecialsmallbusinessstockincentives.

Disadvantages:Eliminatingthesmallbusinessstockexclusionwouldraise the taxrateon investments insmallbusinesses.However,fewbusinessesactuallymakeuseoftheseprovisions,sotheeffectwouldbelimited.

ii. Option 2: Simplify Capital Gains Tax Rate Structure

Thecombinationoftheexpirationofthezeroand15percentcapitalgainstaxratesin2011,thePresident’sproposalfora20percentrateoncapitalgainsoftaxpayerswithincomesover$250,000andthe3.8percentMedicaretaxoncapitalgainsofhigh-incometaxpayersintherecentlyenactedhealthcarebill,suggeststhatitistimelytoreviewthetaxationofcapitalgains.

Thebasic10and20percentratesenactedin1997(alongwiththedepreciationrecaptureprovi-siondiscussedabove)werethoughttoallowreductionofthetopcapitalgainsratewithoutlossoftaxrevenuebecauseoftherevenueefficiencyofthedesignoftheproposal.Thezeropercentrateundercurrent lawraises littlerevenue(onlythroughtheeffectof includingthefullcapitalgainonincome-basedphase-outprovisions). Thezeroratealsoraisesquestionsaboutwhetherevenmiddle-incometaxpayersshouldpaysomecapitalgainstaxontheircapitalgainsincome.


The proposal and its advantages: Oneoptionwouldbetoconverttheseparateratesintoa50 percentexclusion.A50percentexclu-sionwouldresultinapproximatelythesametopincometaxrate(19.6percentvs.20percent)whileimposingratesof5and7.5percentongainsoftaxpayersinthe10and15percenttaxbrackets.Suchapercentageexclusionwouldsimplifythecomputationofthetaxoncapitalgains,especiallyifothercapitalgainsprovisionswerealsoconvertedintopercentageexclusions.Thesamepercent-ageexclusionwouldapplytonetcapitallossestomakethetaxtreatmentsymmetricandreduceanyrevenuelosses.Whiletheseparatecalculationofthetaxoncapitalgainsisslightlymorecompli-catedthananexclusion,simplificationbenefitswouldcomefromcleaninguptheotherprovisionsonspecialtypesofcapitalgains.

Amoremodestoptionwouldbetoreplacethezeropercentratewiththe5percentcapitalgainsrateineffectfrom2001through2007fortaxpayerswithtaxableincomeplacingtheminthe10or15 percentratebrackets. While thiswould increase taxes forsomemiddle-incomeindividuals,capitalgainsareinfrequentandtendtoberelativelysmallinthisincomerange.Asaresult,theoverallincometaxofthesehouseholdswouldstayroughlythesamebecauseofchangestootherprovisions in the simplification package. The 5 percent rate would raise capital gains taxes onhigher-incometaxpayerswithoutdistortingtheirdecisionsaboutstocksalesbecausethosedeci-sionswouldbeaffectedonlybythemaximumratethatappliedtotheirgains.

Disadvantages: Asignificantdrawbackofsuchanexclusionisthatthebasicincomemeasure(AGI)wouldbedis-torted,especiallyfortaxpayerswhoseincomeconsistsprimarilyofcapitalgains.Thisdistortionwouldaffectthestartingpointsforincomephase-outsandpublishedtablesthatuseAGItoshowthedistributionofincome.However,thismightbeanappropriatetreatmentforindividualsforwhomalargecapitalgainisaone-timeorinfrequentevent.

iii. Option 3: Limit or Repeal Section 1031 Like-Kind Exchanges

The proposal and its advantages: OnesimplificationoptionistotightentheeligibilityforthistreatmenttobetteraligntheoperationofSection1031withthejustificationsfortaxdeferraltreatment.Analternativeoptionwouldbetodisallowdeferralofgainonlike-kindexchanges.Otherproposalswouldlimittherollovertoprop-ertyincertaincases.Forexample,someproposalswouldmakedevelopedpropertyandstructuresaseparatecategoryfromundevelopedland.Somedevelopersareabletodefertaxationcontinu-allybyrollingovergainsfromthesaleofdevelopedpropertiesintonewinvestmentinincreasingamountsofland.

Disadvantages:Theproposalwould raise tax ratesonrealproperty. TheSection1031provision interactswithandisanescapevalveforcapitalgainstaxrates. Thus, it ismostimportantforcorporationsastheyfacea35percentcorporatecapitalgainstaxrate.Substantiallimitationoflike-kindexchangeruleswouldincreasethepressuretoreducethecorporatecapitalgainsrate(ortheoverallcorpo-


raterate).Ontheotherhand,limitingthelike-kindexchangerulescouldpartiallyfundalowercorporaterate.

iv. Option 4: Capital Gains on Principal Residences

Homeownersmayexcludeupto$500,000($250,000forasingleindividual)ofcapitalgainfromthesaleofprincipalresidencesprovidedthehomewastheirprincipalresidenceintwoofthelastfiveyears.Thisprovisionwasenactedasasimplificationmeasure—atthetimeofenactmentover95percentofhomesalesproducedcapitalgainsbelowtheexclusionamountandevenfewersalesweresubjecttotaxiftheymettheholdingperiodrequirement—andasamiddle-classtaxbreak.Withthepassageoftime,therealvalueoftheexclusionhasbeeneroded,limitingsimplificationbenefits.4

Calculatingthecapitalgainisitselfacomplexprocedurebecausethetaxbasisofthehome—thead-justedpurchasepriceagainstwhichtocomparethesalesprice—includestransactioncosts,fees,in-vestments,andrenovations(butnotroutinemaintenance)thatoccurredsincepurchase.Recordsdocumentingallofthoseexpenditures(oftencoveringmanyyearsofexpenditures)arerequired.

The proposal and its advantages: Theseissuessuggestindexingtheexclusionforinflation.Ahigherthresholdwouldpreventtheero-sionofthesimplificationbenefitsofthisprovisionandpreventincreasingnumbersofhomeownersfrompayingtaxesonappreciatedresidences.

Disadvantages:Indexingthethresholdforinflationwouldexpandthealreadyveryfavorabletreatmentaffordedtoowner-occupiedhousingandwouldbenefitthosewiththelargestcapitalgains.

d. Option Group D: Simplifying Tax FilingBasedonIRSresearch,onaverageindividualtaxfilersspendmorethan17hoursontax-relatedmatterseachyear.Overall,thatmeansthattheroughly140millionfilersexpendalmost2.5billionhoursdevotedtofederalincometaxes.Inadditiontothetimecost,taxpayersspend$32billionpayingaccountants,lawyers,andtaxpreparersorpurchasingtaxsoftware.Alltold,themonetizedcost(at$25perhour)ofthiscomplianceburdenforindividualtaxpayersisabout$92billion. Ofcourse,thesecalculationsignorethehard-to-monetizecostsoffrustrationandanxiety.

About30percentofthetimeisspentactuallypreparingandsubmittingataxreturn,andthere-maining70percentisspentonrecordkeeping,taxplanning,andothertax-relateditems.Record-keepingalone isnearlyhalfof the total timeburden. Muchof that isdevoted todocumenting

4 Therelativelyshortholdingperiodrequirementoftwoyearsandallowingrepeatuseeverytwoyearsisthoughttoinviteabuseoftheprovisionbyhomebuilderslivinginahousetheybuiltfortwoyearstogettax-freeearningsfromtheirprofitonthehouse,byconversionofrentalorvacationpropertiesintoprincipalresidences,andbyse-rialfixer-upperspecialistswhoalsogettax-freeincomeontheirlaboronthehouse.Anoptioninthecompliancesectionaddressesthisissue.


wages, incomefromdividends, interest,retirementdistributions,andothersources,anddeduc-tions for mortgage and student loan interest or IRA contributions—information that is usuallyprovidedbythirdpartiestotheIRSalready.Thentaxpayersmustinputthisinformationandotherroutineinformationlikenames,SocialSecuritynumbersandchildren’sages,intothecorrectformsonworksheets,whichonaveragetakesanother4hoursand20minutesaccordingtotheIRS.5

Inourmeetings,wewereurgedtoconsiderreformstoreducetheburdenoffilingthroughinfor-mationtechnology,particularlythrough“returnfree”systemslikeCalifornia’s“ReadyReturn”pilotprogram.Thisprogramtargetedasmallgroupofindividualswiththesimplesttaxreturns–singleindividualswithnodependents,noitemizeddeductions,andonlywageincome—andmailedthemapre-filledreturn.Allofthecontentontheformwasprovidedusingcomputerrecords.Partici-pants’SocialSecuritynumberswereusedtoretrieveearningsdatafromtaxrecordsalreadysup-pliedtoCaliforniabyemployers,andinformationontheindividualsliketheirfilingstatuswassup-pliedfromlastyear’sreturn.(Individualswhosetaxsituationhadbecomemorecomplicatedstillhadtofileafullreturn.)Individualssimplyhadtochecktomakesurethattheinformationonthepre-filledreturntheyhadreceivedwascorrect,signtheform,andmailitback.Amongthosewhochosetoparticipate,themedianuserreportedsaving40minutesand$30,andparticipantsgaveravereviews,with98percentsayingthattheywantedtousetheprogramagainthefollowingyear.Thesetimeandmoneysavingbenefitsofautomaticfilingdonotincludetheadditionalbenefitsofreducedfrustrationbytaxpayersandtheirincreasedtrustinthesystem.Lessthan5percentoftheroughly2millioneligibletaxpayersparticipated,however.

Someestimatethatitwouldbepossibletoserveupto40percentofallU.S.taxpayerswithasimilarsystem,savinghundredsofmillionsofhoursandbillionsofdollarsinpreparationfees,whileactu-allyreducingthecosttotheIRSofadministeringthetaxsystembyreducingerrorsandresultantinvestigations.

The California experience also highlighted certain challenges to simplifying the filing process.Taxpayerswithcomplicatedreturns,withincomefromunreportedsources,likeself-employmentincome,orwithunreporteddeductions, likecharitablecontributions,wouldbehard toaccom-modate. Asthecostsoffilingaredisproportionatelybornebythosewithcomplexreturns, thislimitssomeofthepotentialcostsavingsfromfilingsimplification.Inaddition,modifyingthefilingsystemwouldrequirechangesfortheIRSandtheSocialSecurityAdministrationandfortheem-ployersandotherthirdpartieswhoarerequiredtosubmitinformationtotheIRSandwhowouldnowhavetosendinthatinformationonamuch-compressedtimeframe.Inaddition,newtech-nologicalsystemsanddatabaseswouldneedtobedevelopedandimplemented.Currently,theIRSdoesnotreceiveandprocessthird-partyreportedinformationintimeforthefilingseason.Thus,thetimingofreportingandprocessingwouldneedtobeaccelerated,withassociatedinvestmentsinadministrativepersonnelandcomputinginfrastructureateachstepoftheprocess.(Californiaprocesseditsstateunemploymentinsurancerecordsforwagesbytaxfilingseasonforthisproject,andwagesforunemploymentpurposesarenotnecessarilythesameasforincometaxpurposes.)

We received two primary options for simplifying the filing process; implementing either—orboth—wouldsubstantiallyreducethecomplianceburdenformillionsoftaxpayers.

5 Theseestimatesincludethemuchlargeramountsoftimeandmonetarycostsoftaxpayerswithbusinessincome,suchassoleproprietors.Fortaxpayerswithoutanybusiness-relatedincome,theaverageburdenislower.


i. Option 1: The Simple Return

The proposal and its advantages: Oneoption,modeledaftertheCaliforniapilotprogram,istosendtaxpayersapre-filledreturn.Taxpayerswith relatively simple returnswould receiveapre-filled tax return from the IRS thatincludedinformationtakendirectlyfromemployersandfromlastyear’sreturnaswellasapre-liminarycalculationoftaxliability.Taxpayerswouldberesponsibleforupdatingtheirreturnsasneeded—forexample,changingthenumberofdependents,addingadeductionforhomemort-gageinterest,oraddinginself-employmentincome—butmanytaxpayerswouldhavenochangesandwouldonlyhavetosignandreturntheirpre-filledreturns.

Taxpayerswithrelativelysimplereturnswouldbe themost likely initialcandidates for thepro-gram,startingwiththemorethan17milliontaxpayerswithonlywageincomeandsimplefamilyarrangements.Fromthere,theprogramcouldreasonablybeexpandedtoasmanyas60 milliontaxpayers—abouthalfofthetotalnumber—whohavethird-partyreportedincomeandwhodidnotitemizedeductions.

Providing pre-filled returns would relieve millions of taxpayers from the chore of filling in taxforms,whetheronpaperorviataxsoftware,andwouldreducethefrustrationandanxietyoftax-payersattaxtime.

Disadvantages:Thisoptionalonewouldprovidelittlerelieffortaxpayerswithcomplicatedreturns,taxpayerswithbusinessincome,orlow-incomefilersincomplicatedlivingarrangements.Taxpayersinthesesitu-ationswouldstillneedtofilearegularreturn.Further,theIRScurrentlyhasneitherthecomput-inginfrastructure,northeabilitytoobtaininatimelymannertherequiredthird-partyreportsofincomeanddeductionsneededtofilloutacompletereturn,evenforsimplereturns.Consider-ableinvestmentintechnologyandmanpowerwouldberequiredtoimplementsuchasystem.(Asindicatedbelow,suchinvestmentwouldalsoberequiredtoincreaseoveralltaxcomplianceandreducethetaxgapsignificantly.)Apre-filledreturnthatomittedcertainincomesourcesorthatmisstatedataxpayer’sincomeordeductionsinthetaxpayer’sfavorcouldreducetaxcomplianceandcollectionsbyrevealingthegapsinthegovernment’sinformation.However,complianceforsuchincomesources,likecashreceiptsbysmallbusinesses,isverypooralready.(AstudyofCali-fornia’sReadyReturnconcludedthattheprograminfactreducedrevenuesonlyslightly.)Adaptingthesystemtoaddressallthespecialcreditsforlow-incomehouseholdswithchildren,retirementsavings,orotherpurposeswouldbedifficultorimpossibleunlessthosecreditswerealsosimplified.Finally,evenwithtechnological improvements, theIRSwouldnotbeable topreparereturnsassoonafterthecloseoftheyearasmanytaxpayerscurrentlyfiletheirreturnsinordertoobtaintheirtaxrefunds.Thus,theattractivenessoftheprogramforlower-incomefamilieswhoreceivelargerefundsduemainlytotheEITCandchildcreditsmightbelimited.California’sReadyReturnwasapaperformmailedtotaxpayers.Theuseofapaper-basedfilingsystemwouldtendtoeliminatethebenefits(suchasautomaticcomputations,fewercomputationalerrors,andreduceddataentrycosts)ofelectronicallypreparedandsubmittedreturnsforboththeIRSandtaxpayers.


ii. Option 2: Data Retrieval

The proposal and its advantages: An alternative—or auxiliary—proposal would allow taxpayers (or their preparers) to downloadtheirowntaxinformationfromtheIRS.Insteadofmailingapre-filledreturntotaxpayers,theIRSwouldprovideasecuredatabasewhereindividualscouldlookupandretrievethird-partyreportedinformation,likewages,interestincome,dividends,incomefromsaleofsecurities,statetaxespaid,anddeductionslikehomemortgageinterest,allofwhichtaxpayersmustcurrentlyassembleandfillinthemselves.Allofthisinformationismaintainedbythirdpartiesandcouldbemadeavailableinadatabase.Ratherthanbeingmailedtothetaxpayeritem-by-itemtheinformationwouldbeavail-ablefordownloadingdirectlyintothetaxpayer’sreturnathisconvenience.Eliminatingmuchofthepaperworkneededtopreparetaxeswouldsavetime,decreasetaxpayerfrustration,andreduceerrorsintranscriptionandothermistakes.Whiletaxpayerswouldstillneedtofilloutotherinfor-mationonthetaxformlikecharitablecontributionsandcertaincapitalgains,thisoptionhastheadvantageofprovidingfilingsimplificationtoalltaxpayers,notjustthosewithsimpletaxreturns.Mostindividuallineitemsreportedbythemajorityoftaxpayersaresubjecttothird-partyreport-ing,evenforhigh-incometaxpayers,whotendtohavethemostcomplicatedreturns.

Disadvantages:Oneconcernisthatelectronicstorageanddownloadingoftaxinformationtoindividualtaxpay-ersbytheIRSwouldbesubjecttosecuritybreaches.Butproponentsofthisapproacharguethatthestandardsforsecurityforotheronlinetransactionsareveryhighandtheypointoutthatonlinesystemscouldimprovesecuritycomparedtomailinghundredsofmillionsofpaperformsacrossthecountry.Asinthepreviousoption,dataretrievalmightmaketaxpayersawareofalltheitemstowhichthegovernmentdoesnothaveaccessandmakehonestreportingoftheseitemslesslikely.Thisoptionwouldalsorequireadditionalresourcesforinvestmentsintechnologyanddatabases.Also, thisoptionhas the samecosts anddifficulties asOption1ofgetting the third-partydatasubmittedandprocessedearlyenough toenable taxpayers tofile their returnsandobtain theirrefundsontheircurrentschedule.Moreover,ifthirdpartiesnolongerhadtosendcopiesdirectlytotaxpayers,theywouldnotbeabletoacceleratetheirtaxfilingbyusingtheinformationsenttothemdirectly.

iii. Option 3: Raise the Standard Deduction and Reduce the Benefit of Itemized Deductions

Taxpayerschooseeithertotakethestandarddeductionortoclaimthesumofitemizeddeductionswhencalculating their taxable income,generallydependingonwhich is larger. Taxpayerswhoitemizetheirdeductionsmustmaintainrecordsofthosedeductionsandfileanadditionalschedulewiththeirreturn,andadditionalrecordkeepingandreportingisrequiredbythirdpartiesforde-ductionssuchasmortgageinterest.Taxpayerswhotakethestandarddeductiondonotfacetheserequirements.


Overall,in2007,50milliontaxpayersor38percentofregulartaxpayers(otherthandependentfil-ersandthosewhofiledonlytoclaimastimulusrebate)claimeditemizeddeductions.Theitemiza-tionrateincreaseswithincome:forthosewithAGIunder$50,000,18 percentitemize;55percentwithAGIbetween$50,000and$75,000;73percentwithAGIbetween$75,000and$100,000and89percentofthosewithAGIover$100,000.Itemizationishighestfortaxpayersage45to64andlowerforyoungertaxpayersandthoseage65andover.Manytaxpayersinthe$50,000to$100,000incomerangehaverelativelymodestamountsofitemizeddeductionsandcouldberelievedoftherecordkeepingburdenifthestandarddeductionwerehigher.

The proposal and its advantages: Increasingthestandarddeductionandreducingthebenefitofitemizingdeductionswouldsim-plifythefilingprocess,reducerecordkeepingrequirementsformanytaxpayers,andrelievesometaxpayersfromfilingareturnentirely.Forexample,aproposalcouldlimititemizeddeductionsto75 percentofcertainexpensesandusetheresultingrevenueraisedtoincreasethestandarddeduc-tion.Suchalimitationalreadyappliestocertaindeductionslikebusinessexpensesforfoodanden-tertainmentandfortotalitemizeddeductionsforhigh-incometaxpayers.Therevenuesgeneratedbythislimitationcouldthenbeusedtofinanceasubstantialincreaseinthestandarddeduction.

Increasingthestandarddeductionwouldmeanthatmanymorepeoplewouldchoosetotakethestandarddeductionratherthanitemizing,meaningthatfewerpeoplewouldneedtospendtimekeepingrecordsofeligibledeductionsandresultinginmorestreamlinedreturns.Raisingthestan-darddeductionwouldoffsetthereduceddeductionformostlower-andmiddle-incomeitemizers.

Some rough calculations that ignore potential behavioral responses illustrate the effects of thisoption.6 Thecalculationssuggestthatlimitingitemizeddeductionsto75percentwouldgenerateenoughrevenuetoincreasethestandarddeductionby55to85percent,dependingonwhetherthePresident’staxproposalsintheBudgetareenactedorcurrentlawapplies.Forexample,undercur-rentlawwiththeAMTprovisionsindexedforinflation(theso-calledAMT“patch”),thestandarddeductioncouldbeincreasedbyupto85percentby2015.Underthisscenario,nearly30milliontaxpayerswouldshiftfromitemizingdeductionstoclaimingthestandarddeductionby2015,whileabout26milliontaxpayerswouldcontinuetoitemizedeductions.Thiswouldprovideasubstantialamountofsimplificationfortaxpayerswhonolongerneedtoitemizedeductions.ThepercentageoftaxpayerswithAGIbetween$60,000and$75,000whoitemizewoulddecreasefrom51percenttoabout18percent,providingsubstantialsimplificationwhilestillallowingitemizationforthosewith large amounts of such deductions. Among taxpayers in this income group, tax liabilitieswouldbereducedorremain thesame forabout70percentof taxpayers. Moreover, tax liabili-tieswouldremainthesameorbereducedfor96percentoftaxpayerswithAGIlessthan$50,000underthisoption.Taxeswouldincreaseformorethanthree-fourthsoftaxpayerswithAGIover$200,000.Overalongerhorizon,thestandarddeductioncouldbeincreasedfurtherorrevenuescouldbeallowedtorisebecauseitemizeddeductionstypicallyrisefasterthantheinflation-indexedstandarddeduction.

6 Possiblebehaviorresponsescouldincludereductionsincharitabledonationsandsometaxpayersusingsavingstopaydowntheirmortgagessincetheinterestwouldnolongerbefullydeductible.Inaddition,overtimestateandlocalgovernmentsmightreconsidertheirmixoftypesoftaxes,feesandborrowing.


Limitingitemizeddeductionswouldalsoimproveeconomicefficiency.Certainitemizeddeduc-tions—forexamplethedeductionformortgageinterest—providesubsidiesforspecificactivitiesthatencouragethemrelativetootherpossiblymoreproductiveactivities.

SeverallimitationsonitemizeddeductionswereincludedintheTaxReformActof1986,andtheAdministration’s Budget proposal recommends limiting the benefit of itemized deductions forhigher-incometaxpayersto28 percentratherthanuptotheordinaryincometaxrateof35percent.

Disadvantages:Limitingitemizeddeductionswouldbecriticizedonfairnessgrounds.Forexample,limitingchari-tablecontributionswouldreducethe incentives togivetocharityandcouldthereforeadverselyaffectbothcharitableorganizationsandtheirbeneficiaries.Deductionsforwork-relatedexpenseswouldalsobehardtolimit—thecostsofproducingincomearefullydeductibleforallbusinessesandfortheself-employed,butcurrentlyonlypartiallydeductibleforemployeeswithunreimbursedexpenses.Similarly,thedeductionforlargemedicalexpendituresisintendedtoadjustforabilitytopayandthethresholdhasrecentlybeenincreasedtoonlyallowdeductionsover10percentofAGI.Limitingitemizeddeductionswouldalsoraisetaxesmorefromthosewithlargedeductionsthanotherwisesimilarlysituatedtaxpayerswithfewerdeductions. Forexample,homeownerswouldseetheirtaxesrisemorethanrenters.Theremaybemoreefficientwaystolimitthecostsofchari-tabledeductionswithoutreducingtheincrementalincentivetogive,suchasamodestfloorunderdeductions,likethe1 percentfloorsuggestedbythe2005TaxReformPanel,orafixeddollarfloorsuggestedbyothers.

e. Option Group E: Simplification for Small Businesses

Simplified Accounting for Small BusinessesSmallbusinessesspentcloseto1.8 billionhourscomplyingwiththeincometaxin2004andpaidasmuchas$16billionforprofessionalhelp,accordingtoonestudy.Thesecompliancecostsfalldisproportionatelyonsmallerbusinesses,assmallerfirmsbearalargercomplianceburdenrelativetothesizeoftheirbusinessthandolargerfirms.Forthesmallestbusinesses—thosewithonetofiveemployees—theaveragemonetizedcostofcomplianceisestimatedtobe$4,500peremployee.Ac-cordingtotheNationalFederationofSmallBusiness’sProblemsandPrioritiesPoll,taxcomplexityranksfifthof75issues.Thiscomplexityisaprimaryreasonwhy87percentofsmallbusinessown-ersrelyonapaidtaxpreparer.

Thelargestcostoftaxcomplianceforsmallbusinessesisthetimeburdenassociatedwiththead-ditionalrecordkeepingneededforcomplyingwithtaxaccounting.Businessesmayneedtokeepatleasttwosetsofbooks,oneforfinancialaccountingandanotherfortaxaccountingpurposes;oftenbusinessesmustalsomaintainadditionalsetsofaccountsforstatesthathavede-coupledfromfed-eraltaxrules.Formostsmallbusinesses,thesebooksmaynotbethatdifferentbecausetheyalreadyusecashaccountingforbothfinancialandtaxpurposes;about80percentofbusinesseswithgrossreceiptslessthan$500,000andthatmakeorsellgoodsusecashaccountingfortaxpurposes.Withcashaccounting,firmsgenerallyincludeallreceiptsingrossincomeintheyeartheyarereceived,


anddeductmanyexpenseswhenpaid—exceptforthecostsofmaterialsandsupplies,inventories,andothercapitalexpenditures.Taxpayerscannotdeducttheircostsformaterialsandsuppliesuntiltheyareused.Similarly,taxpayersgenerallymaynotdeductthecostsofinventoryuntilthegoodsaresold.However,manysmalltaxpayersneedonlycapitalizethecostsofmerchandisepurchasedforresale. Othercosts,suchasdirectlaborcostsandoverheadcostsmaybeexpensedbythesesmalltaxpayers.Nevertheless,thetaxrulesrequireevenverysmallfirmstomaintainrecordsforpurchasedsuppliesandinventorybeyondtheyearinwhichtheywerebought.Similarly,expendi-turesfordepreciablepropertymustbedeductedovertime,andthedepreciatedbasistrackedfromyeartoyear.Currentlawprovidessomereliefbyallowingsmallbusinessestodeductimmediatelyup to$250,000of investments incertainproperty. (This limit is scheduled todecline toabout$135,000in2011.)

Inadditiontodirectbookkeepingcosts,recordkeepingatsmallfirmsisfrequentlysubjecttoerror.AccordingtooneIRSstudy,somerecordkeepingitemsreportedonthereturnsofsoleproprietor-shipshaveerrorratesover50percent.

Witnessesalsocitedthedifficultyofclaimingadeductionforthebusinessuseofahomeasadrainonsmallbusinesses.Nearlyhalfofsmallbusinessesarehome-basedandmanycouldbeeligibletodeducthomeofficecosts.However,toqualifyforthedeductionanumberofstringenttestsmustbemetandrecordsdocumentinghouseholdandbusinessexpendituresrelatedtotheofficemain-tained.Forexample,aself-employedworkerusingadenforbusinesspurposesmayneedtodocu-mentcostsforutilities,mortgageinterestorrent,andgeneralrepairs,allocatethosecoststothebusinessportionofthehome,andotherwisedifferentiatecostsspecificallyrelatedtothebusiness(likeadedicatedphoneorfaxline)fromthoserelatedtothehome.Also,therearestrictrequire-ments that limit thedeductibilityofhomeofficeexpensesbygenerallyrequiring that thehomeofficespacebeusedexclusivelyforbusiness.

Afinalissueraisedbymanybusinessrepresentativesdealswithproperty(otherthanhomeoffices)that potentially has both business and personal uses, such as automobiles, computers, and cellphones–knownas“listed”property.Topreventthetakingoftaxdeductionsforthepersonaluseoflistedproperty,Congressrequirestaxpayerstoreportasincomethepersonaluseofthisproperty.Strictlyspeaking,inordertocomplywiththeserules,employersandemployeesmustgocallbycallthroughcellphonerecordstoallocatebusinessandpersonaluse.

i. Option 1: Expand Simplified Cash Accounting to More Businesses

The proposal and its advantages: “Simplifiedcashaccounting”or“checkbookaccounting”eliminatestheneedtomaintainmulti-yearrecordsforsupplies,inventories,andmostdepreciableproperty. Inthissystem(advocatedby the 2005 Tax Reform Panel), taxable income for most small businesses would simply equalcashreceiptsminuscashbusinessexpenses—includingcashoutlaysforinventories,materials,anddepreciablepropertyotherthanbuildings.Ratherthanhavingtokeepanadditionalsetofbookssolelyfortaxpurposes,smallbusinessescouldsimplyusetheircashflowrecords—mainlytheir


bankaccounts.Expandingfullcashaccountingtoallbutthelargestfirmscouldallowmillionsofsmallbusinessestosimplifytheirtaxaccountingandlowertheircompliancecosts.Relievingsmallbusinessesoftheburdenofmaintainingtheserecordscouldfreeupresourcesformoreproductiveusesand,bysimplifyingrules,couldreduceerrorsandimprovecompliance.Taxpayerscurrentlyusingcashaccountingarethevastmajorityofbusinesses,buttheyaccountforonlyasmallshareofoverallbusinessactivity.Hence,thedollaramountsinvolvedforprovisionsrelatedtosupplies,in-ventories,anddepreciablepropertyareverylow,makingthecurrentrecordkeepingrequirementsrelatedtosuchpropertyonerousrelativetotherevenuegained.

Anadditionalbenefitofthisoptionisthatitcouldfacilitateimprovementsinthird-partyreportingandthereforecompliance forsmallbusinesses. Undersimplifiedcashaccounting, thebankac-countofabusinessessentiallyrecordsthetaxableincomeofthebusiness—receiptsminusexpens-es.Iffirmswererequiredtomaintainaseparateaccountforthesetransactions,reportingbybanksontheseaccountswouldprovidetaxadministratorswithmorecompleterecordsoftheincomeofsmallbusinesses.(Thisproposalisdiscussedfurtherintheoptionstoimprovecompliance.)

Disadvantages:Providingsimplifiedcashaccountingtosmallfirmswouldreducethepresentvalueofrevenuescollected.Inaddition,certainadministrativeissueswouldneedtobeaddressedwithapermanentlawsuchashowtotreatfirmsmovingacrossthethresholdforsimplifiedaccounting.Transitionissues,likehowcurrentinventoriesweretreated,wouldneedtobeaddressed.Aggregationruleswouldbeneededtopreventlargebusinessesfromcreatingsmallerunitstotakeadvantageofthesimplifiedtreatment.

ii. Option 2: Simplified Home Office Deduction

The proposal and its advantages: Simplifyingthehomeofficedeductionwouldreducetherecordkeepingandcomplianceburdenonsmallfirms.Oneapproachwouldpermitastandarddeduction—aflatdollaramount—forhome-basedbusinesses, similar to thestandarddeduction for individual taxpayers. At-homeworkerswouldfileScheduleC(incomefromself-employment)onlyifself-employmentgrossincomeex-ceeded that threshold and would be permitted a safe harbor for expenses up to that amount—recordkeepingforthoseexpenseswouldbeeliminated. Businessescouldchoosetocontinuetofollowthecurrenthomeofficedeductionrules,ortheycouldchoosethenewstandarddeduction.Underanalternativeapproach,at-homeworkerscoulduseastandardizedformulamoresimilartothecurrentmethodthatisbasedonthesizeofthehomeoffice.Taxpayerswouldfiguretheirde-ductionbymultiplyingthesquarefootageoftheirofficebyastandardhomeofficerate,eliminatingtheneedtomaintainrecordsdocumentingcostsforhomeexpenditures.Eitherofthesesimplifi-cationswouldreducetheburdenofclaimingahomeofficedeductionandwouldencouragemoretaxpayerstodeductexpensesassociatedwiththebusinessuseoftheirhome.


Disadvantages:Eitheroftheseprovisionswouldlikelyreducerevenuesbyincreasingthelikelihoodthattaxpay-erswouldclaimtheseexpensesand,forsometaxpayers,theamountofexpensestheycouldclaimwouldincrease.(Thisrevenuelosscouldbereduced,forexample,ifonlyexpensesoverathresholdcouldbeclaimed.)Manyofthestricttestsappliedinthecurrentsystemaredesignedtodiscourageabusiveuseofthehomeofficededuction.Taxpayerswouldstillhavetomeettheeligibilitycondi-tionsfordeductinghomeofficeexpenses.Finally,addinganoptionalstandarddeductioncouldac-tuallyincreasetaxpayerburdenwithoutdecreasingrecordkeepingcosts,sincemanywouldelecttocomputebothways(standarddeductionandexactmethod)andthendeductthelargerofthetwo.

iii. Option 3: Simplify Recordkeeping for Cell Phones, PDAs, and Other Devices

The proposal and its advantages: DeclassifyingcellphonesandPDAs from“listedproperty”wouldeliminate the requirement todocumenteachindividualcallandallowfirmstodeducttheexpensesusingthesamemethodstheyuseforotherexpenses.(TheAdministration’s2011Budgetincludedthisproposal.)Alternatively,the IRScouldprovidea safeharbormethodunderwhichacertainpercentageofcellphoneorPDAusewasdeemedtobeforpersonaluse.Forexample,50percentofthecostofanemployer-providedcellphonecouldbeassumedtobeforpersonaluse.Thesesimplificationswouldeliminateacostlyrecordkeepingrequirementforbusinesses.

Disadvantages:Removingcellphonesandotherpersonaldigitalassistants (PDAs) fromclassificationas“listedproperty”wouldencouragefirmstoofferemployeesdevicesandphoneplansasfringebenefits,increasing theneed toclarify thecircumstances inwhich thosebenefitsmaybeexcluded fromincome.

f. Option Group F: The AMTTheitemthatwasmentionedmore thananyother taxprovisionwas the individualAlternativeMinimumTax(AMT).TheAMTisaparalleltaxsystemthatrequiresmillionsofAmericanstocalculatetheirtaxestwice,onceundertheregulartaxandonceundertheAMT,andthentopaythehigherofthetwo.WithoutlegislativeinterventiontoincreasetheAMTexemptionamount,morethan28milliontaxpayerswouldneedtopaytheAMTin2010;by2020thenumberwouldclimbtomorethan53million.Evenwithrelief,in2009about4milliontaxpayerspaidAMT(in2020,withtheAMT“patch”almost8millionfilerswouldpaytheAMT).Millionsmorefaceduncertaintyaboutwhether theywouldbe subject to theAMT—andbehitwitha “surprise” taxpayment—andneededtofilloutapreliminaryformandreadpagesofinstructionsjusttofindoutwhethertheywouldneedtofileanAMTreturn.Moreover,becausetheAMTadjustmentseliminatemanypopularexemptionsanddeductionsincludingthosefortaxpayeranddependentexemptions,thestandarddeduction,stateandlocaltaxes,andbusinessexpenses,theAMTnowthreatenstoen-


snaremanyordinaryhouseholds.WithoutcontinualAMT“patches”thevastmajorityoftaxpayersaffectedbytheAMTwouldearnlessthan$200,000.

TheuncertaintycreatedbytheAMTisaprimaryconcern—manyarguedthatwhatataxpayerowesattaxtimeshouldneverbeasurprise.Inaddition,manycitedthedirectburdenofcalculatingtheAMTonthe55-lineform.OthercommentsfocusedonthemanyfeaturesoftheAMTthatseemedatoddswithcommonfeaturesoftheregularincometaxsystem.Forexample,manyaskedwhytheAMTeliminatespersonalexemptionsandthereforetreatsfamiliesofdifferentsizesthesame,whiletheordinaryincometaxincludesmanyprovisionstoaddresshorizontalequity.

i. Option 1: Eliminate the AMT

The proposal and its advantages: MostobserverssuggestedeliminatingtheAMTentirely,andeliminatingalltheheadachesoftheAMTdirectly.

Disadvantages:ThemajorproblemwithcompleterepealoftheAMTiscost:estimatesfromavarietyofsourcessuggestthatrepealingtheAMTwouldcostontheorderof$1.4trillionover10yearsrelativetothecurrentpolicybaseline.“Patching”theAMTbyindexingitsparametersattheir2009levelswouldlimitthenumberofAMTtaxpayerssubstantially—tomillionsratherthantensofmillionsoftax-payers—butwouldstillcostjustover$1trillionovertenyears.AlternativeoptionstoeliminatetheAMTfortaxpayersbelowsomeincomethreshold—sayunder$250,000—wouldalsoreducethenumberofAMTtaxpayerssignificantlybutwouldstillbeveryexpensive—reducingrevenuesbyanamountsomewherebetweenthetwoestimatesabove.

Legislatorshavehistorically“patched”theAMTeachyear(asisnowassumedintheAdministra-tion’sBudgetproposal),sothede-factocostofrepealingtheAMTisaboutthe$320 billiondiffer-ence(over10years)betweenfullrepealandindexingthe“patch”forinflation.

ii. Option 2: Modify and Simplify the AMT

The proposal and its advantages: AnalternativeoptionwouldbetosimplifytheAMTandharmonizeitsprovisionsmorecloselywiththoseintheregularincometax.ThecomplianceburdenoftheAMTarisesbecausetheAMTadjustmentsaresufficientlyopaquethattaxpayerscannotpredictwhethertheywillbesubjecttotheAMTandbecausemanytaxpayersmustfillouttheirtaxestwice,usingadifferentsetofrulesandadifferentsetofcalculationseachtime.IfwearestuckwiththeAMTbecauseofthecostsofrepeal,wecouldatleastmakeitlessburdensome.

TheAMTscheduleincludes28adjustmentstoordinaryincomethatareoftenonlyslightlydifferentfromsimilarprovisionsintheordinaryincometax.Medicalexpensesaredeductibleontheregularscheduleonlytotheextenttheyexceed7.5 percentofincomebut10 percentfortheAMT.(There-centhealthcarelegislationeliminatedthisdifference.)Thedefinitionofdeductiblehomemortgage


interestisslightlydifferentfortheAMT.EmployeestockoptionsaretaxedwhenexercisedundertheAMTbutonlywhenthestockissoldundertheindividualincometax.Toeliminatethepos-sibilityofbeingtaxedtwiceonthesamecompensation,AMTtaxpayersgetacreditagainsttaxespaidinthefuturewhenthestockissoldandregulartaxliabilityisincurred;hencethenetrevenueisgenerallyclosetozero.Inthemeantime,however,thetaxpayermustcarryforwardtwodifferentbasesintheoptionsandstockandcontinuefilingAMTreturnsforinterveningyears.Harmoniz-ingtheseprovisionswouldimprovethepredictabilityofAMTliability,savealotofpaperwork,andmakethesystemmoretransparent.

Manyoftheotheradjustmentsapplytoveryfewtaxpayersandcouldpotentiallybeaddressedelse-whereinthetaxcode.In2006,fewerthan10,000taxpayersofthe8.6millionwhofiledtheAMTmadeadjustmentsforobscureitemslike“electinglargepartnerships”(811taxpayers),thediffer-encebetweenregulartaxandAMTtreatmentof“researchandexperimentalcosts”(1,743taxpay-ers),or“intangibledrillingcostpreference”(5,969taxpayers).Addressingtheseissueselsewhereinthetaxcode—forexample,bymodifyingthetaxtreatmentonlyforthosefewtaxpayers“electinglargepartnerships,”wouldrelieveAMTfilersfromhavingtodealwiththeseprovisions.

Finally,aconsolidationoffamily-relatedtaxcreditsanddeductions,asdiscussedabove,couldre-ducethenumberofAMTtaxpayers.SincepersonalexemptionsarenotdeductibleforAMTpur-poses,havingalargefamilyincreasesthelikelihoodofbeingsubjecttotheAMT.Ifthestandarddeductionandpersonalexemptionswereeliminatedandconsolidatedwitha“familycredit,”thiswouldharmonizetreatmentoffamiliesbetweentheregulartaxandtheAMTandcouldbeusedtoreducethenumberofAMTfilers.

Disadvantages:Muchof theburdenofcalculating taxes twicewouldremain. Harmonizationof individual taxprovisionswouldhelporhurtindividualsaffectedbyindividualprovisions.


III. COMPLIANCE OPTIONSThesecondofthechargestotheTaxReformgroupwastosuggestoptionsforimprovingtaxpayercomplianceandreducingthetaxgap.

Mosttaxpayersreportandpaytheirtaxesvoluntarilyandontime.Overall,thefederaltaxsystemachievesahighlevelofvoluntarycompliancewithtaxpayerspayingabout83.7percentofalltaxesdueinatimelymanner.Theremainingfractionofunpaidtaxesisoftencalledthegrosstaxgap—thedifferencebetweentheamountof taxpayers’ taxobligationforagivenyearandtheamountthatisactuallypaidontime.Thisgapwasestimatedtobe$345billionintaxyear2001.(ThereisnomorerecentIRSestimate.)Ofthe$345billion,voluntarylatepaymentsandIRSenforcementbroughtinapproximately$55billion,leavinga“nettaxgap”of$290 billionofunpaid,uncollectedtaxes.Thisgapresultsprimarilyfromtheunderreportingofincome,withmuchsmalleramountsarisingfromtaxpayerswhofailtofile,orwhofileanddeclareincomebutfailtopay.Thetotaldol-laramountofunpaidtaxeshaslikelyincreasedsince2001becauseofthegrowthintheeconomyandthegrowthintaxrevenues.

Despitethehighratesofvoluntarycompliance,anunacceptablylargeamountofthetaxthatshouldbepaidisnot. Thisdirectlyaffectsfederalrevenues,resultingin largerfederaldeficits,butalsoreducestaxrevenuesforstateandlocalgovernments,whichoftenrelyoninformationreportedonfederaltaxreturns.Noncompliancealsoforcescomplianttaxpayerstoshoulderadisproportion-ateshareoftheburdenofgovernmentfinance.Thetaxgapthereforerepresentsanunfairburdenplacedoncompliant taxpayerswhomustultimatelypaymore forgovernmentservices—anad-ditionalburdenthatrunstothousandsofdollarspertaxpayertosubsidizethosewhodonotpay.Honestbusinessesareputatacompetitivedisadvantagerelativetothosethatcheat,andeveryonesufferswhentaxpayersinadvertentlyunderpaytheirtaxes.Therefore,reducingthetaxgapisaboutmorethanjustincreasinggovernmentrevenues.Itisalsoaboutensuringthateveryonepaystheirfairshare,whichinturnsupportsthewillingnessoftaxpayerstovoluntarilycomplywiththetaxsystemandtheirtrustinit.

Reducingthetaxgapisnotaneasytask.Thenettaxgapdoesnotrepresent“taxdue”billsthattheIRScouldsendtotaxpayers.Rather,thetaxgapprimarilyreflectsanestimateofnoncompliancethattheIRShasreasontobelieveexists,muchofwhichhasnotbeenspecificallyidentified,andwhich,inmanycases,theIRShaslimitedresourcesorabilitytoassessorcollect.(Indeed,limitedIRSresourcesarethemainreasontheofficialestimateofthesizeofthetaxgapisnearlyadecadeold.)Furthermore,someofthetaxgapresultsfromtaxpayerswhomayhaveinsufficientfundstopaythetaxestheyoweorfrombusinessesthatnolongerexist.Morefundamentally,substantiallyreducingthetaxgapcouldrequirebothasignificantincreaseinIRSenforcementcapabilitiesandwouldrequiremoreintrusiveenforcementmeasuresthanmaybeacceptabletoCongressandthepublic.Moreover,additionalresourcesforcollectionandenforcementwouldcompeteforlimitedgovernmentresourcesthatcouldbeusedforotherpurposes.

BothCongressandtheIRShavetakensignificantactionstoreducenoncomplianceandtheassoci-atedtaxgapinrecentyears,andmanyofthesechangeswererecentlyorwillsoonbeputintoeffect.Forexample,informationreportingwillbeenhancedbytworequirementsforcreditcardpayment


andstockbasisreporting.Additionally,therecentlypassedForeignAccountTaxComplianceAct(FATCA)willaddrobustreportingforinternationaltransactionsandprovidetheIRSkeyinfor-mationtohelpidentifyoffshoretaxabuses. Intherecentlyenactedhealthlegislation,Congressexpandedtherequirementforbusinessestoreportaggregatepaymentsof$600ormoreperyeartorecipientsforallgoodsandservicesandtobothnon-corporateandcorporatepayees.Beginningin2011,taxreturnpreparerswhofile10ormorereturnswillberequiredtofilethosereturnselec-tronically.TheAdministration’sBudgetincludesadditionalcomplianceproposalsthatwouldaffectworkerclassificationandincreaseinformationreportingforitemslikerentalpropertyexpensepay-ments,privateseparateaccountsoflifeinsurancecompanies,andgovernmentpaymentsforcertainpropertyandservices,aswellasotherchanges.

Inorderforthesechangestobefullyeffective—bothfromataxcomplianceperspectiveandfroma“customerservice”perspectiveofhelpingtaxpayersavoidmistakesandprovidingtimelierprocess-ingofreturns—theIRSwillneedtodevotenewresourcestargetedintheseareas;meanwhile,theIRSwillstillneedtomaintainitseffortselsewhereprovidingtaxpayerserviceandreducingtax-payerburdensintheadministrationoftaxlaws.Asaresult,theIRSwillneedadditionalfundingbecausewithoutadequateresources,thesenewprovisionswillnotbeeffective.

a. Background on Compliance and the Tax GapIRSresearchshedslightonthetypesofnon-complianttaxpayersandthekindsofincomeandde-ductionswherenoncomplianceismostsevere.Thefollowingtableshowstheestimatesofcompli-ancebytypeoftaxes.Over70percentofthegrosstaxgapisattributabletotheindividualincometax,andsoleproprietorsmakeupmorethanhalfofthispercentage.

Table 5: The Gross Tax Gap, by Type of Tax, Tax Year 2001Type of Tax Gross Tax Gap ($ Billions) Share of Gross Tax Gap

Individual Income 245 71%

Corporate Income 32 9%

Employment 59 17%

Estate 8 2%

Excise NA NA

Totala 345 100%

a. Itemsmaynotaddduetorounding.Source:Figure2,“ReducingtheFederalTaxGap,”IRS&Treasury,August2,2007.

Noncompliancecantaketheformofnotfilingrequiredreturns,underreportingincomeonfiledreturns,orunderpayingtaxesthatarereportedontime. Itisestimatedthat82.6percentofthegrosstaxgapwasattributabletounderreportingoftax(includingunderreportedincomeorover-stateddeductionsandcredits)fortaxyear2001.Theoveralltaxgapisdominatedbytheunder-reportingofindividualincometax,estimatedat$197billion.Table6categorizessourcesofindi-vidualincomeaccordingtothevisibilityofthetypeofincomeandtheassociated“netmisreporting


percentage.”7 Whiletheaccuracyofreportingvarieswidelyfordifferenttypesofincomeorde-ductions,thereportingcomplianceisgreatestwherethereissubstantialinformationreportingorwithholding,suchasforwagesandsalaries.

Table 6: Individual Income Tax Underreporting Gap and Net Misreporting Percentage, by Visibility Groups,

Tax Year 2001

Visibility Group – Type of Income or OffsetUnderreporting Gap

($ Billions)Net Misreporting

Percentagea

Total Underreporting Gap 197 18%

Items subject to:

Information reporting and withholding (wages, salaries, etc.) 10 1%

Information reporting (interest, dividends, pensions, social security benefits, etc.) 9 5%

Some information reporting (capital gains, S corp. & partnership, deductions, exemptions, etc.) 51 9%

Little or no information reporting (proprietor income, rents & royalties, “other” income, etc.) 110 54%

-- Non-farm proprietor income 68 57%

-- Rents & royalties 13 51%

-- “Other income” 23 64%

a.NetMisreportingPercentage–seefootnote7Source:Figure5,“ReducingtheFederalTaxGap,”IRS&Treasury,August2,2007.

Thelargestsourceofunderreportingofincomeisindividualincometaxforincomesourcesnotsubject to withholding or document matching. Voluntary compliance is very high for incomesubjecttobothwithholdingandinformationreporting—morethan99percentofwageandsalaryincomeactuallyreportedonFormsW-2isdisclosed,andthereportingrateonincomesubjecttothird-partyreportingis95percent.ComplianceislowwheretheIRSdoesnotreceivethird-partyreporting,orwherethatreportingisincomplete,andwheretheIRSdoesnothave“lineofsight”toseetransactionsandaccounts.Forexample,theincomereportingpercentagedropsto20percentfor incomeearnedbycertainsoleproprietors(called“informalsuppliers”)whooperate“offthebooks”onacashbasisinareassuchasstreetvending,door-to-doorsales,ormoonlightinginatradeorprofession.Underreportingofbusinessincomebysmallbusinesses,inparticular,accountsforapproximately$153billion—44percent—ofthetaxgap.TheIRSestimatesthatonlyabouthalfofself-employmenttaxesowedareactuallypaidontime,andthattheunderreportingofbusinessincomebyindividualincometaxpayerscosttheTreasury$109billionintaxyear2001.

7 “Netmisreportingpercentage”istheaggregatenetamountofincomemisreporteddividedbythesumoftheab-solutevaluesoftheamountthatshouldhavebeenreported.Theestimatesoftheamountsthatshouldhavebeenreportedaccountforunderreported incomethatwasnotdetectedbytherandomaudits(wheretheburdenofproofisontheauditor)withoutacorrespondingadjustmentforunclaimedoffsets(e.g.,deductions,exemptions,statutoryadjustments,andcredits)thatwerenotdetected(wheretheburdenofproofisonthetaxpayer).


b. General Approaches to Improve Voluntary Compliance and Reduce the Tax Gap

Whenweaskedexpertshowto improvevoluntarytaxcomplianceandreducethetaxgap, theyadvocatedbroadandgeneralprinciplestopromotecompliance.

Onethemeweheardrepeatedlywasthatvoluntarytaxcompliancewouldbeincreasedbyhavingasimpler,moretransparentandmoreeasilyunderstoodtaxsystem,andfromstableandconsistenttaxlaw.Thecomplexityofthecurrenttaxcoderesultsdirectlyininvoluntaryerrorsandfacilitatesintentionalevasion.Areaswherethetaxcodeisparticularlycomplex—theEITC,taxcreditsanddeductionsforeducationexpenses,andlimitsoncontributionstoretirementsavingsplans—arewell-knownsourcesofunintentionalerrors.Onestudyofcapitalgainsfoundthat33percentoftaxpayerswhomisreportedgainsfromsecuritiessalesoverstatedtheircapitalgains. Thesetax-payers overpaid and thus are unlikely to be trying to cheat. Complex provisions also facilitateintentionalnoncompliance(evasion)inpartbecausetheymakeitdifficultfortheIRStodeterminewhetherataxpayeriscomplyingwiththelawabsentasubstantialandsophisticatedaudit.

Wealsoheardalotabouttheneedforpredictabilityandstabilityinthetaxsystem.Themorecer-taintytaxpayershaveaboutthelawandthemorepredictablethelawisfromyeartoyear,theeasieritisfortaxpayerstocomplywiththelawandthelesslikelyitisfortaxpayerstomakeunintentionalerrors.However,taxruleschangealmosteveryyear:therehavebeenmorethan15,000changessince1986andchangesareincreasinglycommon.Inaddition,temporaryprovisionsareincreas-inglyusedforthingslikeeducationcredits,stimulusrebates,disasterarearelief,losscarrybacks,orthefirst-timehomebuyercredit.Thesechangesareconfusingtotaxpayersandtotaxprofession-als.Additionally,eachyeartaxpayersmustawaitreauthorizationsofexpiringtaxprovisionsliketheResearchandExperimentationcredit,AMTrelief,orthesalestaxdeduction.TheJCT’slistofexpiringfederaltaxprovisionsincludesmorethan240provisionsthatexpireby2020.

Expiringandtemporaryprovisionsandotherchangestotaxlawincreasethecostofcomplianceandcreateunpredictability for individuals,resulting inmoreconfusionandmistakes. Fromanadministrativeperspective,suchchangesrequiremajorreprogrammingofcurrenttechnologysys-tems,new informationbooklets,publications, and forms,andreeducating taxpayers,preparers,administrators,andenforcementofficers.AllofthesecostsdivertresourcesfrommoreproductiveusesandreducetheIRS’sabilitytoestablishbestpractices. Forexample,therecenthomebuyercreditwasparticularlychallengingtoadministerandenforce,andtheriskoffraudwassignificantbecauseofuncertaintyaboutappropriatedocumentationrequirementsandareluctancetoimposeexcessivereportingburdensontaxpayersseekingtolegitimatelyavailthemselvesofthecredit.

Asecondthemeweheardwasthatinvestmentsinresearchandtechnologywouldbenecessarytoimprovecomplianceandreducethetaxgap.ContinuedimprovementstoinformationtechnologyanddatabaseswouldprovidetheIRSwithbettertoolstopromotecompliance.Improvingtechno-logicalresourceswouldenabletheIRStoensureallbusinessesandworkersareinthetaxpaymentsystemandthusincreasetheproductivityofexistingIRSresources. Suchimprovementswould


alsospeedrefunds,helpwithcustomerservice,andprovideasteppingstonetowardsystemslikedataretrievalthatwouldmakefilingeasier.

AdditionalresearchisessentialtoenabletheIRStobetterunderstandsourcesofnoncompliance,identifywaystominimizetaxpayerburdenarisingfromcomplianceactivities,andtargetresourcesthatfacilitatevoluntarycompliance.Unlessweunderstandthecausesofnoncompliance,wewillcontinuetohavedifficultyknowingwhetheritisinadvertentorintentionalorwhetheritisfacili-tatedbycertainindividualsororganizations,andwewillnotknowhowtostopit.

Afinalthemewasimprovingtaxadministration.ExpertspointedoutthattheIRShasmultipleobjectivesthatincludeprovidingservicefortaxpayers,collectingrevenue,anddistributingbenefitsthroughcreditsandrefunds,andthatthesedifferentobjectivescompeteforbudgetresources.Newresourcescouldbeusedtohelpdevelopmodernandadaptableadministrationmethods,improvethe design of tax forms and educational materials, improve audit and enforcement procedures,andincreaseauditsandcollectionactivitieswhereappropriate.Anoverarchingthemeidentifiedinthecomplianceareaisthatcomplianceeffortscouldbebettertargetedwithanincreaseduseofelectronicdata.Notonlywouldthisallowfasterprocessing,butitwouldalsoprovidebettercapa-bilitiesfordataanalysisinresearchingareasofnoncompliance.

Wealsoreceivedsomemorespecificoptionsforimprovingcompliance.

c. Option 1: Dedicate More Resources to Enforcement and Enhance Enforcement Tools

Incertainareas,enforcementthroughauditsisoftentheonlywaytouncoverunderreportingofin-come.Overall,infiscalyear2009,theIRSexamined1.4millionorabout1.0percentofindividualtaxreturns.Theexaminationratesrangedfrom0.4percentofsimplereturnswithtotalpositiveincomeunder$200,000upto10.6percentofreturnswithAGIof$10millionandover.Theexami-nationrateswerelowerforsimplerreturnssuchasthosewithonlywageandinvestmentincomeandhigherforreturnswithcharacteristicsknowntohavehighernoncomplianceratesincludingbusinessandrentalincome.Mostexaminationsareconductedbysimplecorrespondencewiththetaxpayer,whilemoreseriousorcomplexissuesmayrequireaformalfieldaudit.

Inaddition,theIRSchecksfortheaccuracyofinformationonmillionsofadditionalreturns.Over2.8millionnoticesweresentoutunder the“matherror”program,which isauthorizedbystat-ute.TheprogramallowstheIRStoidentifyfactuallyinconsistentormissingreturninformationinspecificareas(whicharedefinedbystatute)andcorrect theamountsreportedduringreturnprocessingpriortoissuingataxrefund.Forexample,theIRShasmatherrorauthoritytodenyearnedincometaxcreditstotaxpayerswhofailtoprovidevalidSocialSecuritynumbersforeachchildforwhomthecreditisclaimed.Themostcommonmatherrorsrelatetothecomputationoftheamountoftax,theEITC,thenumberandamountofpersonalexemptions,andthestandardoritemizeddeductions. ExpandingthesetofcircumstanceswheretheIRSmayusematherrorauthoritytoadjustareturnduringprocessingcouldreducethenumberofincorrectrefundsandreducetheneedtouseaformalaudittocorrectmistakes.


UndertheAutomatedUnderreporter(AUR)Program,theIRSmatchestaxreturnstoinformationreturnsreportedbythirdpartiesandcontactstaxpayerstoresolvediscrepanciesandidentifyunre-portedincome.Infiscalyear2008,theIRShad4.8millioncontactsundertheAURProgramthatresultedin$16.5billionofadditionalassessments.

Asstatedearlier,Congresshasenactedanumberofprovisionstoimprovecompliancethatwillgointoeffectoverthenextseveralyears,andtheAdministration’sBudgetincludesadditionalpropos-alstoreducethetaxgap.Inorderfortheseeffortstobeeffectiveinimprovingcompliance,theIRSwillneedadditionalresourcestargetedtocompliance. TheIRSreceived1.9billioninformationreturnsinfiscalyear2008andwillbereceivinglargernumbersinthefutureasadditionalinforma-tionreportingrequirementsarephasedin.TheFY2011BudgetrequestfortheIRSis$12.6billion,representinganincreaseof$487.1millionor4.0percentfromthefiscalyear2010enactedlevel.Ofthetotalbudgetrequested,$2.3billionisfortaxpayerservices,$5.8forenforcement,$4.1foroperationssupport,and$387millionforbusinesssystemsmodernization.TheindependentIRSOversightBoardsupportedtheaddedfundingforIRSenforcementandBusinessSystemsModern-izationprogramtoupgradeIRScomputersystemsandinformationtechnology,andrecommendedevenmoreforIRStaxpayerserviceandbasicIRSoperationssupport.

Anadditionalconsiderationisthedesignoftaxforms.Whileminimizingtaxpayerburdenisanimportantcriterion,IRSformsandpublicationscouldbereviewedandredesignedtoimprovecom-pliance.Forexample,aproposednewscheduleforcorporatetaxpayerswasintendedtoimprovecompliancebyrequiringthereportingofcertainitemsthatmightindicatetheuseofquestionablearrangementsordeductionsthatcouldbeconsideredinselectingfirmsforaudit.Evidencesug-geststhedesignoftaxformsmatters:arecentstudyindicatedthatwhenthethresholdforreportingspecificinformationaboutnoncashcharitabledeductionswasincreasedto$500,alargenumberoftaxpayersincreasedtheirclaimedcharitabledeductionstojustbelowthatthreshold.AdditionalresourceswouldbeneededfortheIRStoimplementandfullyusetheinformationfromredesignedforms.

The proposal and its advantages: MoreresourceswouldenabletheIRStoincreasethenumberofexaminationsandfollow-upsofmismatchesbetweeninformationdocumentssubmittedandtaxreturnsfiled,checkmorequicklyformatherrorsandmissinginformationinreturns,andpursueauditsandcollectionsmoreef-ficientlyandwithalowerburdenoncomplianttaxpayers.Moreresourceswouldalsorelievethebudgetarytradeoffsbetweenenforcementandprovisionoftaxpayerservices. Enforcementrev-enuewas$48.9billioninfiscalyear2009throughcollection,examinationanddocumentmatchingforatotalIRS-widereturnoninvestment(ROI)of4.2to1. Thisfigureexcludestheadditionalrevenuesthatenforcementproducesbydeterringnon-compliancefromoccurringinthefirstplace.Withadditionalresources,theIRSwillcontinueinitiativesimplementedwiththecurrentfundingandestablishnewinitiativestohelpincreaseenforcementrevenue.

Disadvantages:Spendingonenforcementandreportingrequiresreal resourcesboth in termsofdirectcostsofenforcementandthecosttotaxpayersintimeandfrustration.Manyassumethatitisoptimalto


increaseenforcementuntiltheadditionaldollarofenforcementbringsinanadditionaldollarofrevenue.Thisassumptionignoresthefactthatincreasingenforcementusesrealresources—hiringauditorsandrequiringtaxpayerstospendtime—thatcouldbeusedmoreproductivelyelsewhere.Instead,expertsadvisethatenforcementspendingshouldincreaseonlytothelevelwheretheto-talcostofanadditionaldollarofrevenuegainedbyenforcementjustequalsthecostofraisinganadditionaldollarofrevenuethroughsomeothermeans,forexamplebyanincreaseintaxrates.Economistsgenerallybelievethatmosttaxesreduceproductiveeconomicactivitysothatthetruecostofraisingadollaroftaxrevenuethroughthetaxsystemexceedsadollar—typicalestimatesofthetotalcostrangebetween$1.30to$1.50.Fromthisperspective,enforcementeffortsshouldbeincreasedonlytothepointwhereanadditionaldollarofenforcementstillbringsinmorethanthecostofraisingadollarofrevenue.Inaddition,onemustconsiderthatthedirectcostsofadditionalenforcementareonlyonepartofthetotalcostsofincreasedauditing.Anincreaseinauditshasitsdownside,asitcouldbeviewedasintrusiveandonerousfortaxpayers.

d. Option 2: Increase Information Reporting and Source Withholding

Comprehensivethird-partyinformationreportingisanimportantcomponentofachievingahighrateofvoluntarycompliance.Taxcomplianceisextremelyhighfortaxpayerssubjecttowithhold-ingandthird-partyinformationreporting.Asdiscussedearlier,amongworkerswhosewagein-comeisreportedonFormW-2,thenoncompliancerateisonlyabout1percent.ComplianceislowwheretheIRSdoesnotreceivethird-partyreporting,orwherethatreportingisincomplete.

The proposal and its advantages: Expanding information reporting to income sources with little third-party coverage would im-provecomplianceandreducethetaxgapinthoseareaswithouttheneedforadditionalaudits.Forexample, thenewprovisions inFATCAwill significantlyhelp theIRSto lookthroughfinancialintermediariestoidentifyU.S.persons.Historically,however,reportingforinternationaltransac-tionshasnotbeenstrong;afurtherenhancementcouldbemadebyimposingarequirementtoreportoninternationalwiretransfersbyfinancialinstitutions.

Inaddition, expandeduseof reportingon independent contractorsbybusinesses could reduceunderreportingintraditionallycashbusinesses.Requiringwithholdingonlargepaymentstoin-dependentcontractorsandbusiness-to-businesspaymentscouldfurtherincreasecompliance,al-thoughitcouldhaveadverseimpactsonindependentcontractors,especiallythosewhoprovidecombinationsofgoodsandservices.

Disadvantages:Third-partyreportingimposesburdensonthirdparties—generallybusinessesbutpotentiallyin-dividuals—aswellastheIRS. Likeenforcementcosts,thecostofreportingisarealsocialcost.Expandedreportingonindependentcontractorswouldbeburdensomeformanyindividualswhoarenotcurrentlyrequiredtodosuchreporting.Becauseofexpansionsofinformationreportinginrecentlegislation,thepotentialforfurtherrequirementsmaybemorelimited.


e. Option 3: Small Business Bank Account ReportingUnderreportingofsmallbusinessincomemakesup44percentofthetaxgap–thelargestsourceofunderreportedincome.SmallbusinessownersdonottypicallyreceivewagesandsalariesthatarereportedtotheIRSandsubjecttowithholding.Inaddition,manypaymentstosmallbusinessesarenotsubjecttoinformationreporting,sotheaccuracyofthisinformationonabusinesstaxpayer’sreturncannotbeverifiedbasedonthird-partyreportedinformation.ThisprovidesopportunitiesfortaxpayerstounderreporttheirincomeandmakesitdifficultfortheIRStoidentifynoncompli-ance.

The proposal and its advantages: Inconjunctionwithasimplifiedtaxaccountingsystemforsmallbusinessesthatpermitscashac-counting(describedinthesectionontaxsimplification),asmallbusinesswouldberequiredtouseadesignatedbankaccountforallbusinessreceiptsandexpendituresthatissegregatedfromanypersonalbankaccount.Thebankwouldberequiredtoreportthereceiptsandexpenditureswithinthedesignatedaccountannually.

Theproposalwouldofferbothsimplificationandcomplianceimprovements.Asdescribedabove,simplified cash accounting for small businesses would allow business owners to dispense withmany onerous tax accounting provisions, as their checkbook account would effectively providealltheirtaxrecords.Moreover,allowingbusinessestoexpensecertaindepreciablebusinessassetscouldprovideapositiveincentiveintheformofbettercashflowandlowereffectivetaxratestooptintothesystem.

Disadvantages:Bankaccountreportingwouldrequiremillionsofsmallbusinessestoopenandpayforseparateaccounts. Additionally,many soleproprietorshipsusebankaccountsandcredit cards forbothpersonalandbusinessuse.Requiringseparatebusinessaccountswouldhavelessimpactoninten-tionalnoncompliancethanoninadvertentnoncompliance.

f. Option 4: Clarifying the Definition of a Contractor Businessesarerequiredtowithholdincomeandpayrolltaxesonbehalfoftheiremployees,butarenotrequiredtodosoforindependentcontractors. (Inaddition,abusinessmustfulfillrequire-mentsunderlaborlawsforemployeesthatgenerallywouldnotapplytocontractors.)Thedistinc-tionbetweenanemployeeandacontractoristhereforeimportantforthewithholdingoftaxesandreportingofincome—whicharecrucialforensuringtaxcompliance—andforapplyinglaborlawssuchasminimumwages,workplacesafety,oreligibilityforunemploymentbenefits.

However,therulesfordistinguishingbetweenindependentcontractorsandemployeesarecom-plicated,basedonlongstandingcommonlaw,anddependonasmanyas20factorsrelatedtotherelationshipbetweentheworkerandthebusinessthatfrequentlymustbeappliedonacase-by-casebasis. Inaddition, the rules fordistinguishingemployeesandcontractorsaredifferent forincometaxesandpayrolltaxesandforpurposesoflaborlaws.Moreover,somerulesapplytoall


workers,whileotherrulesexcludespecificcategoriesofworkers,suchasengineers,designers,orprogrammers.Additionally,forbusinessesthathavehistoricallyclassifiedworkersasindependentcontractors,aspecialprovision(Section530oftheRevenueActof1978)providesa“safeharbor”exceptionfromtheusual20-factortest.Underthesafeharbor,theIRSmaynotreclassifyworkersasemployees—evenprospectivelyorfornewlyhiredworkers.

Becauseindependentcontractorsarenotsubjecttowithholdingandinformationreportingislesscomprehensive, inadvertent misclassification of workers as independent contractors because ofcomplexityandtheclassificationofemployeesascontractorsatfirms“grandfathered”underthesafeharborrulestendstoreducetaxcompliance.Existingrulessometimesalsoplacefirmsclas-sifyingtheirworkersasemployeesatacompetitivecostdisadvantagerelativetootherfirmsthatclassifytheirworkersascontractors.

The proposal and its advantages: RepealingthecommonlawrulesandallowingtheIRStopublishguidanceonworkerclassificationwouldreducemisclassificationanddisputes. ClarificationofthedistinctionbetweenemployeesandcontractorsandtheeliminationoftheSection530safeharborwouldimprovetaxcomplianceandhelpreducethetaxgap.Applyingthesamerulesequallytoallfirmswouldhelptoleveltheplayingfieldbetweenemployerswhotreatworkersasemployeesversusthosewhoclassifythemascontractors.

Disadvantages:EliminatingtheSection530safeharborprovisionwouldalmostcertainlyleadtomanymorework-ersbeingclassifiedasemployeesratherthancontractors,requiringsomeburdensomechangesforbothemployeesandemployers,evenforthosealreadyincompliancewiththeirtaxes.(Themajor-ityoffirmsandworkers,however,alreadyabidebytheseconditions.)Conversely,repealingthecommonlawrulesforworkerclassificationwithitsnecessaryconcurrentsimplificationandsafeharborruleswouldundoubtedlyallowserviceprovidersandservicerecipientstogether(orservicerecipientsalone)todevelopworkarrangementssothatmoreworkerswouldbetreatedasindepen-dentcontractors.Suchworkerswouldlosethebenefitsofthesocialsafetynet—includingworkers’compensation,unemploymentinsurancebenefits,andvariousfederal,stateandlocalhealthandsafetyprovisions—availableforworkersclassifiedasemployees.

g. Option 5: Clarify and Harmonize Employment Tax Rules for Businesses and the Self-Employed (SECA Conformity)

Self-employedindividualspayemployment(payroll)taxesontheirself-employmentincomeun-der the Self Employment Contributions Act (SECA) just as employers and employees pay em-ploymenttaxesonwagespaidtoemployees.Similarly,generalpartnersinapartnership(suchaslawyersatalawpartnership)aregenerallysubjecttoemploymenttaxesonpaymentstheyreceivefromthepartnership.However,limitedpartnersandScorporationshareholdersareexemptfrom


theserules,andthelawforownersoflimitedliabilitycorporations(LLCs)isunclear.OwnersofScorporationsinsteadareinstructedtopaythemselves“reasonablecompensation”andmustpayemploymenttaxesuponthatamount,likeanyotheremployee.ThisdifferentialtreatmentprovidesincentivesforshareholdersofScorporationstounderreporttheircompensationandinsteadre-ceivetheirbusinessincomeasdistributionsthatarenotsubjecttoemploymenttax.ThismayresultinlowereffectivetaxratesonshareholdersinScorporationsandmembersofLLCsthaninotherbusinessesortheself-employed.Atpresent,generalpartnerspayemploymenttaxon100percentoftheiractiveearningswhileothertypesofownersmaypaylittleornothing.

The proposal and its advantages: Thisoptionwouldrequireallpartners,LLCmembers,andScorporationshareholderstopayself-employment taxes(SECA)onthedistributions fromtheirbusinesses(other thanthosewhodonotmateriallyparticipateinthebusiness).ThiswouldessentiallyapplythesametaxtreatmenttoLLCmembers,limitedpartners,andScorporationshareholdersthatcurrentlyappliestotheselfemployedandtogeneralpartners.(Exclusionsincurrentlawforspecifiedtypesofincomeorlosssuchasinterestandrentalincomewouldremainineffect.)Thiswouldimprovetheequityandfair-nessinthetaxsystembytreatinggeneralpartners,limitedpartners,LLCmembers,Scorporationshareholders,andself-employedworkersequally.

The proposal would raise considerable revenue—perhaps $50 to $60 billion over ten years—bylimitingtheunderreportingofreasonablecompensationbyScorporationshareholders,thelackofemploymenttaxclarityforLLCmembers,andthepotentialfortaxavoidancebylimitedpartners.

Inaddition,thisoptionwouldeliminatethedifficult-to-administerconceptof“reasonablecom-pensation”formosttaxpayersandwouldclarifyandsimplifyrulesforLLCmembersandlimitedpartners.Theproposalalsoeliminatesemploymenttaxesasadistortioninthechoiceoforganiza-tionalform.

Disadvantages:Therevenuesraised fromtheproposalwouldcomeprimarily fromownersof smallbusinesses.Moreover,itwouldimposeemploymenttaxesonincomethatispartiallyareturnoncapitalratherthanareturnonlabor.Providinganexclusionforinvestedcapitalispossible,butcouldbedifficultandcomplicatedtocalculateandadminister.

h. Option 6: Voluntary Disclosure ProgramsVoluntarydisclosureprogramsortemporarytaxamnestieshavebeenproposedasameanstobringnon-complianttaxpayersbackintothetaxsystem,andincreasefuturecomplianceandrevenues.Undersuchprograms,taxpayerswhovoluntarilycomeintothetaxsystemandpaythetaxestheyowewouldbesubjecttoreducedpenaltiesorinsomecasesnopenaltiesatall.Stategovernmentsandmanyforeigngovernmentshaveusedamnestiesinthepast,andthefederalgovernmentre-centlyprovidedaperiodofvoluntarydisclosurefortaxpayershidingincomeabroad.


The proposal and its advantages: Theseprogramscouldincreaserevenuesintheneartermandimprovefuturecompliancebybring-ingtaxevadersbackintothesystemandinformingtaxadministratorsabouttaxevasionpractices.Themosteffectiveprogramsgenerally involve increasedfutureenforcementorpenalties todis-couragetaxpayersfromwaitingforthenextvoluntaryprogram.

Disadvantages:Inpractice,theevidenceontheseprogramsismixed.Moststates(andcertainforeigncountries)haveofferedmultipleprograms,whichmayactuallyprovideincentivesforcontinuedevasiontotheextentthattaxpayersbelievetheywillbeforgiveninthefuture.Theexperienceofstatesisthatmosttaxpayersusingtheseprogramswerealreadyfilingtaxesandonlyamendedoldreturns;fewnewtaxpayerswerebroughtin.Eventherevenuesupposedlyreceivedfromamnestiesissubjecttodebate.Muchamnestyrevenuemerelyrepresentsacceleratedreceiptofrevenuethatwouldhavebeenpaid laterastheresultofenforcementactivities,andthebenefitsofamnestiesforrevenuepurposesarereducedbytheforgivenessofinterestandpenaltiesthatwouldotherwisebereceived.

i. Option 7: Examine Multiple Tax Years During Certain Audits

Currently,thestatuteoflimitationforauditingindividualsandbusinessesextendsbackonlythreeyears.Giventhelonglagininformationgatheringandprocessing,auditorsmaybeabletoinves-tigateonlyoneyearoftaxrecordsbeforethelimitrunsout,evenifnoncomplianceisdiscoveredthatmighthaveoccurredinprioryearsaswell.Thelimitcanbeextendedbacktosixyearsifnon-compliancegreaterthan25percentoftotalliabilityisfound,butthisisahighthreshold.Thusanauditorwhodiscoversapatternofnoncompliancethatwaslikelytohaveoccurredinmanyyearscannotlookforthatpatterninpriorreturns.

The proposal and its advantages: Multi-yearauditsaregenerallyusedforlargerbusinesses.Expandingtheirusetosmallerbusiness-esandindividualswouldreducenoncomplianceandwouldenabletheIRStouseauditresourcesmoreefficiently.Inaddition,alongerstatuteoflimitationswherethereareadjustmentsbyastatethatcouldaffectfederalliability,asproposedintheAdministration’sBudget,wouldalsofacilitatemulti-yearauditsandcouldincreaseIRSauditefficiency.Anotheroptionistolowerthethresholdfor IRS auditors to re-open earlier returns when they have found noncompliance. The currentstandardisquiterestrictivesothatIRSagentsarerarelyabletogobackbeyondthethree-yearopenperiod.

Disadvantages:Alongerstatuteoflimitationscouldbemoreburdensomefortaxpayersrequiredtokeeprecords.AnextensionwithoutconditionsmightbeseenasreducingtheincentivefortheIRStoinitiateandresolveenforcementactionspromptly.


j. Option 8: Extend Holding Period for Capital Gains Exclusion on Primary Residences

Homeownersmayexcludeupto$500,000($250,000forasingleindividual)ofcapitalgainfromthesaleofprincipalresidencesprovidedthehomewastheirprincipalresidenceintwoofthelastfiveyears,andtheexclusionmaybeusedeverytwoyears.Therelativelyshortholdingperiodrequire-mentoftwoyearsandthepotentialforrepeatuseeverytwoyearsinvitesabuseoftheprovision.Some homeowners may seek to convert rental or vacation properties into principal residences.Buildersorserialfixer-upperspecialistsmayalsousetheprovisiontogettax-freeearningsfrombuildingorremodelinghomesbylivinginthemfortwoyears.

The proposal and its advantages: The2005TaxReformPanelandexpertsweheardfromproposedlengtheningtherequiredholdingperiodtothreeyearsoutofsix,orfouryearsoutofseven,andalsoincreasingthetimebetweenuses.Alongerholdingperiodwouldlimitabuses.Taxpayersinhardshipsituationswouldstillbeeligibleforapro-ratedmaximumexclusionifforcedtosellduetodeathofaspouse,divorce,jobchangeorotherreasonscurrentlyallowedbyIRSregulations.Otherstudieshavesuggestedim-provedinformationreportingofprincipalresidencesalescouldimprovecompliance.Thischangecouldbeimplementedinconjunctionwithincreasingorindexingthemaximumexclusionasdis-cussedearlierundersimplificationoptions.

Disadvantages:Lengtheningtheholdingperiodcouldincreasetaxesonsometaxpayerswhomovemorefrequentlybutdonotqualifyforoneoftheexceptions.


IV. CORPORATE TAX REFORMTheUnitedStateshasthesecondhigheststatutorycorporateincometaxrateintheOrganizationforEconomicCo-operationandDevelopment(OECD)behindJapan.Despitethehighstatutoryrate,theaverageeffectivetaxratepaidbycorporationsisclosetotheOECDmedian,andthecor-poratetaxraisesrelativelylittlerevenue—thefourthlowestintheOECDasashareofGDP.Onereasonforthisapparentincongruityisthatthecorporatetaxbaseisrelativelynarrowcomparedtothesizeofthebusinesssector.Abouthalfofbusinessincomenowaccruesto“pass-through”entitieslikeScorporationsandpartnerships;althoughtheincomeofsuchpass-throughentitiesissubjecttotaxattheindividuallevel,itisexcludedfromthecorporatetax.Inaddition,thebusinesstaxsystem—whichoftenappliestonon-corporatebusinessesaswellascorporatebusinesses—hasnumerousprovisionsforspecialdeductions,credits,andothertaxexpendituresthatbenefitcertainactivities.Theseprovisionsreducetheeffectivetaxratebelowthestatutoryrate.

Thecombinationofahighstatutoryrateandnumerousdeductionsandexclusionsresultsinanin-efficienttaxsystemthatdistortscorporatebehaviorinmultipleways.Thehighstatutorycorporatetaxratereducesthereturntoinvestmentsandthereforediscouragessavingandreducesaggregateinvestment.Base-narrowingfeaturesofthebusinesstaxsystemcreateincentivesthatfavordebtoverequity,encourage investment intax-favoredequipmentandcertainotherassetsoverotherkindsofinvestment,anddrivecapitaloutofthecorporatesectorintonon-corporateformsofbusi-ness.AdditionalinefficienciesresultfromthewaytheU.S.taxestheforeignincomeofU.S.multi-nationalcorporations(MNCs),andfromdifferencesbetweentheU.S.approachandthewayothernationstaxtheforeignincomeoftheircompanies.

Distortions in thecorporate tax systemhavedeleteriouseconomicconsequences. Becausecer-tainassetsandinvestmentsaretaxfavored,taxconsiderationsdriveoverinvestmentinthoseas-setsattheexpenseofmoreeconomicallyproductiveinvestments.Becauseinterestisdeductible,corporationsareinducedtousemoredebt,andthusbecomemorehighlyleveragedandtakeonmoreriskthanwouldotherwisebethecase.Becausethecorporatetaxresultsinhighereffectiveratesoncorporatebusinesses,businessactivityandinvestmentareshiftedtonon-corporatebusi-nesseslikepartnershipsandScorporations,ortonon-businessinvestmentslikeowner-occupiedhousing.8BecauseMNCsdonotpayincometaxesonincomeearnedbyforeignsubsidiariesuntilthatincomeisrepatriated,thosefirmshaveincentivestodeferrepatriation,toshifttaxableprofitstolow-taxjurisdictions,andtoengageincostlytaxplanning;nevertheless,thesystemofinterna-tionaltaxationmakesU.S.MNCslesscompetitiveinforeignmarketsandevenathome.Becauseofitscomplexityanditsincentivesfortaxavoidance,theU.S.corporatetaxsystemresultsinhighadministrativeandcompliancecostsbyfirms—costsestimatedtoexceed$40billionperyearormorethan12percentoftherevenuescollected.AllofthesefactorsacttoreducetheproductivityofAmericanbusinessesandAmericanworkers,increasethelikelihoodandcostoffinancialdistress,anddrainresourcesawayfrommorevaluableuses.Mostofthesedistortionsalsoaffectbusinessesbeyondthecorporatesector.

8 Thereducedindividualincometaxrateondividendsandcapitalgainsprovidespartialrelieffromthecombinedeffectsoftheindividualandcorporateincometaxesontheafter-taxreturnstoinvestmentinthecorporatesector.


Theexpertswespoketobelievethatthecurrentcorporatetaxsystemisdeeplyflawedandinneedofreform.Weheardrepeatedlythatreformsthatmovethebusinesstaxsystemfromonewithahightaxrateandanarrowtaxbasetoonewithabroadertaxbaseandalowertaxratecouldcorrectanumberofdistortionsassociatedwiththecurrentsystem.Wealsoheardfrombusinessrepre-sentativesthatthedistinctiveU.S.approachtotaxingtheforeignincomeofU.S.multinationalswasputtingthematacompetitivedisadvantageintheirforeignoperations.Someexpertsandbusinessrepresentativesarguedthatmovingtowardaterritorialsystemlikethatusedbymostotherdevel-opednationscouldreducethisdisadvantage,whileothersadvocatedaworldwidetaxsystematalowerratetoachievethesameobjective.

a. Overview of the Corporate SystemU.S.corporationspaytaxesontheirtaxableincome—totalreceiptsminuscostsofdoingbusinessandotherdeductionsincludingwages,rawmaterialsandsupplies,depreciation,andinterestex-pense—onaprogressivescalewithatopstatutoryfederalrateof35percent.Statecorporatetaxesincreasetheaverageoveralltopstatutoryratetojustover39percent.Comparedtootherdevelopedcountries,theU.S.statutorytaxrateishigh:themedianstatutorycorporateratein2009amongOECDcountrieswas28percent.

However,theeffectivefederaltaxrateonnewinvestmentsbycorporationsisactuallylowerthan35percentbecauseoftaxcreditsanddeductionsthatreducetaxesowed.Afterfactoringinthesedeductionsandthebenefitsoffinancinginvestmentsusingdebt,theoveralleffectivemarginaltaxrateonnewinvestmentsinthecorporatesectorisabout29percentaccordingtoonerecentTrea-surystudy.

Thisrateisstillhigherthanthetaxrateoncomparableinvestmentsbynon-corporatebusinessesoronothernon-businessinvestments, inpartbecausebusinessincomeearnedbybusinessesincorporateformissubjecttotwolayersoftaxation:corporationspaytaxontheircorporateincomeand then individualspay taxondistributions fromcorporations (ondividendpayments)oronthecapitalgainsfromappreciatedcorporatestock. Incontrast,businessincomeearnedbysoleproprietorships,partnerships,andScorporationsis“passedthrough”tothetaxreturnsofthebusi-nessowners.Althoughsuchpass-throughbusinessesgenerallycalculateincomeinthesamewayascorporations(usingthesameaccountingrulesandbenefitingfromthesamedeductionsandcredits),iftheownersareindividuals,thebusinessincomefromthesesourcesistaxedonlyonceattheindividuallevel.

Oneresultofthissystemisthattaxburdensoncapitalincomeinthenon-corporatesector(i.e.,businessesnotoperatedthrough“Ccorporations”)arelowerthaninthecorporatesector.9Thisfavorsnewinvestmentsandnewbusinessformationinnon-corporatebusinessesrelativetocorpo-ratebusinesses.Indeed,businessincomeaccruingtothesenon-corporatebusinesseshasincreased

9 Economistsgenerallybelievethatpartoftheburdenofthecorporateincometaxisultimatelyshiftedtoownersof other types of capital, including the owners of pass-through businesses organized as partnerships, LLCs orsoleproprietorships.Thisshiftingoccursbecausetheshiftofinvestmentfromthecorporatesectortothenon-corporatesectorreducestherateofreturninthenon-corporatesectorandthusreducestheafter-taxreturnsofthosebusinessowners.


overtime,andtheyaccountedforabouthalfofallnetbusinessincomein2007,upfromabout20 percentin1980.In2004amongasampleofOECDcountries,theU.S.hadthehighestshareofbusinesseswithprofitsof$1millionormorethatwerenotincorporated(66 percentintheU.S.comparedto27percentinMexico(thesecondhighestshare)and26 percentintheU.K.).

Anotherfeatureofthecurrenttaxsystemisthatinterestpaidbybusinesses(bothcorporateandnon-corporate)isdeductible,butdividendpaymentsarenot.Thusbusinesseshaveincentivestofavordebtfinanceratherthanequityfinance,evenaftertakingintoaccountthepersonalincometax,whichtaxesinterestincomemoreheavilythandividendsandcapitalgains.Thecurrentsystemthereforeresultsinhigheffectivetaxratesonequity-financedinvestmentsandloweffectiveratesondebt-financedinvestment.Thisprovidesincentivesforbusinessestofinancenewinvestmentswithdebt,andtomaintainahigherlevelofdebtintheircapitalstructure,increasingthelikelihoodoffinancialdistressandbankruptcy.

Manyadditionalinefficienciesresultingfromthecorporatetaxsystemarisefromprovisionsthatconferfavorabletreatmentoncertainbusinessactivitiesorexpendituresbutnotonothers. Forexample,thecostofinvestmentsinplantandequipmentarerecoveredovertimethroughdeprecia-tionallowanceswhereasinvestmentsincertainintangibleassetslikeresearchanddevelopmentandadvertisingaredeductedimmediately.Depreciationschedulesforsometangibleassetsreflectde-preciationratesthatarefasterthantrueeconomicdepreciation(therealdeclineintheasset’svalueovertime),whilethoseforotherassetsreflectslowerrates.Incomefromcertainactivitiesisalsotaxedatlowerratesbecauseofaspecialdeductionfordomesticproductionactivities.Businessesmayalsoclaimtaxcreditsforcertainactivities,forexample,forresearchandexperimentationorforlow-incomehousinginvestment. Asaresultoftheseandotherspecialprovisionsinthetaxcode,incomefromdifferenttypesofassetsistaxedatverydifferentrates.Moreover,thecorporatetaxandotherbusinesstaxesshiftcapitalfrommanufacturingandservicestoowner-occupiedrealestate,whichissubsidizedinotherwaysbythetaxsystem.Whilemostofthesediscrepanciesaffectbothcorporateandnon-corporatebusinesses,theireffectismagnifiedfortheformerasaresultoftheadditional,entity-leveltaxationforsuchbusinesses.

Overall,thecurrentcorporatetaxsystemcontainsnumerousprovisionsthatencouragebusinessestoinvestincertainkindsofassetsortoengageincertainkindsofactivitiesfortaxreasonsratherthanforreasonsofeconomicefficiency.

Table7showstheeffectivemarginaltaxrates—thetaxratesthatapplytoanadditionaldollarofinvestmentinvarioustypesofassets—thatresultfromthecurrentsystemasestimatedinarecentTreasurystudy.Thetableshowsthatcorporatebusinessesfacehighereffectivemarginaltaxratesthannon-corporatebusinesses;thatequity-financedcorporateinvestmentsfacemuchhighereffec-tivemarginaltaxratesthandebt-financedinvestments;andthattheeffectivemarginaltaxrateonowner-occupiedhousingisclosetozero.Withincorporatebusinesses,taxratesalsovarysignifi-cantlybyassettypeand,aswillbeseenlater,evenonanasset-by-assetbasis.


Table 7: Marginal Effective Tax Rates on New Investment

Effective Marginal Tax Rate

Business 25.5%

Corporate Business 29.4%

Asset Type

Equipment 25.3%

Structures 34.2%

Land 32.9%

Inventories 32.9%

Financing

Debt financed -2.2%

Equity financed 39.7%

Non-corporate Business 20.0%

Owner-occupied housing 3.5%

Economy wide 17.3%

Source: Treasury Conference on Business Taxation and Global Competitiveness:BackgroundPaper.U.S.DepartmentoftheTreasury,OfficeofTaxAnalysis2007.

TheU.S. systemfor taxing the foreign-earned incomeofdomesticcorporations isalsoasourceofinefficiency.TheU.S.taxestheforeign-earnedincomeofdomesticcorporationsnotwhentheincomeisearnedbutwhentheresultingprofitsarerepatriatedtotheUnitedStates.However,theU.S.statutoryrateishighcomparedtootherOECDcountries,whichhavereducedtheirstatutoryrates(asseeninFigure4)andhaveoffsetsomeoftherevenuelossbybroadeningthecorporatetaxbase.

Figure 4: Top Statutory Corporate Tax Rates U.S. and OECD

20

25

30

35

40

45

50

55

1981 1985 1991 1996 2001 2006

United States

Median OECD

Average OECD

Notes: Selection of OECD countries with data available from 1981 to 2009. OECD average is weighted by 2007 GDP in PPP excluding U.S. Corporate tax rates include both national and subnational taxes. Source: OECD

Per

cen

t

Year

Notes:SelectionofOECDcountrieswithdataavailablefrom1981to2009.OECDaverageisweightedby2007GDPinPPPexcludingU.S.Corporatetaxratesincludebothnationalandsubnationaltaxes.Source:OECD.


Asa resultof thesedifferencesbetween theU.S.and theOECDcountries,U.S.firmsoperatingabroadreportthattheyoftenfacehighereffectivetaxratesontheiroverseasactivitiesthanforeigncompetitorfirms.InadditiontoaffectingtheinternationalcompetitivenessofU.S.firms,thegrow-inggapbetweentheU.S.corporatetaxrateandthecorporatetaxratesofmostothercountriesgen-eratesincentivesforU.S.corporationstoshifttheirincomeandoperationstoforeignlocationswithlowercorporatetaxratestoavoidU.S.taxes.Overtimeascorporatetaxrateshavefallenaroundtheworld,theseincentiveshavebecomestronger.

Animportantconsiderationwhenaddressingtheaboveissuesthroughreformistheproblemoftransition.Manyoftheproposalsdiscussedbelowresultinshiftingtaxburdens,withcertainbusi-nessesfacinghighertaxburdensandothersfacinglowerones.Thosefacinghigherburdenswillnaturallyseekrelief.However,transitionrelieftoaddresssuchissuescoulddecreaserevenuesorcouldreducethegainsfromsuchchangesiftransitionreliefnecessitatedhighercorporatetaxratestomaintainoverallcorporatetaxrevenues.

b. Option Group A: Reducing Marginal Corporate Tax Rates

Thehigheffectivetaxratesthatapplytocorporateinvestmentsresultinsignificanteconomicdis-tortionsandalowertaxrateoncorporateinvestmentswouldresultindesirablechangesinanum-berofareas.Thetwomostfeasibleandeffectivewaystoreducethetaxrateoncorporateinvest-mentsaretoreducethestatutorycorporatetaxratedirectlyortoincreasethevalueofdeductionscorporationsmaytakefornewinvestment. BecausethehighstatutorycorporatetaxrateintheU.S.causesorexacerbatesmanydistortionsinthecurrenttaxsystem,loweringtheratewouldre-ducetheseinefficiencies.Alternatively,providingaccelerateddepreciationorimmediateexpensingofcorporateinvestmentswouldresultinsimilarimprovementsinefficiency. Reducingeffectivemarginaltaxrateswithoutsignificantrevenuelosseswouldrequireapplyingthetaxtoabroaderincomebase,andadiscussionofoptionstobroadenthebaseareincludedinOptionGroupB.

i. Option 1: Reduce the Statutory Corporate Rate

The proposal and its advantages:Inthisoption,thetopstatutorycorporatetaxratewouldbeloweredfrom35percent.Eachper-centagepointdecreaseinthecorporatetaxratereducescorporatetaxrevenuesbyabout$120 bil-lion over 10 years.10 In a revenue-neutral reform, these revenue losses could be offset by basebroadeningmeasureslikethosedescribedinOptionGroupB.

Loweringthetopratewouldreducethecostofanumberofsignificanteconomicdistortions.Intheaggregate,alowercorporateratewouldlowertheoveralltaxoncapital,encouragingsavingandnewinvestment.Theadditionalsavingandinvestmentbycorporationswouldincreasethestock

10 Thisexerciseassumesthatthetoptwocorporatetaxbracketrates(currently34percentand35percent)areeachreducedbyonepercentagepoint.


ofavailablecapital—newbusinesses,factories,equipment,orresearch—improvingproductivityintheeconomy.

Reducingthecorporateratewouldalsoreducetherelativeadvantagesofalternativeinvestments.Thisisimportantbecauseinvestmentdecisionsshouldreflecttheireconomicreturnratherthantheirtaxadvantages.First,alowerratewouldhelpleveltheplayingfieldacrosscorporateandnon-corporateinvestmentandwouldreducetheincentiveforbusinessestoorganizeinnon-corporateforms.Thiswouldcontributetoamoreefficientallocationofresourcesbetweenthecorporateandnon-corporatesectorsandcouldencouragetheexpansionofthecorporatesectorwithresultantincreasesincorporatetaxrevenuesoverthelongterm.Second,alowercorporatetaxratewouldreducetherelativeadvantageofinvestmentsinnon-businessassetslikeresidentialrealestate.Resi-dentialrealestateisalreadyheavilytaxadvantaged,andmanyexpertsbelievethatasaresultofthese taxsubsidies, investments inowner-occupiedrealestateprovidea lowereconomicreturnthaninvestmentselsewhere.Third,alowercorporatetaxratewouldreducetheincentivetousedebtratherthanequitytofinancenewinvestments.Thiscouldresultinlowerdebtlevels,reducingthelikelihoodoffinancialdistressatover-leveredfirms,andresultinginloweraggregaterisksfromcorporatebankruptcies.Finally,intheinternationalcontext,alowercorporateratewouldlowerthecostofcapitalforAmericanfirms,makingthemmorecompetitiveinrelationtoforeignfirmsbothabroadandathome.ItwouldalsoreducetheincentivesofU.S.companiestoshiftoperationsabroad and to structure their operations and finances to shift profits to lower-tax jurisdictionsabroad,orforforeigncompaniestoacquireU.S.companiesortheirforeignsubsidiaries.

Disadvantages:Areductioninthecorporatetaxratewouldhaveseveraldisadvantagesaswell.First,asalreadynoted,itwouldreducetaxrevenuessignificantly,andthisrevenuewouldneedtobereplacedtoavoidincreasingthefederaldeficit.Second,itwouldreducetaxesoninvestmentsalreadymadebyexistingcompanies.Asaresult,comparedtoothermoretargetedtaxcutstoencourageinvestment,areductioninthecorporatetaxratewouldhaveasmallerincentiveeffectonnewinvestmentperdollaroftaxrevenuelost.Third,loweringthecorporateratetoalevelwellbelowthetopindividualincometaxratecouldencourageboththeshiftingofincomefromtheindividualincometaxbasetothecorporatetaxbaseandtheshelteringofincomeincorporations,althoughtheincentiveofindividualstoshiftincomewouldbelimitedbythedoubletaxationwhentheywanttoconsumethosefunds.11

11 Forexample,ifthetopindividualtaxrateincreasedto39.6percentandthetopcorporateratefelltobelow30 per-centorso,someindividualswouldfinditadvantageoustoreorganizetheirbusinessactivitiesasCcorporations.Thiswouldallowthemtopaythelowercorporatetaxrateontheirbusinessearningsandtodeferpaymentoftaxattheindividualrateuntiltheearningsweredistributedorthestockofthecorporationweresold.Deferralwouldreducethepresentvalueoftheindividualincometaxliability.Moreover,thetaxcouldbeeliminatediftheindi-vidualheldthestockforlife,becausethetaxbasisofthestockwouldbesteppeduptothefairmarketvalueuponthedeathoftheindividualshareholder.Whileexistinglawlimitstosomeextenttheabilitytoaccumulateearningsinacorporation,additionalsafeguardscouldberequiredtopreventrevenuelossifthedisparitybetweencorporateandindividualratesweresufficientlylarge.


ii. Option 2: Increase Incentives for New Investment/Direct Expensing

The proposal and its advantages: Reducingthetaxburdenonlyfornewinvestmentisanalternativeapproachtoreducingtheeffec-tivetaxrateoncorporateincome.Businessescouldbeallowedto“expense”alloraportionoftheirnewinvestmentimmediately—i.e.todeductthecostofinvestmentagainsttaxableincomeintheyeartheinvestmentwasmadeinsteadofrecoveringitgraduallyovermanyyears.Thebusinesstaxsystemalreadyallowsanumberofvariantsofthisideathroughaccelerateddepreciation(allowingbusinessestotakedepreciationallowancesfasterthanimpliedbytrueeconomicwearandtear)andtemporarybonusdepreciation(allowingfirmstoimmediatelyexpense50percentofnewinvest-mentduringthepreviousrecession);smallerbusinessesarealsocurrentlyallowedtoimmediatelyexpensecertaininvestmentsuptoalimit.Infact,theseprovisionsarethelargesttaxexpenditureforbusinesses:priortotherecession,aTreasurystudyestimatedthataccelerateddepreciationandexpensing provisions (excluding temporary provisions enacted for economic stimulus) reducedrevenuesbymorethan$660billionovertenyears.

Inadditiontomanyoftheadvantagesofcuttingthecorporatetaxratedescribedabove,expensingcouldprovidemore investmentperdollarof taxrevenue lost thansimplycuttingthecorporateratebecause“oldcapital”wouldnotreceiveataxbreak.Providingexpensingforphysicalcapitalwouldalsoeliminatethedifferentialtaxtreatmentbetweeninvestmentsinphysicalcapital,whicharecurrentlydeductedovermanyyears,andinvestmentsincertainintangiblecapital(likeresearchanddevelopment,oradvertising),whichbusinessescancurrentlydeductimmediately.Immedi-ateexpensingofinvestmentalsohascashflowbenefitsforbusinessesbecausethetaxdeductionisreceivedinthetaxyearinwhichaninvestmentismaderatherthaninfutureyears.Intheinterna-tionalcontext,lowerratesonnewinvestmentswouldmaketheU.S.moreattractiveforforeignanddomesticinvestors.

Disadvantages:Expensingwouldreducerevenuesbyallowingfirmstodeductthecostoftheirinvestmentsmorerapidlyagainsttheirtaxableincome.Someindustrieswouldbenefitmorethanothersfromthistreatment: some argue that expensing would disproportionately benefit capital-intensive indus-triesthatmakesignificant investments inphysicalcapitalcomparedtohigh-techindustriesandindustriesthatprimarilyinvestinintangibleandintellectualcapital.Butitisthecapitalintensiveindustriesthatarerelativelydisadvantagedbythehighcorporatetaxrateandtheirdifferentialtaxtreatmentinthecurrentsystem.Allowingexpensingfornewinvestmentwouldlowerthevalueofexistingassetsbecauseexistingcapitalwouldnotbenefitfromexpensingandwouldhavetocom-petewithnewcapitalthatdoes.

Allowingforimmediateexpensingofnewinvestmentwhileretainingthedeductibilityofinterestwouldmaintainorcouldevenincreasetheincentivesfordebtfinancinginthecorporatetaxsys-tem.Thisdisadvantagecouldbemitigatedbyreducingthedeductibilityofnetinterestasdiscussedbelow.


Businessownerscommonlyregardexpensingasalessattractiveorpowerfulincentiveforinvest-mentthanareductioninthetaxrateontheirbusinessincome.Expensingprovidesonlyatempo-raryreductionintaxessinceitonlyacceleratesthesameamountofdeduction.Underaccountingrules,thismeansthatexpensingwouldnotallowabusinesstoshowanyincreaseincurrentearn-ingssinceanoffsettingallowanceismadefortheadditionaltaxestobepaidlater.Inaddition,somebusinesspeoplearguethatanimportantpartoftheincentivetoinvestisthepursuitofanabove-normalrateofreturn. Whilea lowercorporate taxratewould increasethe incentivetopursueabove-normalreturns,theexpensingofnewinvestmentwouldnot.

Finally,allowingfortheexpensingofnewinvestmentoraccelerateddepreciationonnewinvest-mentsdoesnotaddressissuesrelatedtothetaxtreatmentofforeignsourceincomethewaythatratereductiondoes,becauseMNCswouldstillfacehighertaxesontheiroperationsabroadthanwouldtheirinternationalcompetitors.

c. Option Group B: Broadening the Corporate Tax BaseEliminatingorlimitingdeductions,credits,andotherbase-narrowingfeaturesofthecorporatein-cometaxwouldallowforalowercorporaterateandcouldimprovetheincentivesinthetaxsystem.Whenothercountriesreducedtheircorporatetaxratesoverthepastdecade,theyusuallyoffsettherevenuelosswithmeasurestobroadenthetaxbasethroughtherepealorreductionofvarioustaxcreditsanddeductions.(Theyalsoincreasedrevenuesfromothersources.)Asaresult,theU.S.corporatetaxbaseisnownarrowerthaninmanyothercountries.Ourdiscussionswithexpertsidentifiedseveralwaystobroadenthecorporatetaxbasethatwouldallowthesameamountoftaxrevenuetoberaisedwhileloweringthecorporatetaxrate.Inaddition,abroadertaxbasewouldmakethecorporatetaxmoreneutralacrossinvestmenttypesandsectorsofeconomicactivity,andthisisanimportantgoalinitselfbecauseitreduceseconomicdistortions.

Broadeningthecorporatetaxbase,however,ismoredifficultthansimplyeliminating“loopholes,”ortaxprovisionsthatcorporationsusetoavoidthetaxeslawmakersintendthemtopay.Infact,mostprovisionsthatnarrowthecorporatetaxbaseareintentional—deductions,credits,orotherprovisionsenactedtoreducetaxesforcertainbusinessesorindustriesorcertainactivitiesthatareoftenreferredtoas“taxexpenditures”andshouldbedistinguishedfrom“loopholes.”Incontrasttotheindividualtaxcode,whichincludesmanysizabletaxexpenditures,therearearelativelysmallnumberofpotentialchangestothecorporatetaxcodethatcouldbroadenthecorporatetaxbasesignificantly.Weconsideredafewofthelargebase-broadeningchanges(eachofwhichcouldbescaledupordowninsize).Andwealsoconsideredafewspecifictaxexpenditurestogivesomeex-amplesandtoshowhoweliminatingtheseexpendituresindividuallywouldnotraiselargeamountsofadditionalrevenueandwouldneedtobecombinedtohaveameaningfulimpactonrevenues.

i. Option 1: Provide More Level Treatment of Debt and Equity Financing

Thetaxcodeencouragesdebtrelativetoequity.Corporatedividendspaidarenotdeductibleatthecorporatelevel.Incontrast,corporationscandeductinterestpayments.Consideraninvestment


thatrequires$1,000todayandwillpayoff$1,100inthefuture.Iffinancedbyequity,acorporationwouldpay$35intaxes(35percentonthe$100profit)andpayout$65asadividendtosharehold-ers.Iffinancedbyborrowingat10percent,thecorporationwoulddeduct$100ininterestpay-mentsmadetothedebtholderagainstthe$100profit—resultinginzerocorporatetaxes.Indeed,thecombinationofthedeductibilityofinterestanddepreciationreducesthecostofdebtcapitaltowhat itwouldbewithnocorporate tax. Whencombinedwithaccelerateddepreciationandotherprovisions,however,thedeductibilityofinterestmakesthecostofcapitalevenlessthanitwouldbewithnocorporatetax.Infact,accordingtoTreasurystudies,forcertainfirmstheeffec-tivemarginaltaxrateondebt-financedinvestmentisnegative(theinvestmentsaresubsidized)asdeductionsforinterest,togetherwithdeductionsforitemssuchasaccelerateddepreciation,morethanoffsettheincomegeneratedfromdebt-financedinvestment.Incontrast,theaveragetaxrateonequityfinancedinvestmentismuchhigherandstillpositiveevenwithaccelerateddepreciation.

The proposal and its advantages: Limitingthedeductibilityofnetinterest(i.e.,theexcessofinterestexpenseoverinterestincome)wouldbroadenthetaxbaseandprovidemoreleveltreatmentofdebtandequity.Asanillustrativeexample,oneoptionwouldbetolimitthedeductibilityofnetinterestto90 percentofexpenseinexcessof$5 millionperyear(i.e.abusinesswith$15millionofinterestexpensewouldbeallowedtodeductthefirst$5millionandthen$9million(90 percent)oftheremaining$10million).Ignor-inglikelybehavioralresponses,arough(static)computationsuggeststhatthisproposalwouldraisecorporatetaxrevenuesbyenoughtoreducethecorporateratebyabout0.7 percentagepoint.Ifthesamerulesappliedtonon-corporatebusinesses,revenueswouldbeincreasedsomewhatmore.

Alimitationonnetinterestdeductibilitywouldlessenthebiasagainstequityfinancingandcouldreducedependenceondebt,therebyreducingtheleverageoffirmsandthelikelihoodoffuturefi-nancialdistress.Limitingthedeductibilityofnetinterestwouldalsoleveltheplayingfieldtosomeextentbetweenbusinessprojectsfinancedbydebtandbusinessprojectsfinancedbyequityandbetweenfirmsthathaveeasyaccesstodebtfinancingandthosethatdonot.

Ifthedeductibilityofnetinterestexpensewerelimited,MNCswouldhaveareducedincentivetoshiftborrowingtotheU.S.toreducedomestictaxliability.Inthecurrentsystem,MNCscanraisedebtcapitalinU.S.markets,deducttheinterestexpenseatthe35 percentU.S.rateagainsttaxableU.S.earnings,andinvesttheproceedsabroad,andtheearningsfromthatinvestmentcanbede-ferredandcanavoidU.S.taxationindefinitely.

Someothercountries impose limitsonthedeductibilityof interestexpense. Forexample,Ger-manyimposesalimitonnetinterestexpense.Interestexpensegenerallyisalloweduptothelevelofinterestincomereceived.Abovethat,interestexpenseinexcessof30 percentofearningsisdisal-lowedsubjecttoanumberofexceptionsincludinga“smallbusiness”exception.

Theintroductionofalimitonthedeductibilityofnetinterestexpensewouldrequireconsiderationofthetreatmentofsmallfirms,whichrelymoreheavilyondebtfinancing;oneoptionwouldbetoimposethelimitationonthedeductibilityofinterestexpenseonlyabovesomethreshold—likethe$5millionthresholdintheexampleabove.(Iftheinterestratewere5 percent,a$5millionthresh-oldwouldexemptabusinesswithasmuchas$100millionindebt.)Furthermore,policymakers


wouldneedtodecidewhethertoapplyaninterestlimitonallbusinessentitiesoronlyoncorpora-tions.Theadvantagesofapplyingthelimittoallbusinessesaresimilartothoseforcorporations—suchasalowerrelianceondebt,reducedriskofbankruptcy,andhigherrevenues.Inaddition,ap-plyingthesamerulestoallbusinesseswouldreducetheoptionsfortaxavoidanceortaxarbitrage,andharmonizedruleswouldbesimplertoenforce.OthertypesoflimitsoninterestdeductionssometimesproposedincludedenyingtheinterestdeductionfortheinflationarycomponentoftheinterestrateandlimitingtheinterestdeductiontotheinterestrateonTreasurysecuritiesonthegroundsthathigherinterestratesrepresentahigherriskpremiumthatismorelikeanequityre-turn.Theeffectsofdifferentkindsoflimitsoninterestdeductionswouldhavetobestudiedmorecarefullyfortheirpossibleeconomicconsequences.

Disadvantages:Limitingthedeductibilityofnetinterestwouldhavedifferenteffectsondifferentsectors,raisingtaxesmoreforsomethanforothers.Forexample,limitationsonnetinterestwouldyieldhighertaxburdensonmanufacturersandutilities,whicharefirmswithsignificantinvestmentsinphysi-calcapitalthatarefrequentlydebtfinanced.Anabruptchangethatdisallowedsomeorallinterestexpensewouldhave significant short-term impactson theprofitabilityoffirms relyingondebtfinancing.Thusthetransitionfromthecurrentsystemtoasystemwithlimitationsonnetinterestdeductionswouldbedifficultforfirmswithdebtintheircapitalstructure,andtransitionalreliefandaperiodoftimeforfirmstoadapttheircapitalstructurecouldbeappropriate.Smallbusi-nessesalsorelyheavilyondebtfinancing,andlimitinginterestexpensedeductionscouldreducetheiraccesstocapitalanddiscouragetheformationofnewfirms.Allelseequal,likeotherbase-broadeningmeasures,limitingthedeductibilityofnetinterestwouldincreasetheeffectivetaxrateoncapitalinvestmentsunlessoffsetbyalowercorporatetaxrate.Finally,limitingdeductionsforinterestexpensewouldcreateincentivesforfirmstoreplaceinterestexpensewithotherexpenseslikeleasingarrangements,whichachievethesameeffectbutwhichwouldremaindeductibleex-penses.

ii. Option 2: Review the Boundary Between Corporate and Non-Corporate Taxation

Anotherfactorthathascontributedtotheerosionofthecorporateincometaxbasehasbeenthegrowthofnon-corporatebusinesses(non-Ccorporations)includingpartnerships,LLCs,Scorpo-rations,andotherpass-throughentities.Suchbusinessespaynoseparatecorporateincometax,andtheirincomeistaxedattheownerlevel.Manyoftheseentitiesprovidethelegalbenefitsoflim-itedliability,buttheirearningsaregenerallytaxedonlyonce—onthetaxreturnsoftheirowners.12Indeed,pass-throughentitiesnowaccountfornearlyhalfofbusinessincomeintheU.S.andabout

12 Corporationscanbeandoftenarepartnersinpartnerships,thuspartnershipincomemaybesubjecttothecorpo-ratetax.WhenallpartnersareCcorporations,suchasinajointventure,allofthepartnershipincomeissubjecttothecorporatetax.Overall,asmuchas15to20percentofthepass-throughincomemayultimatelybesubjecttothecorporatetax.


one-thirdofreceipts(seeTable8).13Changesatthefederalandstatelevelhaveallowedmorebusi-nessestooperateinpass-throughform.14Wearenowinasituationinwhichthecorporateincometaxbillispaidpredominantlybythelargestcorporations:in2006,85percentofcorporateincometaxeswerepaidbylessthan0.5 percentofallCcorporations—fewerthan10,000firms.

Table 8: Shares of Total Business Returns, Receipts and Net Income, 1980-2007

1980 1990 2000 2007

S Corporations

Returns 4% 8% 11% 12%

Total Receipts 3% 13% 15% 18%

Net Income (less Deficit) 1% 8% 14% 14%

Partnershipsa

Returns 11% 8% 8% 10%



Sole Proprietorships

Returns 69% 74% 72% 72%



C Corporationsb

Returns 17% 11% 9% 6%



a. IncludesLLCs&LLPs.b. Includes1120-RICand1120-REIT.Source:InternalRevenueService,StatisticsofIncome,www.irs.gov/taxstats.

Agoalofreforminthisareaistaxneutralitywithrespecttoorganizationalform.Manyindividualswithwhomwemetsuggestedthatitwasneitherfairnorgoodtaxpolicyforbusinessesofsimilarsizeandengagedinsimilaractivitiestofacedifferenttaxregimesanddifferenttaxrates.Stepsto-wardneutrality—harmonizingtherulesandeffectivetaxrates—forcorporateandnon-corporatebusinessescouldbetakeninanumberofways.

The proposals and their advantages: One option would be to require firms with certain “corporate” characteristics—publicly tradedbusinesses, businesses satisfying certain income or asset thresholds, or businesses with a largenumberofshareholders—topaythecorporateincometax.Ineffect,thiswouldbroadenthecor-poratetaxbasebyapplyingthecorporatetaxtomorebusinesses.

Sinceaprimarydistinctionindeterminingwhetherabusinessistreatedasacorporationforfed-eraltaxpurposeshasbeenaccesstopubliccapitalmarkets,theconditionsunderwhichfirmscanaccesspubliccapitalmarketswithoutbeingsubjecttothecorporatetaxcouldbereconsidered.A

13 Thesefiguresdonotremovethedouble-countingthatcanresultfromtieredpartnershipsorScorporationsown-ingpartnershipinterests.

14 TheseincludetheTaxReformActof1986,theadoptionoflimitedliabilitycompanylegislationbyallstatesbytheendofthe1990s,theexpansionofeligibilityforScorporationstatusin1996,andtheadoptionof“check-the-box”bytheIRSin1997.


straightforwardapproachwouldendthecurrentlawexemptionsforentitieswithcertaintypesofincome(naturalresourceorportfolio-typeincome)fromtherequirementthatpubliclytradedenti-tiesbetaxedascorporations.Amorelimitedversionofthis,asreflectedinseveralbillsintroducedinCongress,wouldremovethepubliclytradedpartnership(PTP)exceptionforpartnershipswithpassive-typeincomederivedfromprovidinginvestmentadviserandrelatedassetmanagementser-vices.ThischangewouldeliminatethedistortionsthatresultfromdifferenttaxtreatmentforPTPsandfrombusinessesthatprovidesimilarservicesandoperateinsimilarways.

Alternatively,companysizeorthenumberofshareholderscouldbeconsideredasabasisforcor-poratetaxation,withthecorporatetaxrateappliedtofirmsaboveacertainsizeorwithmorethanaspecifiednumberofshareholders.Theremayalsobesomeindustryorsectorsituationsinwhichimposingthecorporate taxmightbeappropriate,suchas forvery largeScorporationbanksorcreditunions.

Analternativeoptionwouldeliminatethedoubletaxationofcorporateincomeandharmonizetaxratesoncorporateandnon-corporate incomethrough“integration”withtheindividual incometax.Inoneexampleofsuchasystem,individualinvestorswouldbecreditedforallorpartofthetaxpaidatthecorporatelevelagainsttheirindividualtaxes.AnumberofOECDcountries—theU.K.,Canada,andMexicoforexample—haveusedsuchasystem.Insuchasystem,theeffectivetaxburdenoncorporatebusinesseswouldbereducedrelativetothetaxburdenonnon-corporatebusinessesandthelostcorporaterevenuescouldberecoupedattheindividuallevelthroughhigherratesondividendsorhighermarginalrates.Ifthecreditwasnotavailableforforeignshareholders,ahighercorporateratewouldnotraisethetaxonU.S.shareholders.

Disadvantages:Achievingneutralitybetweencorporateandnon-corporatebusinessesbysubjectingmorebusi-nessestothecorporatetaxwouldincreasethecostofcapitalandthusdecreaseinvestmentinthosebusinesses.Inparticular,imposinganadditionalleveloftaxonPTPswouldlikelydiscouragetheflowofequity into such investments. If corporate tax statuswerebasedonan incomeorassetthreshold,complexitieswouldbenumerous.Forinstance,ifafirm’sactivitiesfluctuatedaboveandbelowsuchthresholds,ruleswouldbeneededtoaddressfrequentconversions.Also,ruleswouldbeneededtopreventbusinessesfromavoidingsizethresholdsbysplittingintoparts—forexample,asinglepartnershipsplitting into twoormorepartnerships. Dependingonhowthenewruleswere defined and applied, they could add complexity for existing non-corporate pass-throughsthatwouldberequiredtofollowcorporatetaxrulesandfilecorporatetaxreturns.However,thiscouldreducethecomplianceburdenforlargenon-corporatebusinesseswithmanyshareholdersorpartners,eachofwhommustcurrentlyreportthebusiness-relatedincomeanddeductionsontheirindividualreturns.Theshiftofbusinessactivityfromthecorporateintothenon-corporatesectorhasresultedinmarketefficiencies(e.g.,theformationofpartnershipsthatarejointventuresinvolvingtheassetsoftwoormoreentities). Thetaxationofsuchpartnershipsascorporationsmightpreventtheformationoftheseproductiveventures.

Finally,eliminatingthedifferencesbetweenthetaxtreatmentofcorporateandnon-corporatebusi-nessesbyintegratingthecorporateincometaxsystemwiththeindividualincometaxsystemwouldcarryarevenuecosttotheextentthatcreditsforcorporatetaxespaidreducedrevenuesfromindi-


vidualtaxes.However,thelostrevenuescouldbeoffsetbytaxingcorporateincomeatahigherrateattheindividuallevel.

iii. Option 3: Eliminate or Reduce Tax Expenditures

Anumberofprovisionsinthetaxsystemnarrowthetaxbaseforcertainbusinesses,withtheresultthathigherstatutoryratesareneededtoachievethesamerevenue.SomeofthelargestoftheseexpendituresareprovidedinTable9,whichshowsthe10-yearrevenuelossesduetoeachprovi-sion.Theestimatesdatefrom2007,andthusproviderevenuenumbersthatarenotaffectedbytherecession.

Table 9: Special Tax Provisions Substantially Narrow the Business Tax Base

Revenue, 2008-2017 (FY, $ billions)

Major Special Business Tax Provisions Corporate Non-Corporate Total

Deduction for U.S. production/manufacturing activities 210 48 258

Research and experimentation (R&E) tax credit 132 1 133

Low-income housing tax credit 55 6 61

Exclusion of interest on life insurance savings 30 0 30

Inventory property sales source rules 29 0 29

Deductibility of charitable contributions 28 0 28

Special ESOP rules 23 4 27

Exemption of credit union income 19 0 19

New technology credit 8 1 9

Special Blue Cross/Blue Shield deduction 8 0 8

Excess of percentage over cost depletion, fuels 7 0 7

Other business preferencesa 27 28 55

Total 576 88 664

Accelerated depreciation/expensing provisions 356 306 662

Total Revenue from Business Preferences 932 394 1,326

a. None of the special business tax provisions in this category exceed $5 billion over the 10-year budgetwindow.

Source:U.S.DepartmentoftheTreasury,OfficeofTaxAnalysis.

Manyoftheseprovisionsdistorteconomicactivity,increasethecomplexityofthetaxcode,andviolateprinciplesthatbusinesseswithsimilarcharacteristicsshouldbetreatedequally.Eliminatingspecificexpenditureswouldthusimproveefficiencywhilesimplifyingthetaxcode.Manyofthedisadvantagesofeliminationarespecifictotheproposals;eliminationwilldisadvantagethosewhobenefitfromthetaxexpenditure.

Adiscussionofthelargestoftheseprovisionsfollows.


1. Eliminating the Domestic Production Deduction

In2004,theU.S.beganallowingbusinesses(bothcorporationsandpass-throughentities)todeductpartoftheirearningsfromcertainkindsofdomesticproductionfromtheirtaxableincome.ThisdeductioniscalledthedomesticproductiondeductionanditwasintroducedasasubstitutefortheForeignSalesCorporation(FSC)lawthatwasruledillegalbytheWTOin2000.ThepurposeofthedomesticproductiondeductionwastoencouragemanufacturingproductionintheUnitedStates.However,thescopeofthedefinitionof“production”issufficientlybroad—encompassingactivitieslikethewritingofcomputersoftwareandeventheproductionoffastfoodhamburgers—thatmanysectorsbenefitfromthededuction.

The proposal and its advantages: Weestimate thateliminating thisprovisionwould raisecorporate revenuesbyenough toallowareductioninthecorporatetaxrateofabout1.1percentagepoints.Thecorporateratecouldbereducedbyabout1.4percentagepointsiftheprovisionwasrepealedforallbusinessesandtherev-enueusedtoreducethecorporaterate.

Eliminatingthedeductionwouldalsoresultinconsiderabletaxsimplificationbecausethedefini-tionofqualifyingproductioniscomplexandraisescomplianceandadministrativecosts.More-over,thedeductiondoesnotapplytoalldomesticproductionsothisprovisiondistortseconomicdecisions.Sincethedeductionissimilarineffecttoaratereduction,itwouldmakethetaxsystemsimplerandmoretransparenttosimplyreducerates.

Disadvantages:Aconcernisthatthiswouldraisetheeffectivecorporatetaxrateonmanufacturingindustriesbyabout3percentagepointsifthestatutorycorporatetaxrateisnotreduced.Itwouldberevenueneutralforthecorporatesectoronlyifthecorporateratewasreduced.Additionally,non-corporatebusinessesreceiveabout20percentofthebenefitfromthededuction,sothateliminatingthepro-visionandusingtherevenuetoreducethecorporateratewouldresultinwinnersandlosersbyorganizationalform.

2. Eliminate or Reduce Accelerated Depreciation

Asdiscussedabove,accelerateddepreciationandexpensingprovisionsare the largestsingle taxexpenditure(measuredrelativetostraightlineeconomicdepreciation)forbusinesses(bothpass-throughentitiesandcorporations).Accelerateddepreciationprovidesalowerratetonewinvest-ment,similartoexpensingorbonusdepreciation.Italsoreducesthepenaltyoninvestinginplantandequipmentandcommercialrealestaterelative to investing inresearchoradvertising,or inowner-occupiedhousing.

The proposal and its advantages: Eliminatingaccelerateddepreciationwouldraisesignificantrevenuesfromcorporations—enoughtoreducethecorporateratebyaround3 percentagepoints.(Almostasmuchrevenuewouldberaisedbyeliminatingaccelerateddepreciationforthenon-corporatesector;completeelimination


ofaccelerateddepreciationwouldraiseenoughrevenuetolowerthecorporaterateapproximately5percentagepoints.)Amorelimitedoptionthatwouldraiseproportionatelylessrevenuewouldbetoreducethedegreeofaccelerationinthedepreciationformulas.

Ingeneral,theadvantages(anddisadvantages)ofcurtailingaccelerateddepreciationarethesameasthosediscussedinOptionGroupAabove.

Disadvantages:Eliminatingaccelerateddepreciationwouldraisetaxesfornewinvestments,reducinginvestmentintheaggregate.Itwouldexacerbatethedifferentialtreatmentofplantandequipmentinvestmentsrelativetoothercorporateinvestments,likeadvertisingorresearch.Somefirmswouldseetheirtaxesrisemorethanothers—forexample,newerfirmsorfirmsincapital-intensiveindustries;ineffectthiswouldrewardexistingcapitalatthecostofnewinvestments.

3. Eliminate Other Tax Expenditures

Table9alsoenumeratesanumberofadditional,smallertaxexpendituresthatexpertshavemen-tionedaspossiblebase-broadenersinabusinesstaxreform.Afewspecificprovisionsarediscussedbelow.

A. SpecialEmployeeStockOwnershipPlan(ESOP)Rules

ESOPplansareemployer-sponsoredretirementplansthattypicallyinvestentirelyinstockoftheemployer.SpecialrulesallowemployerstodeductdividendspaidtostockinESOPsandallowem-ployeestodeferpayingcapitalgainstaxesoncertainemployer-stocktransactions.SomearguethatthespecialtreatmentgiventoESOPs,whichisevenmorefavorablethanotheremployer-sponsoredretirementaccounts,resultsinalackofdiversificationinemployees’retirementsavingsthatcanand,historicallyhas,sometimesresultedinoutsizedlossestoretirementwealth.EliminatingthesespecialprovisionsandtreatingESOPplanslikeotheremployer-sponsoredretirementplanswouldraiserevenuesandharmonizetaxincentiveswithotherretirementplans.

B. ExemptionofCreditUnionIncomefromTax

Unlikeotherfinancialinstitutionslikebanksandthrifts,creditunionsdonotpaycorporatetaxesontheirincome.Thisputsthematacompetitiveadvantagerelativetootherfinancialinstitutionsfortaxreasons. Eliminatingthisexemptionwouldraiserevenueandleveltheplayingfield,butwouldclearlyraisetaxesoncreditunions.

C. Low-IncomeHousingCredit

Thelow-incomehousingcreditencouragestheconstruction,rehabilitation,andpurchaseoflow-incomerentalhousing.Someexpertssuggestthatotherfederalaid(likehousingvouchers)would


assist low-incomehouseholdsatalowercost. Proponentsofthecreditarguethatitencouragesinvestmentinrentalpropertiesinlow-incomeareasandhelpstorevitalizethoseneighborhoods.

81

V. ADDRESSING INTERNATIONAL CORPORATE TAX ISSUES

Asnotedabove,theU.S.hasoneofthehigheststatutorycorporatetaxratesamongdevelopedecon-omies,andthedifferencebetweentheU.S.taxrateandthetaxratesimposedbyotherdevelopedcountrieshasincreasedovertimeasothercountrieshaveloweredtheirrates.TherelativelyhighU.S.taxrateisparticularlyimportantforU.S.MNCsbecausetheyaresubjecttotheU.S.corporatetaxontheirworldwideincome,regardlessofwhereitisearned.Asaresult,U.S.MNCsoperatinginlower-taxjurisdictionsfacehigherstatutorytaxratesthantheircompetitors. TemperingthisburdenisthefactthattheU.S.corporatetaxispaidonlyifandwhenacorporationrepatriatesitsforeign-earnedincome,forexampleasadividendtoitsparentcorporation.Incontrast,theincomeearnedbyU.S.corporationsdomesticallyissubjecttotheU.S.corporateincometaxatthetimeitisearned.Inpractice,mostMNCstakeadvantageofdeferralanddefertherepatriationofasignifi-cantfractionoftheirforeign-earnedincomeforlongperiodsoftime,oftenindefinitely.Deferralthereforereducestheeffectivetaxrateonforeign-earnedincome,mitigatingthetaxdisadvantagesU.S.MNCsfacewhenoperating in foreign jurisdictionscomparedto their foreigncompetitors.AnotherconsequenceisthatU.S.MNCsfacelowereffectivetaxratesontheirforeign-earnedprof-itsthanondomestically-earnedcorporateincome.

ManyexpertsandbusinessrepresentativesarguedthatthehigheffectivecorporatetaxrateintheU.S.discouragesMNCsfromchoosingtheU.S.asasitefortheproductionofgoodsandservicesorasaheadquartersfortheirglobalactivities.Moreover,weheardconcernsthattheU.S.systemplacesU.S.MNCsoperatinginothercountriesatacostdisadvantagerelativetotheirbusinesscom-petitorsinthosejurisdictions.Bothoftheseconcernsareexacerbatedbythefactthatinadditiontohavinglowerstatutorytaxrates,mostotherdevelopedcountriesalsoexemptfromcorporatetaxa-tionallormostoftheoverseasincomeearnedbytheircorporations.Incontrast,theU.S.exemptssuchincomefromtaxationonlyaslongasitremainsabroad.

OtherexpertsarguedthatthedifferenceintheeffectivetaxratesbetweenincomeearnedathomeandincomeearnedoverseasprovidesU.S.-headquarteredMNCsincentivestoshifttaxableprofitsto their foreign subsidiaries to delay taxation, and encourages costly and wasteful tax planningmeasurestodoso.Ascorporatetaxratesinothercountrieshavedeclinedandasglobalmarketshavegrown,theincentivesandopportunitiesforU.S.MNCstoshiftprofitsabroadhaveincreased,strainingthealreadycomplicatedsystemoflawsandenforcementthatattemptstoregulatetheseactivities.Expertsalsocautionedthatsuchtaxavoidanceeffortsreducethedomestictaxbaseandreducecorporatetaxrevenues.

MostexpertsemphasizedtheneedforchangestothecurrentrulesfortaxingtheforeignincomeofU.S.corporationstoaddresstheaboveconcerns.Butexpertsdifferedonwhatchangesshouldbemadebecauseoftheirevaluationofhowchangeswouldaffectthefollowing,sometimescom-peting,policygoals:increasingtheattractivenessoftheU.S.asaproductionlocationforU.S.andforeigncompanies;reducingthetaxdisadvantagesofU.S.MNCsoperatinginlow-taxjurisdictionscomparedtotheirforeigncompetitors;reducingtheincentivesforU.S.MNCstoshiftactivitiesandreportedprofitsabroadtoavoidpayingU.S.corporatetax;reducingthecostsofadministrationand


compliance;andreducingtheerosionoftheU.S.taxbaseandthelossofcorporatetaxrevenuesthatresultfromtaxavoidancemeasures.

a. The Current U.S. Approach to International Corporate Taxation

Asnotedabove,theU.S.usesaworldwideapproachtothetaxationofcorporateincomeearnedbyU.S.companiesoverseas.ThebasicprincipleofthisapproachisthatalloftheincomeearnedbyU.S.companiesanyplaceintheworldshouldbesubjecttotheU.S.corporateincometax.ButthecurrentU.S.systemalsoallowsU.S.companiestodeferpaymentofthetaxonmostoftheoverseasactiveincomeearnedbytheirforeignsubsidiariesuntilitisrepatriated,forexampleasdividendstotheparentcorporation.U.S.taxisnotdeferredonpassiveinvestmentincome(suchasportfo-liointerest)earnedabroadoronothereasilymoveableincomeofforeignsubsidiariesundertheso-called“subpartF”anti-deferralrules.ProfitsorlossesofforeignbranchesofU.S.corporations(ratherthansubsidiaries)aresubjecttoimmediateU.S.taxjustasiftheprofitsorlossesaccrueddomestically.

TopreventthedoubletaxationofincomeearnedbyaU.S.companybyboththegovernmentofaforeigncountryinwhichtheU.S.companyisoperatingandbytheU.S.government,currentU.S.taxlawincludesprovisionstoallowacreditforforeignincometaxes. Undertheserules,aU.S.companyisallowedaforeigntaxcreditforforeignincometaxespaidbyitandbyitsforeignsub-sidiariesonearningsrepatriatedtotheUnitedStates.TheforeigntaxcreditisclaimedbytheU.S.companyonitsU.S.taxreturnandreducesitsU.S.taxliabilityonforeignsourceincome.(SeeBox1foradiscussionoftheforeigntaxcredit.)

Asaresultofdeferralandforeigntaxcredits,theU.S.corporatetaxpaidbyU.S.MNCsonforeignsourceincomein2004wasonly$18.4billion.ArelativelysmallpartofthatrevenuewasderivedfromdividendspaidbyforeignsubsidiariestotheirU.S.parents.Foreignsourceroyalties,aswellasforeignsourceinterestandincomefromforeignsubsidiariesnoteligiblefordeferralunderthecurrent system, represent a much more important source of tax revenue than dividends. Evenwithforeigntaxcredits,U.S.multinationalshaveastrongincentivetokeeptheiroverseasearningsoutsidetheU.S.asaresultoftheinterplaybetweenthehighU.S.statutorycorporatetaxrateanddeferral.In2004,whenCongressallowedcompaniestorepatriateoverseasincomeforalimitedamountoftimeatareducedcorporateeffectivetaxrateof5.25 percent,theamountofrepatriatedincomejumpedfromanaverageofabout$60 billionperyearfrom2000-2004toabout$360billionin2005.In2004,U.S.multinationalshadover$900billioninunrepatriatedoverseasincome.Evenafterrepatriatingover$360billionin2005,U.S.companiesreportedover$1trillionofpermanentlyreinvestedearningson2008financialstatements.Mostofthebusinesspeoplewespokewithpre-dictedthatasignificantportionofthisincomewouldberepatriatedtotheU.S.iftherewasanothertemporarytaxholidaywithareducedrateoriftherewasareductioninthecorporatetaxrate.


b. Box 1: The Foreign Tax CreditTheforeigntaxcreditrulesarecomplicatedandincludeseveralsignificantlimitations.Inparticular,theforeigntaxcreditisappliedseparatelytodifferentcategoriesofforeignincome(generallydistinguishingbetween“ac-tive”and“passive”income).ThetotalamountofforeigntaxeswithineachcategorythatcanbecreditedagainstU.S.incometaxcannotexceedtheamountofU.S.incometaxthatisdueonthatcategoryofnetforeignincomeafterdeductions.Incalculatingtheforeigntaxcreditlimitation,theU.S.parent’sexpenses(suchasinterest)areallocatedtoeachcategoryofincometodeterminethenetforeignincomeonwhichthecreditcanbeclaimed.TheallocationofexpensestoforeignincomeisintendedtoassurethatcreditsforforeigntaxesdonotoffsetU.S.taxondomesticsourceincome.Theportionofexpensesallocatedtoforeignincomethereforereducestheamountofforeigntaxthatcanbecreditedthatyear.Thisforeigntaxcredit limitation,however,allowsactiveincomesubjecttohighforeigntaxes(usuallyactiveearningsofforeignsubsidiariesdistributedtoU.S.parentcorporationsasdividends)tobemixedwithactiveincomesubjecttolowforeigntaxes(includingroyaltiesorinterestfromaffiliates).Thus,ifearningsrepatriatedbyaforeignsubsidiaryhavebeentaxedbytheforeigncountryinexcessoftheU.S.rate,theresulting“excess”foreigntax(i.e.,theamountofforeigntaxontheearningsthatexceedstheU.S.taxthatwouldbeowedonthedividend)maybeusedtooffsetU.S.taxonother,lower-taxedforeignsourceincomeintheappropriatecategory.Thismethodofusingforeigntaxcreditsarisingfromhigh-taxedforeignsourceincometooffsetU.S.taxonlow-taxedforeignsourceincomeisknownas“crosscrediting.”Oneconsequenceofcross-creditingisthatifaU.S.parentcorporationdevelopsanintangibleasset,suchasapatentortrademark,andlicensestherightstoitssub-sidiariesoperatinginforeigncountries,theroyaltyincomegenerallywouldbeconsideredactiveandtheU.S.taxonthatincomemaybeoffsetbyexcessforeigntaxcreditsonotheractiveincomesubjecttohighforeigntaxes.IfaU.S.parentdoesnothaveorexpecttohaveexcessforeigntaxcreditsfromearningsinahigh-taxcountry,itmayhaveanincentivetostructureitsaffairssothattherightstosuchanintangibleareownedfortaxpurposesbyaforeignsubsidiaryinalow-taxcountry.ThismaybeaccomplishedthroughuseofanR&Dexpensecostsharingarrangement,whichallowstheU.S.parentcorporationtoretainlegalownershipoftheintangiblerightsforintellectualpropertylawpurposesbutfortaxpurposesallowstheforeignsubsidiarytobetreatedasowninganundividedinterestintheintangible.ItisnotnecessarytopayaroyaltytotheU.S.parentforanintangiblewhosecostshavebeenshared;however,theU.S.parentlosesitsU.S.deductionfortheportionofR&Dexpensethatisshared.Theforeignsubsidiarymayusetheintangibleorsub-licensetherightstoaffiliatesthatmakeuseoftheintangibleandearnreturnsattributabletothecostsharedintangible.Itgenerallyispossibletoachieveadeductioninthecountryofoperationandincomeinthelower-taxedcountry,whileavoidinganyU.S.taxunderthe“subpartF”anti-deferralrules.ProperallocationofearningsbetweenaU.S.parentcorporationandaforeignsubsidiarynecessarilyrequiresputtingappropriate fairmarketpricesonservices,productsandtransfersof intangiblerightsexchangedbe-tween the two. If these“transferprices”are toohighor too low,earningsmaybe incorrectlyallocatedandU.S.taxmaybeavoidedbyshiftingearningstoalower-taxcountry.Thisistheso-calledtransferpricingis-sue.Theincentivetomanipulatetransferpricesisrelatedtothedifferenceineffectivetaxratesbetweencoun-triesinvolvedinatransaction.Inthecostsharingarrangementdescribedabove,ifrightstoanintangiblearecost shared after the intangible has significant value, the party receiving the benefit should pay for pre-ex-istingvalue(a“buy-inpayment”). Thisisoneofthemostdifficulttransferpricingissuestoadministerandenforce, and highlights the challenges facing governments in applying national tax systems tocross-bordertransactions.


TheUnitedStatesistheonlymajordevelopedcountryeconomythatusesaworldwide(withdeferral)approachtothetaxationofcorporateincome.Otherdevelopedcountriesusea“territorial”or“dividendexemption”approachthattaxesonlythedomesticincomeoftheircorporationsandexemptsallorasignificantportion(e.g.,95 percent)oftheiroverseasincomefromdomestictaxes.(BoththeU.K.andJapanrecentlyswitchedfromaworldwideapproachtoaterritorialapproach.)Additionally,allofthedevelopedcountrieswiththeexceptionofJapanhavealowerstatutorycorporatetaxratethantheUnitedStates.IncontrasttotheworldwidesystemusedintheU.S.,interritorialsystemsthereisno(orverylittle)additionaldomestictaximposedonexemptoverseasincomewhenitisrepatriated.AterritorialsystemthereforeprovidesanevengreaterincentiveandopportunityforacompanytoreduceitsdomesticcorporatetaxesbyreportingprofitsabroadanddeductiblecostsathomethantheU.S.approach.However,themagnitudeoftheadditionalincentiveissubjecttodebate,withsomearguingthatitisactuallyquitesmallbecausethecurrentU.S.systemalreadyprovidesterritorial-liketreatmentforunrepatriatedearnings.OtherspointtothewillingnessofU.S.corporationstorepatriatesubstantialforeignearningsin2005inresponsetoatemporary5.25 percenteffectiverateasevidencethattheimplicitcostsofdeferralaremoresizable.

AsimpleexampleshowsthedifferencebetweentheworldwideapproachusedbytheUnitedStatesandaterritorialapproach.AU.S.companywithasubsidiaryinIreland,wherethecorporatetaxrateis12.5percent—amongthelowestintheOECD—paysU.S.taxontheprofitsearnedfromactivebusinessoperationsinIreland,adjustedbyaforeigntaxcreditsforforeigntaxespaidinIre-land(toensuretheearningsarenotdoubletaxed),whentheprofitsarerepatriatedintotheUnitedStates.Thus,iftheincomeearnedbytheIrishsubsidiaryisrepatriated,thetaxrate,adjustedforapplicableforeigntaxcredits,isincreasedfrom12.5percenttothestatutoryU.S.corporaterateof35percent.AFrenchcompanywithanIrishsubsidiaryalsopaystheIrishtaxof12.5percentonincomefromactivebusinessoperationsofitsIrishsubsidiary.IncontrastwiththeUnitedStates,iftheincomeearnedbytheIrishsubsidiaryisrepatriated,theFrenchcompanyonlypaysFrenchtaxon5 percentoftherepatriatedprofitswhentheseprofitsarerepatriatedtoFrance.Insuchacase,thetaxrateontheFrenchsubsidiaryistheIrishrateof12.5percentplusasmalladditionalFrenchtax.

Astheprecedingexampleindicates,theafter-taxresultoftheU.S.worldwidewithdeferralsystemandaterritorialsystemissimilarifforeignearningsarenotrepatriated.Indeed,someexpertssug-gestedthatwithdeferraltheU.S.systemisverysimilartosometerritorialsystemsusedelsewhere.FinancialaccountingrulespreservethispatterninthattheydonotrequireaccrualoftheU.S.taxonrepatriationofearningsifthecompanymakesanelectiontotreattheearningsaspermanentlyreinvested,butthatsimilaritydisappearsiftheU.S.companywantstopaydividendsfromtheforeignsubsidiarytotheparentinordertofinanceinvestmentintheU.S.orpaydividendstoshareholders.


c. Economic Effects of the Current U.S. Approach

i. Effects on the Location of the Economic Activities of U.S. Multinationals

TherearetwocontrastingviewsabouthowU.S.internationalcorporatetaxrulesaffecttheproduc-tionandemploymentofU.S.MNCsathome.Oneviewrestsonthebeliefthattheforeignopera-tionsofU.S.multinationalsareasubstitutefortheirdomesticoperations,inthesensethatincreasesinforeignoperationscomeattheexpenseofdomesticoperations.Accordingtothisview,factorsthatreducethecostofforeignoperations,includinglowertaxesonforeignsourceincome,increasetheincentiveforAmericancompaniestoshiftproduction,investmentandemploymenttolower-costforeignlocations.Underthisview,reducingtherelativetaxburdenontheforeignsourcein-comeofU.S.MNCsincreasestherelativecostadvantageoftheiroverseasactivityandencouragesthemtomoveinvestment—andjobs—abroad,reducingemploymentandproductionathome.Bythislogic,increasingtherelativetaxburdenontheforeignsourceincomeofU.S.multinationalswouldencouragethemtorelocateproductionandjobsbacktotheU.S.

There isevidencethatsupports theviewthatcostdifferencesaresometimesasignificant factorbehind MNC decisions to substitute overseas employment for domestic employment. StudieshavefoundthatU.S.employmentcorrelatespositivelywithforeigncountrywages,indicatingthatdomesticandforeignlaboraresubstitutes,andthathigherforeigncostsincreaseemploymentathome.OtherstudiesfindthatthesignoftherelationshipvariesbycountryandlikelydependsonthetypeofforeignactivitybeingundertakenbytheU.S.company.

AcontrastingviewisthattheforeignoperationsofU.S.multinationalsareacomplementtotheirdomesticoperations—thatis,thatemploymentandothereconomicactivityatforeignsubsidiariescorrelatepositivelywithdomesticemploymentandactivity. Accordingtothisview,theforeignsubsidiariesofU.S.multinationalsincreaseemployment,output,investmentandR&DintheU.S.bothbyenhancingtheefficiencyandcostcompetitivenessofU.S.multinationalsandbyincreasingtheirsalesinforeignmarkets,manyofwhicharegrowingmuchmorerapidlythantheU.S.market.Inthisview,theforeignoperationsofU.S.companiesgeneratejobsandactivityattheirdomesticoperations.Accordingtothisview,factorsthatincreasetheattractivenessofforeignoperations,includinglowertaxesonforeignsourceincome,willincreasetheeconomicactivityofU.S.MNCsbothoverseasandathome,andalsoincreasetheuseofequipmentandinputsproducedbyU.S.suppliers.

ThereisalsoevidencethatsupportstheviewthattheforeignoperationsofU.S.MNCscomplementtheirdomesticactivities.Recentstudieshavefoundpositiverelationshipsbetweenboththedo-mesticandforeignemploymentofU.S.MNCsandbetweentheirdomesticandforeigninvestmentlevels.

Onafirm-by-firmandindustry-by-industrybasis,thereislikelytobesignificantheterogeneityintherelationshipbetweendomesticandforeignactivity.Formanybusinesses,theabilitytosubsti-tutedomesticactivitiesforforeignactivitiesinordertoserveforeignmarketsislimitedbywhat


theyproduce. Forexample,firmsthatrequirealocalpresencetoexploitU.S.innovationorex-pertisetoserveforeignmarkets,firmswhosebusinessrevolvesaroundnaturalresourceslocatedabroad,firmsthatrequirearetailpresenceorwhosebusinessrequiresface-to-facerelationshipswithconsumers,andfirmsthatproducegoodsthatarecostlytotransportareoftenunabletoserveforeignmarketsfromtheirdomesticlocationsandtosubstitutedomesticemploymentandinvest-ment for overseas employment and investment. Indeed, in 2007, 19 percent of U.S. exports ofgoodswereintra-companyexportsfromaU.S.parenttoaforeignaffiliate.FirmsinsuchsectorsandcarryingonsuchactivitiesoftenhavesignificantadministrationandR&DactivitiesintheU.S.tosupportorcomplementtheirforeignoperations.Incontrast,firmsthatproducehighvalue-to-weightgoodsandgoodsthatareeasytotransportarebetterabletoserveforeignmarketsthroughexportsfromU.S.locations.Forsuchcompanies,therelativecostofinvestingabroad(includingtaxes)islikelytobeamoreimportantdeterminantofdecisionsaboutwhethertolocateproductionandemploymentintheU.S.oroverseas.

ii. Effects on the Costs of U.S. Companies and their Foreign and Domestic Competitors

Thecombinationoflowerforeigncorporatetaxratesandtheterritorialsystemofcorporatetaxa-tionusedbyothercountriesreducesthecostofproductionforforeignfirmscompetingwithU.S.companies outside of the U.S.—thus raising the relative cost of U.S. MNCs operating in lower-taxforeignjurisdictions.Althoughdeferralreducesnationaldifferencesineffectivecorporatetaxrates,suchdifferencesmaystillplaceU.S.MNCsatarelativedisadvantageininternationalmarketsandmaybeinfluencingcompanysharesinglobalmarketsandpreventingglobalproductionfrombeingallocatedtothemostefficientcompanies.

TheU.S.worldwide/deferralapproachtocorporatetaxationfavorsforeignfirmsoperatingintheirowncountrycomparedtoU.S.firmsinthatcountry.ForeignandU.S.firmsbothpaycorporatetaxesinthatcountry—onaverageatlowerratesthanintheU.S.—butU.S.firmspayanadditionaltaxonrepatriationofthoseprofits.ThesameistruewhenU.S.andforeigncompaniescompeteinalow-taxthirdcountry;foreignfirmsoperatinginsuchacountry(e.g.,aFrenchfirminIreland)paythethirdcountryrate,buttheU.S.firmpaysanadditionaltaxwhenitrepatriatesitsearningstotheU.S.Overall,theterritorialsystemlowersthecostofdoingbusinessbyforeignfirmsinlow-taxthirdcountriescomparedtoU.S.firms. However,becauseU.S.MNCshavebeensuccessfulinreinvestingtheirincomeabroadanddeferringU.S.taxes,thistaxdisadvantagemaybesmall.Nevertheless,U.S.companiesthatdonotremitforeignearningsduetotheU.S.repatriationtaxbearcoststhatarisefromtax-inducedinefficienciesintheirfinancialstructure—coststhattheircompetitorsbasedinterritorialcountriesdonotbear.

TheU.S.worldwide/deferraltaxapproachalsoputsU.S.MNCsatadisadvantageintheacquisitionandownershipofbusinessesinothercountriescomparedtoforeigncompaniesthatoperateunderaterritorialapproach.Forexample,aforeigncompanycanpaymorethanaU.S.companytoac-quireafirminEuropeorinalow-taxthirdcountrybecausethenet-of-taxprofitsresultingfromtheacquisitionwillbehigherfortheforeigncompanythanforitsU.S.competitor.


Indomesticmarkets,however,bothU.S.MNCsandtheirforeigncounterpartsbenefitfromthelowereffectiveratesapplied to their foreign-source incomeanda lowercostofcapital,andcanspreadtheiroverheadcostsoverabroaderbaseofsalesthancanpurelydomesticfirms.Moreover,multinationalfirmsmayalsobenefitfromreduceddomestictaxesthroughtaxplanningandtrans-ferpricingtoshiftdomestically-earnedprofitstolower-taxforeignjurisdictions.Suchtaxavoid-anceopportunitiesarenotavailabletopurelydomesticfirms.

iii. Erosion of the Business Tax Base through Transfer Pricing and Expense Location

BecauseoftherelativelyhighU.S.corporatetaxrateandtheabilitytodeferforeign-earnedincomeindefinitely,U.S.companieshaveastrongincentivetoshiftprofitsabroadtodelaypaymentoftheircorporatetaxes,andtodeductthedomesticbusinessexpensesincurredinsupportoftheirforeignoperationsagainsttheircurrentdomesticearnings.Forexample,twoofthemostimportantmeth-odsthatU.S.MNCsusetoavoidtaxesrelatetothelocationofdebtandtothelocationofvaluableintangibleproperty.Inthefirstexample,acorporationissuesdebtinahigh-taxlocation(e.g.theU.S.)andusesthecapitaltogenerateactiveincomeabroad,whichisthendeferred.Thispracticeal-lowsbusinessestoreducetaxableincomefromtheirdomesticoperationsimmediatelywhiledefer-ringthepaymentoftaxesontheirforeignprofits.Inthesecondexample,acorporationtransfersavaluableintangibleasset,likeapatentorcopyright,toasubsidiaryinalow-taxjurisdictionwithoutappropriatecompensation.Thecompanythenexploitstheintangibleassetthroughthesubsidiarywithoutappropriateroyaltypaymentstothedomesticparent.Thecompanybenefitsfromdeduct-ingthecostsofdevelopingtheintangibleintheU.S.,thehigh-taxcountry,andreportingprofitsfromexploitingtheintangibleinthelow-taxcountry.U.S.MNCsalsohaveastrongincentivetoclassifypassiveincomeearnedoverseasasactiveincomebecausedeferralappliestothelatterformof incomeandnottotheformer. Furthermore,thecurrentsystemofforeigntaxcreditsallowsfirmstouseforeigntaxcreditsreceivedforprofitsearnedinhigh-taxcountriestooffsettaxesdueonprofitsearnedinlow-taxcountriesortooffsettaxesdueonotherkindsofincome,likeroyalties.Thissystemprovidesadditionalincentivestomanipulatethelocationofprofits(andthetypeofearnings)attainedabroadtoqualifyforforeigntaxcredits.

Policingtransferpricingischallengingbothbecauseoftheintrinsicdifficultyofassigningpricestointra-firmsalesthatarenotobservedthewayarm’slengthtransactionscanbeandbecauseofthecomplexityandnumberofrelated-partytransactionsthatoccurwithinMNCs.Thus,changesinthetaxsystemmotivatedbythegoalofimprovingthe“competitiveness”oftheforeignsubsidiariesofU.S.multinationalswithrespecttotheirforeigncompetitorsmayalsohavetheeffectofincreas-ingtheincentiveforU.S.MNCstoreducethetaxestheypayontheincometheyearnintheU.S.Indeed,apartofthetaxexpenditureformaintainingdeferralinthecurrentsystemorforshiftingtoaterritorialsystemisthereductionintaxespaidbyU.S.MNCsontheirdomestically-earnedincome.


iv. The Costs of Administering and Complying with the Current U.S. System

MostexpertsagreethatthecurrenthybridU.S.systemthatcombinesaworldwideapproachwithdeferralembodiestheworstfeaturesofbothapureworldwidesystemandapureterritorialsystemfromtheperspectiveofsimplicity,enforcementandcompliance.Inapureworldwidesystem,allincomeissubjecttothesametaxrate,eliminatingthenecessityofdistinguishingactivefrompas-siveincome(andthecomplexityofsubpartF)andofdistinguishingdomesticandforeignsourcesofprofits(andthereforetheneedtopolicetransferpricing).Hence,costlytaxplanningtoshiftincometolow-taxhavensortore-characterizepassiveincomeasactiveincomeissignificantlyre-duced.Andsoistheneedforenforcement.However,eveninapureworldwidesystem,aforeigntaxcreditsystemisstillrequiredtoensurethatcompaniesarenotsubjecttodoubletaxation.(Andtheforeigntaxcreditsystemiscomplicated.)Moreover,inapureworldwidesystemwithoutdefer-raltherewouldbeagreaterincentiveforU.S.multinationalstoshifttheirheadquartersabroadandreorganizeasforeigncompaniestoavoidthehighU.S.corporatetaxrateonforeignincome.

Inaterritorialsystem,foreignactiveincomeisgenerallynotsubjecttodomestictaxbutforeignpassiveincomeis. Thelocationofprofitsandthesourceof incomeareveryimportantbecausesomeincomeistaxedatthefulldomesticrate(35percentintheU.S.)andsomeincomeistaxedpotentiallyatzero.Thus,inaterritorialsystem,theretypicallyarerulestodifferentiateactivefrompassiveincome(likesubpartFunderpresentlaw),andrulestodifferentiateprofitsearnedathomefromprofitsabroad(includingtransferpricingrules).Aforeigntaxcreditsystemisrequired,butonlyforpassiveincomeandotherforeignincomenoteligibleforexemption(e.g.,royalties).Inapureterritorialsystem,dependingonthedifferenceineffectivetaxratesondomesticincomeandforeignincomeeligiblefordividendexemption,firmshavestrongincentivesfortaxplanning,andspendtimeandmoneydoingit.

TheU.S.hybridapproach,likeapureworldwideapproach,requiresabroadforeigntaxcreditsys-temtoavoiddoubletaxation.Butdeferraleffectivelyprovidesterritorial-liketreatmenttoactiveearnings until repatriated, generating the same incentives for tax planning and transfer pricingasaterritorialsystem.Plus,onlyactiveincomemaybedeferredwhilepassiveincomemaynot.Therefore,thecurrentU.S.systemrequiresacompleteforeigntaxcreditsystem(includingexpenseallocation rules), subpart F anti-deferral rules for passive income, and onerous transfer pricingenforcement,whilegeneratingstrongincentivesfortaxplanningandavoidancebybusinesses.Inshort,thecurrentU.S.systemcombinessomeofthemoredisadvantageousfeaturesfrombothpureworldwideandpureterritorialsystems.

TheincentivesgeneratedbythecurrentsystemencourageagreatdealofcostlytaxplanningbyfirmsandnecessitateasignificantamountofcostlyenforcementandcomplianceactivitiesbytheIRS. Moreover, the provisions to address problems created by deferral, foreign tax credits andexpenseallocationrules,andtodifferentiatepassiveandactiveincomecontributesignificantlytothecomplexityofthecorporatetaxcode.Accordingtoonestudy,largecompaniesreportedthat40percentoftheirtaxcomplianceburdenarisesfromthetaxationofforeignsourceincome.AndtheIRSmaintainsthattheinternationalprovisionsfortaxationofcorporateincomeareamongthehardesttoadministerandenforce.


MostexpertsagreethatthecurrentrulesfortaxingtheforeignincomeofU.S.corporationsshouldbereformed,butthereisdisagreementabouthow.Intheremainderofthissection,wesummarizetheprosandconsofthreebasickindsofreformsthatwediscussedwithexpertsduringourworkoninternationalcorporatetaxation:movingtoaterritorialsystemsimilartothoseofotherdevelopedcountries;maintainingaworldwideapproachbutatalowercorporaterateandwithoutdeferral;andtighteningorendingdeferralwithnochangeinthecorporaterate.Wealsodiscusstheimpli-cationsofmaintainingthecurrentsystemwithdeferralandalowercorporatetaxrate.

v. Option 1: Move to a Territorial System

The proposal and its advantages:TheUnitedStatescouldadoptaterritorialapproachsimilartothoseusedbymostotherdevelopedeconomiesandexemptfromU.S.taxationtheactiveforeignincomeearnedbyforeignsubsidiariesorbythedirectforeignoperationsofU.S.companies.(Transitionrulesmightbeimposedtolimitthepotentialwindfallfromeliminatingthetaxthatwouldhavebeenpaidwhenandifaccumulatedanddeferredprofitscurrentlyheldabroadarerepatriated.)

MovingtoaterritorialsystemwouldeliminatetheincentivesofU.S.MNCstokeepincomeearnedfromforeignoperationsabroadratherthanrepatriatingthisincometotheU.S.,reducingtheim-plicitcostscompaniesincurtoavoidrepatriation.Movingtoaterritorialsystemwouldthereforeimprovetheefficiencyofcorporatefinancedecisions.

AdoptingaterritorialsystemwouldmeanthattheforeignsubsidiariesofU.S.MNCswouldfacesimilareffectivetaxratestothosefacedbytheirforeigncompetitorsheadquarteredincountrieswithterritorialsystems.ThiswouldreducethecostofdoingbusinessincountriesthathavelowertaxratesforU.S.multinationalsrelativetotheirforeigncompetitorsinthoseforeignmarkets.

AterritorialsystemwouldalsoenhancetheabilityofU.S.multinationalstoacquireforeignfirmsandwouldeliminatetheincentivesforU.S.multinationalstomergewithorselltheirforeignop-erationstoforeigncompaniesfortaxreasons.Eliminationofthesedistortionstotheownershipofcapitalassetswouldhelpensurethatthoseassetsweremanagedbythemostproductivebusinesses.

TotheextentthatforeignoperationscomplementthedomesticoperationsofU.S.MNCs,movingtoaterritorialsystemthatreducestheircostsandincreasestheirsharesinforeignmarketswouldboosttheirproduction,investment,andemploymentintheU.S.

Movingtoaterritorialsystemcouldalsoprovidesomesimplificationbenefitsbyeliminatingtheneedforforeigntaxcreditprovisions(exceptthosethatapplytopassiveincomeandothernon-exemptincome).

Disadvantages:Theprincipaldisadvantagesof adoptinga territorial systemderive from the fact that in suchasystemthedifferencesintaxratesappliedtorepatriatedforeignearningsversusdomesticearningsandactiveversuspassiveincomewouldincrease,strengtheningtheincentivesforfirmstoshiftin-comeoffshorethroughtransferpricingandexpenseshifting,andencouragingactivetaxplanning


(aslongastheU.S.corporatetaxrateremainssignificantlyhigherthantheratesimposedbyothercountries).Asnotedabove,however,theincrementaleffectoftheseincreasedincentivescomparedtothecurrentsystemwithdeferralmaybemodest.AddressingthesedisadvantagesofaterritorialsysteminordertoprotecttheU.S.domestictaxbaseandmaintaintaxrevenueswouldplacepres-sureonthecurrenttaxadministrationandcomplianceregimeandcouldrequirerulesandregula-tionsthatdifferedsignificantlyfromthoseofothercountries.

Inparticular,tomaintaincorporatetaxrevenues(frombothdomesticandinternationalprofits)underaterritorialsystem,critical(andtechnical)detailswouldneedtoberesolved,including:theshareofforeigncorporateincomeexemptedfromU.S.taxes;theU.S.taxtreatmentofU.S.businessexpensesincurredbyU.S.companiestosupporttheirforeignoperations;andtheU.S.taxtreat-mentofroyaltyorpassiveincomeearnedabroadbyU.S.corporations.

Therevenueconsequencesofthesedesigndecisionsarematerial. AccordingtoroughestimatesfromtheTreasury,asimplifiedterritorialsystemwithoutfullexpenseallocationruleswouldloseapproximately$130billionoverthe10-yearbudgetwindow.Incontrast,aterritorialsystemwithfullapplicationofexpenseallocationrulescouldberevenueneutralorcouldraiserevenuedepend-ingonthebehavioralresponsesofcorporationsandtheabilityoftheIRStopolicetransferpricingandexpenseallocations. Indeed,earlier studies fromthe JCT,Treasury,and theCongressionalBudgetOffice(CBO)havescoredterritorialtaxsystemswithexpenseallocationrulesbasedonthecurrentrulesusedfortheforeigntaxcreditasraisingbetween$40 billionand$76billionover10years.Differencesintheseestimatesresultfromdifferencesinbehavioralassumptions,thedetailsoftheproposals,andthedatausedtomaketheseestimates.Thewidevariationinrevenueeffectshighlightstheimportanceofcomplexspecificationdetailsandtheincentivescreatedunderdiffer-entregimes.

Areformthatmaintainedthecurrenteffectivetaxrateonthedomestically-earnedincomeofU.S.MNCswouldrequireincreasedattentiontotransferpricingenforcementandtherulesregardingthelocationofexpenses.Forexample,tomaintainrevenueneutrality,taxdeductionsforinterestandotheradministrativeexpensesofU.S.MNCsusedtofinanceoperationsabroadwouldneedtobedisallowedsothattheycouldnotbeusedtoreducedomestictaxableincome.Thiswouldlimitanysimplificationbenefitsofreform.Moreover,aterritorialsystemthatincludedexpensealloca-tionruleswithrigorousenforcementwouldremainverydifferentfromtheterritorialsystemsofotherdevelopedcountries.Mostcountriesusingterritorialsystemsdonot“allocateanddisallow”domesticbusinessexpensesinthiswayeitherbydesignorbecausetheirrulesareundeveloped.Inasystemwithstringentallocationrules,manyU.S.firmscouldstillfacehighercostsofdoingbusi-nessinforeignjurisdictionsthantheirforeigncompetitors.Similarly,shiftingtoaterritorialsys-temwhileretainingthecurrentrulesonroyaltyincomewithoutareductionintheU.S.corporatetaxratewouldmeanthatroyaltyincomefromforeignsourceswouldbetaxedatahigherratethanroyaltiespaidtoforeignfirmsoperatingfromlower-taxjurisdictions.15

15 AterritorialsystemwouldimposeahighereffectiveU.S.taxrateonforeign-sourceroyaltyincome,providingfirmswithagreaterincentivetoreclassifyroyaltypayments(andothernon-exemptincome)asexemptactivein-come.Currently,royaltiesaremostlyshelteredfromtaxusing“excess”foreigntaxcredits.Shiftingtoaterritorialsystemwouldeliminatetheseexcessforeigntaxcredits.


Anumberof foreigngovernmentswith territorial systemsattempt to recouprevenueby taxingasmallportionoftheforeignsourceactiveincomeoftheircorporations(typicallybyexemptingaround95 percentofrepatriatedearningsfromtax). TheU.S.couldadoptsuchanapproachtorecoupsomeofthelostrevenuefrommovingtoaterritorialsystem.Thiswouldreducethead-ministrativeandcompliancecostsofaterritorialsystemcomparedtoonethatusedacomplicatedexpenseallocationsystemlikethatcurrentlyusedfortheforeigntaxcredit.Revenuelossescouldalsobereducedbydenyingexemptionforincomeearnedinalow-taxcountry(a“taxhaven”)thatdoesnothaveaminimumeffectivecorporatetaxrate.

Aterritorialsystemthatresultedinlowereffectiveratesonforeign-earnedprofitscouldalsoaf-fectthelocationdecisionsofU.S.multinationals.Totheextentthatproductionoverseasisasub-stitutefordomesticeconomicactivity(orinindustrieswherethisistrue),adoptingaterritorialsystemcouldencouragethemovementofproduction,employmentandinvestmentoutoftheU.S.tolower-taxjurisdictions.AterritorialsystemthatraisedeffectiveratesonroyaltyincomefromU.S.-domiciledintangiblescouldencouragefirmstoshiftintellectualpropertyandresearchanddevelopmentabroad.

Finally,aterritorialsystemwouldretainorexacerbatemanyoftheincentivesforinefficientbehav-iorinthecurrentworldwidesystemwithdeferral:incentivesforshiftingincometolow-taxloca-tionsbydistortingtransferpricesorpayinginadequateroyalties;incentivesforusingrelated-partytransactions(wheretransferpricingcanbeusedtoreducetaxes)ratherthanarm’slengthtransac-tions;andincentivesforalteringthelocationoftangibleandintangibleassets.

vi. Option 2: Move to a Worldwide System with a Lower Corporate Tax Rate

The proposal and its advantages: Thisoptionwouldimposeapureworldwidetaxsystemandenddeferralaspartofalargercorpo-ratetaxreformthatloweredtheU.S.corporatetaxratetoalevelcomparabletotheaverageofotherdevelopedcountries.Ifthestatutorycorporateratewereloweredtoarateatwhich,onaverage,U.S.MNCsexperiencednochangeintheeffectivetaxratetheycurrentlyfaceonincomeearnedabroadthereformwouldbe“burdenneutral”forthiscategoryofincome(thoughasdiscussedbelowtherewouldprobablybeindividual“winnersandlosers”).Oneestimateoftherequiredburdenneutralcorporaterateforthisreformis28 percent.Thisoptionwouldresultinasignificantoverallrev-enuelossbecausethelowercorporateratewouldapplytobothdomesticandforeignincomeandtoallU.S.corporationsregardlessofwhethertheyhaveforeignoperations.Toreduceoravoidthisrevenuelosswouldrequirerevenueincreaseselsewhere,forexamplebybroadeningthedomesticcorporatetaxbaseasdescribedaboveunderOptionGroupB.(Loweringthecorporatetaxratewouldalsohaveefficiencybenefitsinthedomesticcontext,asdescribedinOptionGroupA.)

Movingtoaworldwidesystemandendingdeferralwouldhavesignificantbenefitsforsimplifica-tion,compliance,enforcement,andefficiency.Byeliminatingdeferralforactiveforeignincome,allincomewouldbetaxedatthesamerateregardlessofwhereitisearned(domesticallyorinter-nationally),orwhetheritispassiveoractiveincome.Thesubpart-Fanti-deferralprovisionsand


mostrulestodifferentiatepassiveandactiveincomecouldbesimplifiedoreliminated.Thesystemofforeigntaxcreditswouldbemaintainedtoavoidthedoubletaxationofforeign-earnedincome,butitwouldbepossibletosimplifythesystembyeliminatingtheallocationofexpenses.

Movingtoaworldwidesystemwithoutdeferralwouldalsoreducemanyoftheincentivesfortaxplanningandtaxavoidance,andthereforewouldrequirelesscomplexandonerousanti-abusepro-visionsandlessenforcement.Incentivestoengageinincomeshifting,forexamplethroughtransferpricing,wouldbeeliminated,reducingplanningandcompliancecostsatbusinessesandrequiringlessoversightfromtheIRS.

Anotheradvantageofthisproposalisthatitremovesincentivesforanumberofinefficientbehav-iors.First,becauseallincomeistaxedcurrently,firmswouldnolongerhaveaU.S.taxincentivetokeepcashabroadtoavoidrepatriation,improvingtheefficiencyofcorporatefinancingdecisions.Second,asmentioned,thereisnoincentiveforU.S.multinationalstoengageinincomeshiftingthroughexpenselocationortransferpricing,andthiswouldreducethedistortionsthatarisefromincentivestouserelated-partytransactions,tolocatetangibleandintangibleassetsinalternativelocations for taxpurposes,or to favorcertainfinancingchoices (likedomesticdebt)overotherchoices.

FinallytotheextentthattheforeigneconomicactivitiesofU.S.MNCssubstitutefortheirdomesticeconomicactivities,thisoptionwouldencourageproduction,investmentandemploymentintheU.S.

Disadvantages:Adifficultywiththisapproachisthat loweringthetaxratetotherequiredburden-neutral level(around28 percent)wouldeithernecessitatesignificantbasebroadeningthroughtheeliminationofothercorporatetaxcreditsandtaxdeductions,orasubstantial lossofcorporatetaxrevenue.Ending deferral would itself permit a revenue-neutral reduction in the corporate rate by about1.5 percentagepoints.

Althoughcuttingthecorporateratetotheburden-neutrallevelwhileendingdeferralwouldresultinnochangeintheaveragetaxrateonforeignincome,somefirmswithsuchincomewouldfacetaxincreasesandotherstaxreductions.Forexample,firmsoperatingprimarilyinlow-taxcoun-triesbenefitmorefromdeferralthancompaniesoperatinginhigh-taxcountries,soendingdeferralwouldraisetaxesmoreontheformergroupoffirms.Thus,thisoptionwouldintroducegreatercountry-by-countryheterogeneityinthecompetitivenessofU.S.firmsdependingonthetaxratesof thecountries inwhichtheyoperate,andU.S.MNCswould facegreater taxdisadvantages inlower-taxcountriescomparedtotheircompetitorsheadquarteredincountrieswithlowercorpo-ratetaxratesand/orwithterritorialsystems.Otherfirmslikelytobenegativelyaffectedbyendingdeferralevenwithaburden-neutralreductioninthecorporatetaxrateincludethoseabletousetransferpricingtomoveprofitsabroad—forexample,thosetransferringhard-to-valueintangibleassetsorservices.

Underthisoption,U.S.MNCswouldstillfacecompetitivedisadvantagesonforeignoperationsinjurisdictionswithcorporatetaxratesbelow28percent.Thisoptionwouldalsoretaintheincen-tivesforforeignfirmstoacquireU.S.companiesortheirforeignsubsidiaries.Althoughthesein-

93

centiveswouldbelimitedtosomeextentbecausethegainsfromthesalesofsubsidiariesaresubjecttoU.S.taxation,thisoptionwouldreducetheabilityofU.S.firmstocompeteintheacquisitionofforeignfirmsthatfacelowereffectivetaxrates.

Indeed,theincentiveforforeignfirmstoacquiretheforeignsubsidiariesofU.S.MNCswouldlikelyincreasebecausethoseforeignsubsidiarieswouldbemorevaluableinthehandsofforeignfirmsthaninthehandsoftheU.S.MNCs.Further,thisproposalwouldincreaseincentivesforforeignfirmstoacquireU.S.MNCsoutrightandthenusetransferpricingtoshiftprofitstolower-taxjuris-dictions,raisingconcernsovertransferpricingenforcementofforeignMNCsoperatingintheU.S.Preventingthisoutcomewouldrequirecontinuedenforcementeffortsunderthetransferpricingrules.Thus,transferpricingruleswouldremainimportantforthesefirmsand,toalesserextent,forU.S.taxadministrators.

vii. Option 3: Limit or End Deferral with the Current Corporate Tax Rate

GiventhehighU.S.corporatetaxrate,underapureworldwidetaxsystemwithoutdeferral,U.S.MNCswouldfaceahighereffectivetaxratecomparedtoforeignMNCsheadquarteredincoun-trieswithlowercorporatetaxrates,territorialtaxsystemsorboth.Deferraloffsetsmuchofthisdisadvantagebyapproximatingtheeffectiveratesfacedinforeignjurisdictions.WithdeferraltheforeignoperationsofU.S.corporationsaretaxedcomparablytotheforeignoperationsoftheirfor-eigncompetitorsoperatinginthesameforeigntaxjurisdictions.Asaresultofthe“timevalueofmoney”advantageofpostponingtaxpayments,deferralallowstheforeignsourceincomeofU.S.corporationstobetaxedatalowereffectiveratethanitwouldbeifitwereearnedintheU.S.ThiscreatesanincentiveforU.S.corporationstokeeptheirforeignearningsabroadaslongaspossibleanddistortstheirinvestmentandbusinessdecisions.

The proposal and its advantages: MaintainingthesystemofdeferralforU.S.MNCstoallowthemtoenjoysimilartaxratestocom-petitorswhenoperatinginforeignjurisdictionscomesatasignificantrevenuecost—approximately$180billionovertenyears.Endingthistaxexpenditurewouldraiseconsiderablerevenues,enoughtoreducethecorporateratebyabout1.5percentagepoints,relievingtheeconomicdistortionsofthecorporatetaxalonganumberofmargins.

ForthosewhoseetheforeignactivitiesofU.S.MNCsasasubstitutefordomesticactivities,defer-ralbothreducesjobs,productionandinvestmentbyU.S.companiesathomeandencouragestheseactivitiesabroad,aswellasallowingU.S.companiestoavoidtaxes.Bythislogic,limitingorelimi-natingdeferralwouldcauseU.S.MNCstosubstitutedomesticforforeignactivities,wouldreducetaxavoidance,andwouldincreasetaxrevenues.

Like theburden-neutral reformdiscussedabove, thisoptionwouldsimplify the tax system, re-duceincentivesforincomeshiftingandtaxplanningandavoidance,andwouldthereforeimproveinternationalenforcementandreduceadministrativeandcompliancecosts.Itwouldbeeasierto


enforcethanthecurrentsystembecauseitwouldleavelittleincentivefortransferpricingortheuseoftaxhavens.

Disadvantages:WithoutasubstantialreductionintheU.S.corporateincometaxrate,however,thisoptionwouldimposeasignificantburdenonU.S.multinationals,raisingtheeffectivetaxratesonincomeearnedattheirforeignsubsidiariesrelativetotheratesthatapplytotheircompetitorsinlower-taxcoun-tries,andhamperingtheirabilitytobidforandpurchaseforeignassetsinlower-taxjurisdictions.Atthesametime,endingdeferralwouldmakeitmoreattractiveforforeignfirmstoacquiretheforeignassetsofU.S.companies.TotheextentthattheforeignactivitiesofU.S.MNCscomplementtheirdomesticactivities,deferralincreasesjobs,productionandinvestmentathomeandlimitingoreliminatingdeferralwouldreducethecompetitivenessofU.S.companies,woulddecreasejobs,productionandinvestmentintheUS,andwouldreducecorporatetaxrevenuesovertime.

viii. Option 4: Retain the Current System but Lower the Corporate Tax Rate

The proposal and its advantages: ThisoptionwouldlowerthecorporaterateasinOption2,butwithinthecurrenttaxsystem,whichtaxestheactiveforeignearningsofU.S.MNCsonlyuponrepatriation.TheefficiencybenefitsofalowercorporatetaxrateforallU.S.corporationsregardlessofwheretheyearntheirincomearedis-cussedintheearliersectionofthisreportoncorporatetaxation.Atthesametime,deferralwouldoffsetmuchofthedisadvantageU.S.firmsfacewhenoperatinginlow-taxcountries.Becauseofthelowercorporaterate,thedifferenceintaxratesbetweenincomeearneddomesticallyversusincomeearnedabroadwouldbereduced,reducingtheincentivesfortransferpricingandexpenselocationandthedisincentivetorepatriateforeignearnings.

Disadvantages:Thisoptionwouldreducerevenuesbyloweringtherateandwouldretainthetaxexpenditureofdeferral(atalowercost),butwouldnotprovidemanyofthesimplificationandefficiencybenefitsofOption2.Boththecomplexityofthecurrentsystemandtheincentivestolocateprofitsabroadanddeferrepatriationfortaxavoidancewouldberetained.


VI. ACKNOWLEDGMENTSAllofusonthePresident’sEconomicRecoveryAdvisoryBoardwouldliketoexpressourutmostgratitudetotheBoard’sTaxReformSubcommitteeandstafffortheirtirelesseffortsinproducingthisreport.Inresearching,revising,coordinating,andorganizinginputfromhundredsofpeoplearoundthecountry,theyappliedtheiradmirablediligenceandpublic-spiritednesstothisformida-bletask,andthisreportisareflectionoftheirdedication.ThemembersofthesubcommitteewerePaulVolcker,WilliamDonaldson,MartinFeldstein,RogerFerguson,andLauraD’AndreaTyson.

Wewanttothankthestaffthathelpedassistintheworkofthereport:AustanGoolsbee,theStaffDirectorandChiefEconomistofthePERAB;EmanuelPleitez,theDesignatedFederalOfficer;andespeciallyAdamLooney,senioreconomistatCEAandthePERAB,withoutwhosehardworkanddiligencethisreportwouldneverhavebeenpossible.Adam’sknowledgeofthecomplexitiesofthetaxcodewasindispensable,andheoversawalargemountainofworkontheproject.Weowehimaspecialdebtofgratitude.WewouldalsoliketothankPERABstaffers:EmilyAngulo,LauraBlum,RonnieChatterji,TonyDowd,WendyEdelberg,ArielGold,JoshuaGoldman,MaxHarris,BrittanyHeyd,MerylHolt,ArikLevinson,AndrewMetrick,ReneMoreno,JohnOxtoby,JesseRothstein,PaulSmith,IrinaVarela,CatherineVargas,andJacquelineYenfortheirworkontheproject.

WearealsoindebtedtothesupportoftheDepartmentoftheTreasury,theInternalRevenueSer-vice,theDepartmentofCommerce,theCouncilofEconomicAdvisers,theFederalReserveSys-tem,andtheNationalEconomicCouncil.Themenandwomenstaffingtheseagenciesgracefullyloanedustheirdecadesofexpertisethroughouttheprocess.

Mostofall,wewouldliketothankthepublic.Thosewhotestifiedinperson,spoketousonthephone,submittedtheir ideas inwriting,andthosewhoparticipatedinourpublicmeetingson-line—eachcontributedinanimportantway.Intheend,wereceivedhundredsandhundredsofideasandsuggestionsandtorecognizetheircontributions,wehavelistedallthedirectcontributorsintheappendixtothereport.


VII. APPENDIXThePresident’sEconomicRecoveryAdvisoryBoard(PERAB)metwithorganizationsandrequest-edpubliccommentsforideasontaxreform.Uponsubmission,suchcommentsbecamepartofthepublicrecordandsubjecttopublicdisclosure.Wemakenorepresentationregardingthena-tureofthecommentsastheywereself-reportedbythepublic.Thepublishingofthislistdoesnotconstituteendorsement,recommendation,orfavoringbythePERAB.Thestateslistedforcertainindividualswerederivedfromtheareacodesofthephonenumbersthattheyprovided.

Last First Organization

Abraham Terri Individual from Georgia

Abramson Steve Individual from New York

Ackerman Deena U.S. Department of the Treasury

Ackman Sheldon Fair Tax Organization

Aitken David Individual from Colorado

Al-Bakri Abdel Ilah None provided

Alfera Donald AlfsDogs

Almand Charles Georgians for Fair Tax

Altshuler Rosanne Urban-Brookings Tax Policy Center

Anderson Dave Honeywell

Anderson Melva Individual from Missouri

Annee Carl Individual from Georgia

Arias John Individual from New York

Arnett Charles Individual from Georgia

Arnold Steve Individual from Georgia

Arnold Stephen M. Tax Payer, Citizen, and a FAIRTAX supporter

Arslan Kristie National Association for the Self-Employed

Ashbaugh Margaret Individual from Missouri

Asnip Andrew Individual from Georgia

Atkinson Larry Individual from Georgia

Auerbach Alan UC Berkeley

Augustine Alexander Individual from Pennsylvania



Auten Gerald U.S. Department of the Treasury

Avi-Yonah Reuven S. University of Michigan Law School

Baehr Ted Individual from Louisiana

Bain Stuart None provided

Baker Teal Podesta Group

Baker Mary U.S. Senate Finance Committee

Baldassari Gene Baldassari for Assembly 2009

Ballard Mark Individual from Illinois

Bankman Joe Stanford University

Barba Chris Individual from Colorado

Barker, Professor William Penn State Law School

Barnes Scott Individual from Florida

Barrett William C. Applied Materials

Bean Elise U.S. Senator Carl Levin

Beard Bill None provided

Beaumont Simon IBM

Bedford Daniel Individual from Virginia

Bedingham Ann Individual from Arizona

Beharelle Lisa Individual from Georgia

Behler Jr. George F. None

Belson Goluboff Nicole Individual from New York

Bennett Jim Americans for Fair Taxation

Beran Robin Caterpillar

Betz Joseph Individual from Pennsylvania

Biddison Bonnie None provided

Binder Michael None provided

Bindner Michael Individual from Virginia

Bisson Joe Individual from Georgia



Black Rachel Bread for the World

Blakley III David W. Individual from Missouri

Blanchard Kimberly S. Weil, Gotshal & Manges LLP

Bontrager Jason Blinn College

Borom Andrew Individual from Florida

Bostick George U.S. Department of the Treasury

Bouma Herman B. Buchanan Ingersoll & Rooney PC

Boyd Janet Dow

Bradshaw Stephen None provided

Brady Woods Elizabeth Individual from California

Brannon Craig Individual from Georgia

Brock Bob Individual from New Mexico

Brothers Jeremy Individual from Ohio

Brown Fred B. University of Baltimore School of Law

Brown Becky The Information Factory

Brown Tom Retired scientist

Brown Jason Individual from Arizona

Brown Ketron Individual from Florida

Brown Gerald Individual from Georgia

Brown Jim Individual from Georgia

Bruce Paul None provided

Buel Estelle Individual from Texas

Burchill John FairTax.org

Burger Frank Jos. Individual from New York

Burnley Kristin Individual from Georgia

Burns Kevin Individual from Georgia

Burns William A. Individual from South Carolina

Burritt Dave Caterpillar



Buttonow Jim New River Innovation, Inc.

Calianno Joseph M. Georgetown Law School

Callihan Jesse W. Individual from Georgia

Campbell Speedy Bonnie AARP Tax-Aide

Cannoles, CPA/PFS Gordon Individual from Texas

Cardaropoli, Jr Anthony J. Individual from California

Carrigg Daniel University of Rhode Island

Castro Juan A. Individual from Florida

Caswell Steven Individual from Georgia

Chambers Lisa Individual from Georgia

Chetty Raj UC Berkeley

Chew Thomson None provided

Chwee Monica None provided

Clay Alex Individual from California

Clemens Jeff Harvard University

Coleman Dorothy National Association of Manufacturers

Colgan Daniel R. Individual from Minnesota

Colon Elizabeth None provided

Comeaux Kim Alliance Realty Team

Cooper Michael U.S. Department of the Treasury

Coratolo Giovanni U.S. Chamber of Commerce

Coussoule John Individual from Florida

Crago Chris Winston & Cashatt

Crain Jack L. Individual from Louisiana

Crandall Ted Rockwell Automation

Crider Oakey Individual from Indiana

Croft Charles R. Individual from Georgia

Cullinan Ronald Individual from Texas



Cummings, Jr. Jasper L. Alston & Bird

Curtin Ashley None provided

Curtiss Alison Individual from Florida

Dahl Sr. Jeffrey T. Individual from Arizona

Dale Emily Macon Organizing for America

D’Arrigo Emanuele Individual from the UK

David Ryan M. Individual from Texas

David Forte Sydney Citizen of the Corporate States of America

Davidson Charles Taxpayer Advocacy Panel

Dawson Shirley Individual from Missouri

de Grandis G. Individual from Pennsylvania

Debes Harry None provided

Deck Christopher Self Employed Accountant/Governmental Auditor

Desai Mihir Harvard Business School

DeTate Jack Individual from California

Devlin Peter Individual from Mississippi

Dey Dan Individual from Missouri

Dickel Ronald Alcoa

Dicker Eli J. Tax Executives Institute

Dilworth Robert McDermott Will & Emery LLP

DiStefano Theresa Individual from Georgia

Distefano Anthony Fairtax supporter

Dodd Randall AARP MEMBER

Dolezal Uva B. Individual from Georgia

Dosmann Todd Individual from Florida

Driggers Jacqueline Individual from Kentucky

Dukes Rita Individual from Colorado

Duperon Theresa Individual from California



Dwyer Terence Individual from Minnesota

Early Sheila Individual from Georgia

Earnest Diane Individual from Georgia

Earnest Patrick Individual from Illinois

Edwards Chris Cato Institute

Edwards Shannon None provided

Eichner Jesse M. JMEArtists.com

Eldridge Matthew Individual from Vermont

Elias Les Individual from Kansas

Elkins Stephen American Chemistry Council

Ellis George Individual from Florida

Engle Kyley Individual from Washington

Engler John National Association of Manufacturers

Engwall Randy Individual from Georgia

Ettlinger Michael Center for American Progress

Evangelist Michael Center for Economic Progress

Fabii Reno Individual from Florida

Fairbanks Steve None

Fath Meredith Tax Analysts

Faust Ed None provided

Fearon Rick Eaton

Feenberg Dan NBER

Feeney Michael Marks Building Systems

Femia Rocco V. Miller & Chevalier

Feraios Thomas Individual from Pennsylvania

Fige David Individual from Georgia

Finch Mike Individual from Virginia

Finis Carla J. Individual from Idaho



Finkelstein Amy MIT

Finnell Stephen C. Individual from Georgia

Fisher Carey Individual from Georgia

Flach Robert D. Taxpro Services Corporation

Ford Fred fwf inc

Fox Rockey Individual from Georgia

Frank Jeremie None provided

Freeman Art None provided

Friesen Corey Individual from Oregon

Froelich Daniel Individual from Pennsylvania

Fry Carol Individual from Georgia

Fulton Kathryn H&R Block

Furman Jason NEC

Gailey Scott Individual from California

Gale Bill Brookings

Galvin Walt Emerson

Garcia James Individual from New Mexico

Garmon Andrea Individual from New Jersey

Gaspard Michael Individual from California

Gastler Shirley Individual from Missouri

Gavalis Albert Individual from NY

Geeting Jonathan Individual from Pennsylvania

Gellasch Tyler U.S. Senator Carl Levin

Gerardi Geraldine U.S. Department of the Treasury

Germann Christine Individual from New Jersey

Gibson L. None provided

Gilbert Karl Individual from Maryland

Gilbert Frank Individual from Ohio



Godwin Robert Century Homes

Goluboff Nicole Individual from New York

Gordon Roger UC San Diego

Gordon Jane None

Goulder Robert Tax Analysts

Graham John F. Ansett

Grantham Doug Individual from Georgia

Grantham Douglas None provided

Granwell Alan W. DLA Piper

Gray Victor E. Individual from Nevada

Greco Cal Individual from Pennsylvania

Green Bradley Individual from California

Green Jason Individual from Georgia

Greenstein Robert Center on Budget and Policy Priorities

Greer Lisa Individual from Georgia

Gropper Adam Baker Hostetler

Gross Drew Individual from North Carolina

Grubert Harry U.S. Department of the Treasury

Grumet Louis New York State Society of Certified Public Accountants

Guerard Teresa Individual from Florida

Gustafson Susan Princess House, Inc

Gwyn Brigitte Business Roundtable

Hadstate James Individual from South Carolina

Hahn BruceAmerican Homeowners Grassroots Alliance/American Homeowners Foundation

Hakim Joseph B. Individual from Iowa

Halber Barry Individual from Florida

Hamden Robert Individual from Florida

Hammett Eugene None provided



Hamor Kathy The Savings Coalition of America

Harper Jonathan Individual from South Carolina

Hasset Kevin AEI

Hatano Daryl Semiconductor Industry Association

Hausner Tony Individual from Maryland

Hay Christopher Individual from South Carolina

Hayes Gregory United Technologies

Haynes James Individual from Ohio

Hazelwood Dennis The Gates Corp.

Heil Mary Individual from Michigan

Heller Ken National Small Business Association

Herzig, Professor David Valparaiso University School of Law

Heter Thomas Individual from Kansas

Hightower Mark A. Mark A. Hightower, CPA, P.C.

Hines Jr. James R. University of Michigan Law School

Hodges James Individual from Kansas

Holbrook Anthony Georgians for Fair Taxation

Holland Rebecca Individual from Georgia

Holzer HarryGeorgetown Center on Poverty, Inequality and Public Policy

Hooper Jeff None provided

Hoover Brandy Leigh Individual from West Virginia

Horvath David Individual from Michigan

Hoxby Caroline Stanford University

Hu Wendy Individual from Florida

Hu Jon Individual from Florida

Hubbard Frankie Individual from Georgia

Huckle Mike None provided

Huddleston Joe Multistate Tax Commission



Huffman Sam Individual from Oregon

Hughes Davis U.S. Senate Finance Committee

Hughes Greg Individual from Georgia

Hume John None provided

Hunt James Individual from Georgia

Hunt, Jr. Marshall Accounting Aid Society

Irons John Economic Policy Institute

Iwan David Small business owner

Iwry Mark U.S. Department of the Treasury

Jacobowitz Gerald N. Jacobowitz and Gubits, LLP

Jaeger Mike Individual from California

James Jonathan Individual from Tennessee

Jens Dean Individual from Illinois

Johnson Calvin H. Texas Law School and Shelf Project

Johnson Pamela Individual from Georgia

Jones Teresa None provided

Jones Robert Individual from Georgia

Jones Robert A. Individual from Georgia

Jones Trevor Individual from Utah

Jones Billie ACORN

Kaplan David Individual from Massachusetts

Kappler Jim Community Metrics, LLC

Karas Matthew Individual from Connecticut

Karl Ed AICPA

Karobonik Sheri Individual from Arizona

Kayal David Nicholas Individual from California

Kebschull William David Individual from Maryland

Keefer Jeff DuPont



Keeling J. Michael The ESOP Association

Kelley Paul FairTax

Kellner Richard Individual from New York

Kelly Barry Individual from Missouri

Kelly Kevin Individual from Virginia

Kesselman, Professor Jonathan R.Simon Fraser University, Graduate Public Policy Program, Vancouver, BC, Canada

Kieffer Mike Individual from Utah

Kilgallen Kim Individual from Georgia

King Larry Individual from Georgia

Kinyon Richard S. Morrison & Foerster LLP

Kitchen John U.S. Department of the Treasury

Kleinbard Edward USC Gould School of Law

Klepinger David None provided

Klopping Randall None provided

Knakmuhs Sarah Altria

Knittel Mathew U.S. Department of the Treasury

Koch Cathleen U.S. Senate Finance Committee

Korth Christopher M. Western Michigan University

Koschik Julie Individual from Ohio

Koutoulas Pete Individual from Kentucky

Krueger Alan U.S. Department of the Treasury

Kukreja Michael None provided

Kupfer Jeff President’s Advisory Panel on Federal Tax Reform

Laforme Bill Individual from Massachusetts

Laing David Individual from Maine

Lane Shirley Individual from Georgia

Lang Helen Individual from Florida

Lanton Ron H. D. Smith



Lara David Office of Governor David Paterson

Larson Paul None provided

Lau Gibian Karen Investment Company Institute

Lee Marie TechAmerica

LeMaster, Executive Director

Roger The Tax Council

Lenard Thomas M. Technology Policy Institute

Lenney Cheryl Individual from Georgia

Lenzi Tony Individual from Virginia

Lerman Allen U.S. Department of the Treasury

Levitsky Brion Individual from California

Lewis Claudia Individual from Ohio

Libin Jerome B. Sutherland Asbill & Brennan LLP

Lifson, CPA David A. NY State Society of Certified Public Accountants

Linbeck, Jr. Leo E. Americans For Fair Taxation

Livingston Peg Individual from Oklahoma

Lobel Martin Lobel Novins & Lamont, LLP

Loberger Patrick None provided

Locke Jeffrey Individual from Kansas

Lockwood David Strategy Management, Inc.

Lokpez Midiala Individual from Florida

Looker, CPA Michael Individual from New York

Looney Steve Tax Attorney

Lowrey Lee Individual from Georgia

Lykken Matt SharedEconomicGrowth.org

Lyon Andrew PwC

M David None provided

Macker Brian Individual from New York

Manieri Marc AFFT



Manners Jahmaal Individual from Maryland

Mansell Bev None provided

Marr Charles Center on Budget and Policy Priorities

Martin Riley D. Individual from Georgia

Martin Robert Individual from Wisconsin

Massie Roy None provided

Matthews, JD/CPA Robert (Chip) Sam Houston State University

Maxwell Gary Individual from California

Maydew Ed UNC Kenan-Flagler Business School

Maynes Bruce Individual from Georgia

Mazur Mark U.S. Department of the Treasury

McAdory Henry Individual from Georgia

McCarthy Jim Procter & Gamble

McConnell Bill Individual from Tennessee

McCrady Howard Individual from Arizona

McDonald Rob Emerson

McDonald Timothy Procter & Gamble

McGinnis Richard PwC

McGuire Monica R&D Credit Coalition

McIntyre Robert S. Citizens for Tax Justice

McKay Bernard Intuit

McLane Charles Alcoa

McMillion John None provided

Meier Ron Individual from Nebraska

Melancon Barry AICPA

Menke Roger Individual from Missouri

Merrill Peter PwC

Merszei Geoffrey Dow



Meyrow Sarah National Retail Federation

Michaelson Robert Individual from New

Miller Matthew M. Financial Executives International

Mioli Dean Individual from Pennsylvania

Miran Steve Harvard University

Moeller Jon Procter & Gamble

Mole Alan Individual from Colorado

Molnar Anna Individual from Illinois

Mongiello Stormy The Inn of the Patriots Bed and Breakfast

Montague Rachael Individual from California

Montgomery James Individual from Georgia

Moore Theresa M. None provided

Moore Allen Individual from Illinois

Mullis Sharon Individual from Georgia

Mundaca Michael U.S. Department of the Treasury

Mundy Kimbo Individual from New Mexico

Murray Fred F. Georgetown Law School

Nader Bertte greensceneshop.com

Najour Larry Azar Electric, Inc.

Najour Judy Individual from Georgia

Nellen Annette San José State University

Nelson Susan U.S. Department of the Treasury

Nelson Suzanne Individual from Georgia

Netzley Matthew Individual from Indiana

Neubig Thomas Ernst & Young

Newman Thomas None provided

Newman Dan Individual from Colorado

Ninovski Stanimir None provided



Nissen Matt None provided

Nobles Jerry Individual from Mississippi

Nowland Anne Individual from Massachusetts

Nowland Ian Individual from Massachusetts

Noyes Paul M. Individual from Georgia

O’Brien Jim Fair Tax

Oh-Willeke Andrew Individual from Colorado

Olander David U.S. House Ways & Means Committee

Olson Jim Individual from Georgia

O’Melia John M. None provided

Orme Vickie Individual from Georgia

Orszag Peter OMB

Ozanne Larry Congressional Budget Office

Parr Curtis Individual from Oklahoma

Patterson Stephen None provided

Peacock Philip J. ExaTech Solutions, Inc.

Perez Ruth IRS

Perez-Fox Prescott Starship Design LLC

Perrone Anthony Individual from Florida

Peters Jeremy Individual from Michigan

Pettingill Eric Mental Wellness Center

Petzold Charles Individual from New York

Pfost Bodie Individual from California

Phillipine Louis Individual from New Jersey

Phillips Richard INFRADANT LLC

Phillips John Phillips & Cohen LLP

Pinkerton Lorilyne None provided

Place Bob Individual from Georgia



Plattner Robert None provided

Ponder Kendall Individual from Missouri

Poot Hu None provided

Poterba Jim MIT

Prater Mark U.S. Senate Finance Committee

Putz Nancy Individual from Illinois

Quinn Ronald Individual from Florida

Radlo Lee Individual from Massachusetts

Rakes Richard Individual from Colorado

Rauls Venecia Individual from Oregon

Ravitch Richard Office of Governor David Paterson

Ray Suzanne Individual from Georgia

Recob Joseph Individual from Missouri

Regalia Martin U.S. Chamber of Commerce

Reister William L. None provided

Reister Bill Individual from Georgia

Rice Derica Eli Lilly

Richards Shan Individual from California

Rish Paul Individual from Georgia

Roach Robert U.S. Senator Carl Levin

Robb Jeremy Individual from Utah

Roberson Graham Individual from North Carolina

Roberts Bill AICPA

Rodriguez Edward Individual from California

Roesser Tom Microsoft

Rosenbloom H. David Caplin & Drysdale

Ross Jeanne U.S. Department of the Treasury

Ross Samuel Individual from New Jersey



Ross Chip None provided

Rossotti Charles Carlyle Group

Rough John E. None provided

Roxx Kimillion Robertson Properties

Rutherford Ken Individual from Georgia

Rutledge Jacob Individual from Georgia

Rys William National Federation of Independent Business

Sama Rob Individual from Massachusetts

Sammartino Frank Congressional Budget Office

Samuel Randall Individual from Ohio

Samuels John GE

Samwick Andrew Dartmouth College

Satagaj John Small Business Legislative Council

Savage Jeffrey Individual from Missouri

Sawyer James Praxair

Sayler Joy Individual from Nevada

Schenk Deborah H. NYU Law School

Scheppers John Individual from Missouri

Schiavo Pete Individual from California

Schifferl Donald Individual from Indiana

Schilling Juli Computer & Communications Industry Association

Schmid Heinrich O.E. Individual from Austria

Schoewe Thomas Walmart

Sears Brayden Individual from Kentucky

Seden Michael Individual from Georgia

Sedlak Sophie Individual from Georgia

Sepp Pete Taxpayers Union

Seto Theodore Loyola Law School Los Angeles



Shahi Hurshbir None provided

Shannon Guy None provided

Sharaf Eldin Aref Ahmed BUSINESS

Shaviro Daniel N. NYU Law School

Shay Stephen U.S. Department of the Treasury

Shear Anissa M. Andyrsco & Associates, Inc.

Sherman Jillian L. Virginia College Savings Plan

Shimandle Adie Fair Tax

Shlaes Amity NYU Stern School of Business

Shulin J. None

Shulman Doug IRS

Shultz Ronald Individual from Pennsylvania

Shumans Diane Individual from Georgia

Sica Bob Individual from Georgia

Silverman Mark Steptoe & Johnson LLP

Singer Paula N. Vacovec, Mayotte & Singer, LLP

Skipton F. Individual from Oregon

Slater Kim Individual from Georgia

Slemrod Joel University of Michigan

Slot Bryan G. Individual from Illinois

Smith Frederick W. FedEx Corporation

Smith Tiffany U.S. Senate Finance Committee

Smith Robert Individual from Florida

Smith Joshua Individual from Florida

Smith Darrel E. Individual from Indiana

Smith, Jr. F. Houston Individual from North Carolina

Sparkman Don Individual from Georgia

Spradley Chip Individual from Georgia



Spradling Gregory B. Individual from Tennessee

Starkman, CPA Jay Jay Starkman, PC

Stauffer John None provided

Stegner Bill Individual from Georgia

Stephens Terrell Individual from North Carolina

Steuerle C. Eugene Peter G. Peterson Foundation

Stresing Matthew None provided

Stretch Clinton Deloitte Tax LLP

Strickland Brent Yale University

Strier Robert Individual from Florida

Suez Emmanuel UC Berkeley

Sulcer Tom Individual from New Jersey

Summers Larry NEC

Sutter Matthew Individual from Georgia

Szrejter Timothy Individual from Georgia

Taiwo Olufemi Indiana University

Talbert Michael A. IRS - retired

Talisman Jonathan Capital Tax Partners

Taney Eric Individual from Texas

Taperman Rolnick Thala National Small Business Network

Tauro Richard Individual from Ohio

Taylor Rusty San Juan Financial

Taylor Dillon SBA Office of Advocacy

Taylor Richard Individual from Georgia

Taylor Jim Individual from Georgia

Taylor Sharon Individual from Pennsylvania

Thaxton James Individual from Georgia

Thomas Dawn Individual from Texas



Thomas Donald Individual Taxpayer Advocacy Panel Member

Thompson Todd Individual from Florida

Threadgill Jeremy Eco Concepts of Mississippi/AMMO

Throckmorton Charles D. Voting US Citizen

Thuronyi Victor Individual from Maryland

Tiedemann John @homecomputers

Tilton Sandy 9-12 Project

Toder Eric Urban Institute

Townsend Jr. Alvin Individual from Georgia

Treml Rudy Individual from Florida

Trimble Ray Individual from Georgia

Tuck Lee None provided

Tuszynski Tyler Individual from Florida

Vallee Jean None provided

Vande Guchte John None provided

Vaughn Latricia Individual from Missouri

Vazquez Alex None provided

Viard Alan AEI

Vincent Joshua Center for the Study of Economics

Vodanovich Adam Individual from Louisiana

Vogelman Mike AB Courier

Walker Robert None provided

Waller Alex Individual from Georgia

Walser David None provided

Walter Robert Individual from Georgia

Walter Carolyn Fair Tax Grassroots

Warlick Mike and Marian Americans for Fair Taxation

Warlick, Sr. Michael D. Americans for Fair Taxation/Georgians for Fair Taxation



Warren Mark Retail Industry Leaders Association

Washington Dianne Individual from New York

Waters Jack Individual from Pennsylvania

Weaver Debra Internal Revenue Service

Weinburg Mark Individual from Massachusetts

Weiner Joann M. George Washington University

Wells Kenneth Individual from Alaska

Wells Steve Individual from Georgia

Welsh Walter ACLI, AALU, GAMA, NAILBA, and NAIFA

West Jade The LIFO Coalition

West Philip Steptoe & Johnson LLP

Westover-Kernan Tiffany Corporate Voices for Working Families

Whalen Richard None provided

Whitehead Lois NY State Society of Certified Public Accountants

Whitson Herb Individual from Georgia

Wilkerson Matt None provided

Wilkerson Matt Americans for Fair Taxation

Williams Michael North American Equipment Dealers Association

Williams Lyn AFFT

Wilson John Meredith College

Wilson Leslie Wilson & Associates Architects, Inc.

Wilson Logan Individual from Arizona

Wilson Charles Individual from Ohio

Witt David Individual from Ohio

Wolf Maurice A. Individual from California

Wrick Nancy Individual from Pennsylvania

Wright Arthur W. University of Connecticut

Wright Sam None provided



Wyden Ron U.S. Senator Ron Wyden

Yin George K. University of Virginia School of Law

Young Mary Ann Fair Tax

Zagaris Bruce Berliner, Corcoran & Rowe, LLP

Zieburtz Wiliam None provided

Zobel Kenneth Individual from New York

Zolt Eric M. UCLA

Beckham None provided

Burrton Individual from Georgia

Chris Individual from Georgia

Colin Individual from Missouri

Ed Individual from Pennsylvania

Edward Individual from France

Froggy Individual from Colorado

Glenn LU 803

Greg Illinois State University Graduate Student

Harry None provided

Indigent Salvation Army

J None provided

Jess None provided

Jill Individual from Utah

Jim Individual from Georgia

John None provided

Joy Individual from Arizona

Kalanda Individual from Florida

Karen Fair Tax

Kristina Individual from Florida

Nancy None provided

118


Peter Self-Employed

Peter Self-Employed

Tasha Individual from Michigan

Ted Individual from Florida

National Tax Association

IRS Research Conference

NBER Tax Policy and the Economy Conference

the president’s - the washington post the report on tax reform options: simplification,...

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