It is said to cost the country in lost time, economic efficiency, trade, and contentment. This report surveys some of the issues to be considered in debating such drastic tax changes, considering not only a broader based income tax but also three basic forms of consumption taxes: the Hall-Rabushka "flat tax," the value-added tax (VAT), and the national retail sales tax. Although many recent proposals are referred to as "flat taxes," most actually go much further than merely adopting a flat-rate tax structure and would change the tax base from income to consumption. The President indicated that fundamental tax reform would be a major priority of his second term, although the shape of that reform is uncertain at this point. His advisory commission has included a modified flat tax (which included a tax on financial income) as one of the recommended options along with an income tax reform. (There are distributional consequences to this feature that will be discussed subsequently). Effects on Saving

Intertemporal models also tend to predict an increase in savings in switching from income to consumption taxes and this effect is often viewed to be a positive result of a consumption tax (separate from the efficiency gains described above). Other sectors that might be adversely affected by broadening the base to more fully reflect income and by removing itemized deductions are the non-profit sector, the state and local sector, the residential real estate industry, and the health care sector. These are sectors that receive special benefits under the income tax. Proposals to shift the tax base from an income base to a consumption base (most proposals), while generally increasing business investment, would differentially affect firms, depending on their growth rate, capital structure, and employee benefit structure. They would also make investment in pensions, insurance policies, owner-occupied housing, and tax-exempt bonds relatively less attractive, and investments in ordinary stocks and bonds more attractive. While all shifts to a consumption tax cause some common transitional disturbances and windfall gains and losses, the most serious problems arise from a shift to a national retail sales tax or to a value added tax. Windfall Losses for Equity Investments Under the Flat Tax

The flat tax also produces some transitional effects on cash flow that can be quite severe for owners of assets because it does not require a price accommodation. Such revisions would be costly to include, and would require much higher tax rates, perhaps for a long period of time. In fact, for many individuals, the current system is a flat tax with a single rate and a large exemption. Administrative costs often arise from taxpayers' attempts to avoid paying taxes, and no tax reform will produce a system in which people do not wish to avoid taxes. How Would the Distribution of the Tax Burden and the Level of Tax Revenues be Affected by a Different Tax System? The required rates in other proposals will depend on the base. Increases in labor supply would increase the tax base. Wealthy individuals would have their tax burdens reduced over their lifetime if they maintain and increase their assets.
The current income tax system is criticized for costly complexity and damage to economic efficiency. Reform suggestions have proliferated, including a national retail sales tax, several versions of a value-added tax (VAT), the much-discussed "Flat Tax" on consumption (the "Hall-Rabushka" tax), the "USA" proposal for a direct consumption tax, and revisions of the income tax. The President has indicated that major tax reform will be a priority item in his second term, and his tax reform commission has included a modified flat tax as one of its options.
Most reform proposals are based on the notion that switching to a consumption tax base or exempting savings from tax would increase the savings rate and improve economic efficiency. Although theoretical inter-temporal models predict that saving and efficiency would increase, evidence from past tax cuts does not bear out this prediction. Any effect on savings would depend crucially on the transition provisions. It is also argued that these taxes could improve the country's trade balance. Trade balances, however, depend on capital flows and would be affected by these tax changes only if they do bring about an increase in the U.S. savings rate. There is no reason to expect trade benefits from any of the tax changes per se.
A broader tax base would have diverse effects on economic sectors. Sectors that might be adversely affected include the non-profit sector (loss of charitable contributions deductions), the state and local sector (loss of state tax deductions, change in their own tax structures), and the health care sector (taxation of fringe benefits). Shifting the tax base from income to consumption, while generally increasing business investment, would differentially affect firms, depending on their growth rate, capital structure, and employee benefit structure. Such a shift would also make investment in pensions, insurance policies, owner-occupied housing, and tax-exempt bonds relatively less attractive.
There are macroeconomic problems with a transition to a consumption tax, and these problems are extremely serious for transiting to a system that collects all revenue from business (VAT or retail sales tax). For these tax shifts, avoiding a serious economic contraction would be quite difficult. The flat tax would not have these problems but it can cause significant windfall losses in asset values.
A flat-rate tax is also intended to simplify the system and reduce compliance and administration costs. Many of the proposals, if kept simple while being enacted, would reduce costs; however, many individual taxpayers are currently under a flat-rate income tax, so their lot would not be much improved. An enacted law, however, might not be as simple as the proposals.
Consumption taxes also change the distribution of tax burdens, especially on generations. The old consume more of their incomes, and their burden would increase; younger people save more, and their burdens would fall. Higher income individuals would see a reduction in taxes. This report does not track current legislation and will not be updated.