The Advisory Panel's Tax Reform Proposals

Publication Date: July 2006

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Banking and finance

Type:

Abstract:

In November 2005, the President's Advisory Panel on Tax Reform presented two potential reform proposals: a simplified income tax (SIT) and a direct consumption tax proposal (the growth and investment tax, or GIT). Both proposals would eliminate itemized deductions while allowing, for all taxpayers, a credit for mortgage interest deductions and deductions for charitable contributions and health insurance. Both proposals substitute credits for personal exemptions and standard deductions. Both would allow greatly expanded tax-preferred savings plans. SIT would eliminate taxes on dividends and most capital gains from corporate stock, simplify depreciation and allow expensing (deducting costs immediately) for small business, and alter the international tax regime. GIT, as a consumption tax, would allow expensing of all investment. GIT also includes a tax on passive capital income (dividends, interest, and capital gains).

Both proposals are stated to be both revenue and distributionally neutral. Because the panel uses a baseline assuming the 2001 tax cuts are permanent, both would lose revenue compared to the Congressional Budget Office (CBO) official baseline, which has the tax cuts expire as provided by current law. An additional revenue loss is expected in the long run because of the proposals for tax-deferred savings plans. These measures also cause the income tax proposal to be slightly less progressive than current law. The consumption tax proposal is likely to be significantly less progressive than current law.

The plans would simplify tax filing for higher-income individuals and the self employed; lower-income taxpayers could, in some cases, have more complicated tax returns. Much simplification rests on the assumption that many minor provisions, not actually discussed, will be eliminated, an unlikely event in the case of certain provisions such as casualty losses and catastrophic medical expenses.

Both plans would likely increase efficiency in the allocation of capital, but these effects would be quite small for SIT and lessened for GIT due to the tax on financial income. The SIT may magnify distortions in the allocation of capital around the world. The effects on overall economic growth would be negligible for SIT because of the limited change in marginal tax rates. Although there would be a substantial reduction in effective tax rates on new investment under GIT, the growth effects for this plan are uncertain and may be quite modest. In any case, they are not large enough to materially affect the budget outlook. The effects on economic efficiency other than in the allocation of capital are mixed: a floor under charitable deductions along with expansion to non-itemizers would contribute to efficiency, but the effects on health markets are unclear.

Transition problems present difficulties; the main issue with the SIT would probably be in the loss of deductions for homeowners with large houses and mortgages. These transition problems in the SIT are minor, however, in comparison with the significant problems in the GIT arising from the loss of depreciation deductions, interest deductions, and deductions for the recovery of inventory. This report will not be updated.