Nellen, Annette M.

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San Jose State UniversitySJSU ScholarWorksFaculty Publications Accounting and Finance1-1-2005Incorporating Tax Reform into Tax CoursesAnnette M. NellenSan Jose State University, annette.nellen@sjsu.eduFollow this and additional works at: https://scholarworks.sjsu.edu/acc_fin_pubPart of the Accounting Commons, and the Taxation CommonsThis Article is brought to you for free and open access by the Accounting and Finance at SJSU ScholarWorks. It has been accepted for inclusion inFaculty Publications by an authorized administrator of SJSU ScholarWorks. For more information, please contact scholarworks@sjsu.edu.Recommended CitationAnnette M. Nellen. "Incorporating Tax Reform into Tax Courses" The Tax Adviser (2005): 299-303.TaxEducation How to Incorporate Tax Reform into Tax Courses Editor's note: Professor Nellen is a former member of the AICPA Tax Division Task Force that pro­duced the tax policy concept statement cited in the exhibit on p. 303 of this column, and the Tax Executive Committee. For more information about this col­umn, contact Prof. Nellen at anellen@sjsu.edu. About once every decade, fundamental tax reform returns to the national polit­ical agenda. Discussions about replac­ing the Federal income tax with a sales tax, a value-added tax (VAT) or a flat tax often become front-page news. Unfortunately, the vastness ofintroductory tax courses and the intricacies of tax reform preclude coverage of reform in most tax text­books. But, in overlooking it, tax educators miss an opportunity to help students understand and appre­ciate tax policies and get involved in a national debate of wide interest. This column offers an approach for including tax reform in an intro­ductory tax course-whether at the undergraduate or graduate level. It provides a structure, basic content and student assignments. This course module will enable students to: 1. IdentifY key reasons why funda­mental tax reform has been suggested. 2. Define "fundamental" tax reform. 3. Explain the difference between an income tax and a consumption tax. 4. Explain the basics of the flat tax, national sales tax and VAT. 5. Evaluate tax reform proposals.  Editor and Author: Annette Nellen, CPA, Esq. Professor, Department of Accounting & Finance San Jose State University San Jose, CA Why Is Tax Reform on the National Political Agenda? Typical reasons for revamping or replacing the Federal income tax include simplification and economic growth. Specific concerns often cited are that the income tax discourages savings, taxes corporate income twice, provides a preference for cor­porate debt over equity (because interest is deductible, but dividends are not), taxes inflationary gains, includes too many tax preferences that distort decisionmaking and cre­ates a significant tax gap (i.e., the dif­ference between taxes owed and taxes voluntarily paid). Also suggest­ed is that the income tax is not suffi­ciently transparent, because of numerous deductions, credits and exemptions, as well as the effect of the al ternative minimum tax, making it difficult for taxpayers to know their marginal tax rate. Student assignments: 1. Find three government reports that provide evidence supporting the claim that today's income tax is too complex. Consider looking for reports by the Joint Committee on Taxation (JCT) and the IRS's THE TAX ADVISER / MAY 2005 299 How to Incorporate Tax Reform into Tax Courses Nellen, Annette The Tax Adviser; May 2005; 36, 5; ABI/INFORM Complete pg. 299 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Tax.Education National Taxpayer Advocate. Be sure to cite your sources. 2. Give three specific examples of how to simplifY today's income tax, without repealing it. Explain how each example would lead to simpli­fication. 3. Find data from a report no more than two years old on the size of the Federal tax gap. Explain two reme­dies to reduce the gap, noting, for each, two challenges of implement­ing that solution. 4. Acting as a member of Congress, write a letter to your constituents explaining either why you do (i) not support tax reform or (ii) support tax reform. What Is "Fundamental" Tax Reform? A point often overlooked in funda­mental tax reform discussions is that most proposals call for replacing the income tax with a consumption tax. Some of the proposals, such as the flat tax proposal introduced by former Congressman Dick Armey (R-TX), look like an income tax, but are really a consumption tax. Students need to know the basic differences between incom.e and consumption taxes and how to determine the system on which a proposal is based. An income tax is based on revenue less cost of goods sold and allowable deductions. The formula is similar to financial accounting. Common questions that arise in creating an income tax include: What is income? Should a broad economic concept be used that would include items such as government-provided bene­fits, imputed rental value of owner­occupied housing and gifts received? Which expenses should be allowed to reduce income? Should rates be progressive or flat? A consumption tax is one on spending rather than on income; income is taxed when spent (con­sumed), not when saved. Common forms are the sales tax and the VAT. A consumption tax exempts savings and allows businesses to deduct 300 THE TAX ADVISER / MAY 2005 Students need to know the differences between income and consumption taxes. investment in capital (such as land, buildings and equipment) currently, rather than depreciating it. Such expensing removes from taxation the expected future income from that investment. A commonly cited economic benefit of a consumption tax over an income tax is that it does not penalize taxpayers who earn and save in early years and consume in later years, relative to taxpayers who do not postpone consumption. A con­sumption tax would treat taxpayers with either consumption pattern sin"lilarly. Unequal treatment under an income tax stems from the early savers paying tax on earnings from savings. Stated another way, early consumers will have less income over their lifetimes (i.e., less earnings from savings), which would affect lifetime income taxes, but not life­time consumption taxes. Thus, the perceived benefit of a consumption tax versus an income tax is its ability to increase savings and investment. Common questions that arise in designing a consumption tax include: Who is the taxpayer/ con­sumer? For exatnple, who is the con­sumer of a college education or child care? Is education an invest­ment or a consumption? Should any type of consumption (such as med­ical care and food) be exempt? Should rates be progresstve or flat? How should regressivity concerns be addressed? A tax is regressive if a higher percentage of a lower­income taxpayer's incon"le goes toward paying the tax, relative to a high-income taxpayer (e.g., taxes on sales and gasoline are regressive). Example: Two individuals, A and B, each buy the same quantity of gasoline and pay $100 of excise taxes. A has $10,000 income, while B has $100,000 income. For A, the gasoline tax repre­sents 1% of his income, while it repre­sents only 0.1% of B's income. In contrast, a tax is progressive if taxpayers with higher incomes pay a higher percentage of their income in taxes than lower-income taxpayers (for example, the current income tax system). In explaining income and con­sumption taxes to students, it can be helpful to point out that annual income is either spent or saved: Income = Consumption + Savings. Consumption can be taxed directly, such as with a sales tax or by a for­mula: Consumption = Income -Savings. (Of course, this simple equa­tion becomes complicated when a taxpayer borrows money for con­sumption.) Measuring consumption as income less savings can be done under either a (1) cashflow approach (which follows the formula of income less savings, but gets compli­cated when accounting for debt) or (2) tax prepayment approach, by exempting income from savings (such as with the flat tax). For more infor­mation, see JCT, Description and Analysis of Proposals to Replace the Federal Income Tax (JCS-18-95, 6/5/95) (JCT 1995 Report), pp. 51-56, available at www.house.gov/ jct/s-18-95.pdf. Student assignments: 1. Should a Federal consumption tax apply to college tuition costs (is that a consumption or an investment)? 2. Should medical care be exempt under a consumption tax? List and Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TaxEducation explain two reasons why it should be exempt and two reasons why it should be taxed. 3. Is all income subject to tax under today's Federal income tax system? Explain. How Do Some Reform Proposals Operate? The three broad categories ofreform proposals are (1) a signifi­cantly modified income tax, (2) a consumption tax and (3) some com­bination of the two. (There are many government reports on tax reform. For an example of one that provides an overview to the many different proposals of the past decade, see Bickley, Flat Tax Proposals and Fundamental Tax Reform: AnOverview, Congressional Research Service, November 2004; available at www.fas.org/ sgp/ crs/IB95060.pdf.) Income tax overhaul: Significant modifications that could be made to the income tax include (1) com­pressing the rate structure, so there are fewer rates; (2) eliminating many credits and deductions, while lower­ing rates to allow for simplification and revenue neutrality; and (3) mak­ing the system. return-free for nuny individuals. Information on these types of modifications can be obtained from the JCT's 2001 sim­plification study (www.house.gov I jct/pubs01.html); the JCT's 2005 report on reforming tax expenditures (www.house.gov /jet/ s-2-05. pdf); and Treasury's 2003 report on return-free tax systems (www. treas.gov I offices/ tax-policy /library I noreturn.pdf). Consumption tax: Proposals calling for a consum.ption tax include the flat tax, national retail sales tax, VATs or a system based on the formula ofincome less savings. As used in tax reform discussions, "flat tax" typically refers to a tax designed by economists Hall and Rabushka, which is a modi­fied, subtraction-method VAT; see Hall and Rabushka, The Flat Tax, Hoover Institution Press, 2d ed., 1995. Former Congressman Armey based his flat-tax proposal on this model.    302 THE TAX ADVISER / MAY 2005 Under a subtraction-method VAT, the rate is applied to sales less purchases (i.e., the "value added" by a business). A significant component of the value added is wages. Under the flat tax, businesses can deduct wages paid to employees (but not fringe benefits). Under a pure sub­traction VAT, there would be no wage deduction. Under the flat tax, employees are taxed on wages, but allowed significant personal and dependency deductions to address some of the tax's regressivity. Under the flat tax, there are two types of taxpayers-businesses (regardless of the form of entity) and wage earn­ers. The same single rate applies to the tax base of both of these. Interest income and expense are omitted from the tax calculations. A VAT is a tax on the value added at each stage of production and distri­bution of goods and services. There are three main types: (1) credit invoice method (commonly used in Europe), (2) subtraction method and (3) addi­tion method. VATs are typically designed to be consumption taxes, in that businesses expense purchases of assets rather than depreciating them. A VAT yields the same an10unt of tax as a sales tax (assuming both use the same base). The difference is that the sales tax is collected at the consumer level. For examples of how each type of VAT works, see JCT 1995 Report, pp. 19-29. A national retail sales tax would operate much like a state sales tax. Some proponents suggest that the states could administer and collect it for Treasury. The tax base would need to be defined, as there is no uniform tax base among the states. An example of a formula approach to taxing consumption was the unlimited savings allowance (USA) tax introduced in 1995 by former Senator Sam. Nunn (D-GA) and Senator Pete Domenici (R­NM) (S 722, 104th Congress, 1st Sess.).That proposal included a grad­uated rate structure for individuals and a USA deduction, a concept similar to IRA deductions. This approach is also referred to as a con­sumed-income approach. Combination system: A combina­tion income and consumption tax system could involve a consun1ption tax for businesses and an income tax for high-income individuals. Student assignments: 1. Use the Congressional website (http:! /thomas.loc.gov) to find a proposal from the current or prior three Congresses that calls for a flat tax. Review the proposal and cre­ate two tax calculation worksheets, one for individuals and one for businesses. 2. Under a flat tax, such as the one introduced by former Congressman Armey or Senator Richard Shelby (R-AL) (S 1040, 108th Congress, 2d Sess.), investment income is not tax­able. What type of rule might be needed to distinguish between non­taxable investment income and tax­able business income? For example, if an individual (not an art dealer) buys a painting for $500 and sells it five years later for $5,000, is the $4,500 gain nontaxable investment income or taxable business income? What kind of rule can help distin­guish between these two types of income? 3. Many low-wage individuals bene­fit from the earned income tax cred­it (EIC), which would disappear under a flat tax. How could similar relief be provided without compli­cating what is intended to be a much simpler system? Would the EIC still be needed under a flat tax? 4. How might a national sales tax operate in conjunction with a state sales tax when the tax bases would differ? Can you design a system that would enable the states to collect the national sales tax? 5. Explain the types of changes needed to the current incom.e tax system to enable the IRS to com­pute the tax liability (a return-free system) for individuals using Forms W-4, W-2 and 1099. Explain whether such a system could be used Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. for all individuals? 6. Calculate today's income tax, as well as the flat tax under S 1040, for the following families, each with two children ages 5 and 16 and $15,000 mortgage interest: (i) $100,000 wage income and $20,000 investment income; and (ii) $20,000 wage income and $100,000 investment income. Analyzing Proposals There are many considerations in evaluating tax reform proposals. One approach considers 10 principles of good tax policy; see the exhibit at right. Additional considerations include: 1. What is the effect on state and local governments (incorporate into princi pie # 1 0)? For example, will they owe the national sales tax on their purchases? Will costs of bor­rowing increase when interest mcome on all bonds is tax-exempt (rather than only on municipal bonds)? Will donations to charity decline, pressuring governments to provide some charitable services because charitable donations are no longer deductible? Will the tax gap increase for state sales tax systems when the sales tax rate becomes very high, due to the addition of a Federal sales tax? 2. How will nonprofit organizations be taxed? 3. Will the Federal government be able to raise the same amount of revenue (revenue neutrality)? 4. Will there be winners and losers in terms of changed tax liabilities? 5. How should the government tran­sition from the old system to the new? Should relief be provided for loss and credit carryovers from the income tax system? Should spending from current savings be exempt under the assumption that it has already been subject to income tax when earned? 6. Does the proposal use a destination basis or an origin basis, and what is the likely effect (if any) on international competitiveness? (Under a destination basis, goods and services are taxed Exhibit: AICPA's 10 guiding principles of good tax policy 1. Equity and fairness 6. Neutrality 2. Certainty 7. Economic growth and efficiency 3. Convenience of payment 8. Transparency and visibility 4. Economy in collection 9. Minimum tax gop 5. Simplicity 1 0. Appropriate government revenues Source: AI CPA's Tax Policy Concept Statement!, Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax Proposals. For further details, see www.aicpa.org/download/members/div/tax/ Tax_Policy _simi !.pdf. where consumed; thus, imports would be taxed, but not exports.The destina­tion principle is commonly used by countries employing a VAT and is supposed to prevent tax rates from influencing the decision of where to purchase goods and services. Under the origin basis, goods and services are taxed where value is produced.) Student assignments: 1. Compare and contrast the flat tax and national sales tax systems as applied to individuals, using the principles of simplicity, transparency and minimum tax gap. 2. Which is more "fair," a flat tax or a progressive income tax? Explain your position. 3. List and explain two pros and cons for having your state conform to a national flat tax that replaces the Federal income tax. 4. Will a change from the current income tax system to a national sales tax system cause the price of hous­ing to increase or decrease (e.g., due to the loss of deductions for mort­gage interest and property taxes)? Look for government reports to get a better understanding of how taxes apply to housing and their likely effect. References There are numerous government reports on tax reform, particularly from the JCT and Congressional Research Service. There are also nonprofit tax organizations, such as the Center for Budget & Policy Priorities and various trade associa­tions, which have position papers on tax reform approaches . Many of the government reports, as well as links to legislative proposals, can be found at www.cob.sjsu.edu/nellen_a/txre fupd.html. A web search on tax reform and a particular issue (such as housing or international competi­tiveness) should yield papers from other organizations on these topics as well. Student assignments: 1. Conduct a web search for a par­ticular industry association and tax reform to find a position paper. Briefly summarize the organization's position and explain whether it con­sidered the principles of good tax policy (see exhibit above). 2. Using information gained from this tax reform lesson, write an edi­torial suitable for your school news­paper on some aspect of tax reform, which includes your supported posi­tion on the matter. 3. D escribe the current status of the work of the President's Advisory Panel on Federal Tax Reform. Conclusion A great deal of information is readily available from the Federal government and other sources on major tax reform. Due to media cov­erage, the topic is likely to pique the interest of tax and accounting stu­dents and, thus, presents a great opportunity to help them under­stand contemporary tax issues and to gain a better understanding of the types of taxes and principles of good tax policy. TTA THE TAX ADVISER/ MAY 2005 303 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 

Incorporating Tax Reform into Tax Courses

San Jose State University

San Jose State University
SJSU ScholarWorks
Faculty Publications Accounting and Finance
1-1-2005
Incorporating Tax Reform into Tax Courses
Annette M. Nellen
San Jose State University, annette.nellen@sjsu.edu
Follow this and additional works at: https://scholarworks.sjsu.edu/acc_fin_pub
Part of the Accounting Commons, and the Taxation Commons
This Article is brought to you for free and open access by the Accounting and Finance at SJSU ScholarWorks. It has been accepted for inclusion in
Faculty Publications by an authorized administrator of SJSU ScholarWorks. For more information, please contact scholarworks@sjsu.edu.
Recommended Citation
Annette M. Nellen. "Incorporating Tax Reform into Tax Courses" The Tax Adviser (2005): 299-303.
TaxEducation 
How to Incorporate Tax Reform 
into Tax Courses 
Editor's note: Professor Nellen is 
a former member of the AICPA 
Tax Division Task Force that pro­
duced the tax policy concept 
statement cited in the exhibit on 
p. 303 of this column, and the 
Tax Executive Committee. For 
more information about this col­
umn, contact Prof. Nellen at 
anellen@sjsu.edu. 
About once every decade, fundamental tax reform returns to the national polit­
ical agenda. Discussions about replac­
ing the Federal income tax with a 
sales tax, a value-added tax (VAT) or 
a flat tax often become front-page 
news. Unfortunately, the vastness of
introductory tax courses and the 
intricacies of tax reform preclude 
coverage of reform in most tax text­
books. But, in overlooking it, tax 
educators miss an opportunity to 
help students understand and appre­
ciate tax policies and get involved in 
a national debate of wide interest. 
This column offers an approach 
for including tax reform in an intro­
ductory tax course-whether at the 
undergraduate or graduate level. It 
provides a structure, basic content 
and student assignments. This course 
module will enable students to: 
1. IdentifY key reasons why funda­
mental tax reform has been suggested. 
2. Define "fundamental" tax reform. 
3. Explain the difference between an 
income tax and a consumption tax. 
4. Explain the basics of the flat tax, 
national sales tax and VAT. 
5. Evaluate tax reform proposals. 
 
Editor and Author: 
Annette Nellen, CPA, Esq. 
Professor, Department of Accounting & Finance 
San Jose State University 
San Jose, CA 
Why Is Tax Reform on the 
National Political Agenda? 
Typical reasons for revamping or 
replacing the Federal income tax 
include simplification and economic 
growth. Specific concerns often cited 
are that the income tax discourages 
savings, taxes corporate income 
twice, provides a preference for cor­
porate debt over equity (because 
interest is deductible, but dividends 
are not), taxes inflationary gains, 
includes too many tax preferences 
that distort decisionmaking and cre­
ates a significant tax gap (i.e., the dif­
ference between taxes owed and 
taxes voluntarily paid). Also suggest­
ed is that the income tax is not suffi­
ciently transparent, because of 
numerous deductions, credits and 
exemptions, as well as the effect of 
the al ternative minimum tax, making 
it difficult for taxpayers to know 
their marginal tax rate. 
Student assignments: 
1. Find three government reports 
that provide evidence supporting the 
claim that today's income tax is too 
complex. Consider looking for 
reports by the Joint Committee on 
Taxation (JCT) and the IRS's 
THE TAX ADVISER / MAY 2005 299 
How to Incorporate Tax Reform into Tax Courses 
Nellen, Annette 
The Tax Adviser; May 2005; 36, 5; ABI/INFORM Complete 
pg. 299 
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 
Tax.Education 
National Taxpayer Advocate. Be sure 
to cite your sources. 
2. Give three specific examples of 
how to simplifY today's income tax, 
without repealing it. Explain how 
each example would lead to simpli­
fication. 
3. Find data from a report no more 
than two years old on the size of the 
Federal tax gap. Explain two reme­
dies to reduce the gap, noting, for 
each, two challenges of implement­
ing that solution. 
4. Acting as a member of Congress, 
write a letter to your constituents 
explaining either why you do (i) not 
support tax reform or (ii) support tax 
reform. 
What Is "Fundamental" Tax 
Reform? 
A point often overlooked in funda­
mental tax reform discussions is that 
most proposals call for replacing the 
income tax with a consumption tax. 
Some of the proposals, such as the flat 
tax proposal introduced by former 
Congressman Dick Armey (R-TX), 
look like an income tax, but are really 
a consumption tax. Students need to 
know the basic differences between 
incom.e and consumption taxes and 
how to determine the system on 
which a proposal is based. 
An income tax is based on revenue 
less cost of goods sold and allowable 
deductions. The formula is similar to 
financial accounting. Common 
questions that arise in creating an 
income tax include: What is income? 
Should a broad economic concept 
be used that would include items 
such as government-provided bene­
fits, imputed rental value of owner­
occupied housing and gifts received? 
Which expenses should be allowed 
to reduce income? Should rates be 
progressive or flat? 
A consumption tax is one on 
spending rather than on income; 
income is taxed when spent (con­
sumed), not when saved. Common 
forms are the sales tax and the VAT. 
A consumption tax exempts savings 
and allows businesses to deduct 
300 THE TAX ADVISER / MAY 2005 
Students need 
to know the 
differences 
between 
income and 
consumption 
taxes. 
investment in capital (such as land, 
buildings and equipment) currently, 
rather than depreciating it. Such 
expensing removes from taxation the 
expected future income from that 
investment. 
A commonly cited economic 
benefit of a consumption tax over 
an income tax is that it does not 
penalize taxpayers who earn and save 
in early years and consume in later 
years, relative to taxpayers who do 
not postpone consumption. A con­
sumption tax would treat taxpayers 
with either consumption pattern 
sin"lilarly. Unequal treatment under 
an income tax stems from the early 
savers paying tax on earnings from 
savings. Stated another way, early 
consumers will have less income 
over their lifetimes (i.e., less earnings 
from savings), which would affect 
lifetime income taxes, but not life­
time consumption taxes. Thus, the 
perceived benefit of a consumption 
tax versus an income tax is its ability 
to increase savings and investment. 
Common questions that arise 
in designing a consumption tax 
include: Who is the taxpayer/ con­
sumer? For exatnple, who is the con­
sumer of a college education or 
child care? Is education an invest­
ment or a consumption? Should any 
type of consumption (such as med­
ical care and food) be exempt? 
Should rates be progresstve or flat? 
How should regressivity concerns 
be addressed? A tax is regressive if 
a higher percentage of a lower­
income taxpayer's incon"le goes 
toward paying the tax, relative to a 
high-income taxpayer (e.g., taxes on 
sales and gasoline are regressive). 
Example: Two individuals, A and B, 
each buy the same quantity of gasoline 
and pay $100 of excise taxes. A has 
$10,000 income, while B has $100,000 
income. For A, the gasoline tax repre­
sents 1% of his income, while it repre­
sents only 0.1% of B's income. 
In contrast, a tax is progressive if 
taxpayers with higher incomes pay a 
higher percentage of their income 
in taxes than lower-income taxpayers 
(for example, the current income tax 
system). 
In explaining income and con­
sumption taxes to students, it can be 
helpful to point out that annual 
income is either spent or saved: 
Income = Consumption + Savings. 
Consumption can be taxed directly, 
such as with a sales tax or by a for­
mula: Consumption = Income -
Savings. (Of course, this simple equa­
tion becomes complicated when a 
taxpayer borrows money for con­
sumption.) Measuring consumption 
as income less savings can be done 
under either a (1) cashflow approach 
(which follows the formula of 
income less savings, but gets compli­
cated when accounting for debt) or 
(2) tax prepayment approach, by 
exempting income from savings (such 
as with the flat tax). For more infor­
mation, see JCT, Description and 
Analysis of Proposals to Replace the 
Federal Income Tax (JCS-18-95, 
6/5/95) (JCT 1995 Report), pp. 
51-56, available at www.house.gov/ 
jct/s-18-95.pdf. 
Student assignments: 
1. Should a Federal consumption tax 
apply to college tuition costs (is that 
a consumption or an investment)? 
2. Should medical care be exempt 
under a consumption tax? List and 
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 
TaxEducation 
explain two reasons why it should be 
exempt and two reasons why it 
should be taxed. 
3. Is all income subject to tax under 
today's Federal income tax system? 
Explain. 
How Do Some Reform 
Proposals Operate? 
The three broad categories of
reform proposals are (1) a signifi­
cantly modified income tax, (2) a 
consumption tax and (3) some com­
bination of the two. (There are 
many government reports on tax 
reform. For an example of one that 
provides an overview to the many 
different proposals of the past 
decade, see Bickley, Flat Tax Proposals 
and Fundamental Tax Reform: An
Overview, Congressional Research 
Service, November 2004; available at 
www.fas.org/ sgp/ crs/IB95060.pdf.) 
Income tax overhaul: Significant 
modifications that could be made to 
the income tax include (1) com­
pressing the rate structure, so there 
are fewer rates; (2) eliminating many 
credits and deductions, while lower­
ing rates to allow for simplification 
and revenue neutrality; and (3) mak­
ing the system. return-free for nuny 
individuals. Information on these 
types of modifications can be 
obtained from the JCT's 2001 sim­
plification study (www.house.gov I 
jct/pubs01.html); the JCT's 2005 
report on reforming tax expenditures 
(www.house.gov /jet/ s-2-05. pdf); and 
Treasury's 2003 report on return-free 
tax systems (www. treas.gov I offices/ 
tax-policy /library I noreturn.pdf). 
Consumption tax: Proposals calling 
for a consum.ption tax include the flat 
tax, national retail sales tax, VATs or a 
system based on the formula of
income less savings. As used in tax 
reform discussions, "flat tax" typically 
refers to a tax designed by economists 
Hall and Rabushka, which is a modi­
fied, subtraction-method VAT; see 
Hall and Rabushka, The Flat Tax, 
Hoover Institution Press, 2d ed., 1995. 
Former Congressman Armey based 
his flat-tax proposal on this model. 
 
 
 
302 THE TAX ADVISER / MAY 2005 
Under a subtraction-method 
VAT, the rate is applied to sales less 
purchases (i.e., the "value added" by 
a business). A significant component 
of the value added is wages. Under 
the flat tax, businesses can deduct 
wages paid to employees (but not 
fringe benefits). Under a pure sub­
traction VAT, there would be no 
wage deduction. Under the flat tax, 
employees are taxed on wages, but 
allowed significant personal and 
dependency deductions to address 
some of the tax's regressivity. Under 
the flat tax, there are two types of 
taxpayers-businesses (regardless of 
the form of entity) and wage earn­
ers. The same single rate applies to 
the tax base of both of these. 
Interest income and expense are 
omitted from the tax calculations. 
A VAT is a tax on the value added 
at each stage of production and distri­
bution of goods and services. There 
are three main types: (1) credit invoice 
method (commonly used in Europe), 
(2) subtraction method and (3) addi­
tion method. VATs are typically 
designed to be consumption taxes, in 
that businesses expense purchases of 
assets rather than depreciating them. A 
VAT yields the same an10unt of tax as 
a sales tax (assuming both use the 
same base). The difference is that the 
sales tax is collected at the consumer 
level. For examples of how each type 
of VAT works, see JCT 1995 Report, 
pp. 19-29. 
A national retail sales tax would 
operate much like a state sales tax. 
Some proponents suggest that the 
states could administer and collect it 
for Treasury. The tax base would 
need to be defined, as there is no 
uniform tax base among the states. 
An example of a formula 
approach to taxing consumption was 
the unlimited savings allowance 
(USA) tax introduced in 1995 by 
former Senator Sam. Nunn (D-GA) 
and Senator Pete Domenici (R­
NM) (S 722, 104th Congress, 1st 
Sess.).That proposal included a grad­
uated rate structure for individuals 
and a USA deduction, a concept 
similar to IRA deductions. This 
approach is also referred to as a con­
sumed-income approach. 
Combination system: A combina­
tion income and consumption tax 
system could involve a consun1ption 
tax for businesses and an income tax 
for high-income individuals. 
Student assignments: 
1. Use the Congressional website 
(http:! /thomas.loc.gov) to find a 
proposal from the current or prior 
three Congresses that calls for a flat 
tax. Review the proposal and cre­
ate two tax calculation worksheets, 
one for individuals and one for 
businesses. 
2. Under a flat tax, such as the one 
introduced by former Congressman 
Armey or Senator Richard Shelby 
(R-AL) (S 1040, 108th Congress, 2d 
Sess.), investment income is not tax­
able. What type of rule might be 
needed to distinguish between non­
taxable investment income and tax­
able business income? For example, 
if an individual (not an art dealer) 
buys a painting for $500 and sells it 
five years later for $5,000, is the 
$4,500 gain nontaxable investment 
income or taxable business income? 
What kind of rule can help distin­
guish between these two types of 
income? 
3. Many low-wage individuals bene­
fit from the earned income tax cred­
it (EIC), which would disappear 
under a flat tax. How could similar 
relief be provided without compli­
cating what is intended to be a much 
simpler system? Would the EIC still 
be needed under a flat tax? 
4. How might a national sales tax 
operate in conjunction with a state 
sales tax when the tax bases would 
differ? Can you design a system that 
would enable the states to collect the 
national sales tax? 
5. Explain the types of changes 
needed to the current incom.e tax 
system to enable the IRS to com­
pute the tax liability (a return-free 
system) for individuals using Forms 
W-4, W-2 and 1099. Explain 
whether such a system could be used 
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for all individuals? 
6. Calculate today's income tax, as 
well as the flat tax under S 1040, for 
the following families, each with two 
children ages 5 and 16 and $15,000 
mortgage interest: (i) $100,000 wage 
income and $20,000 investment 
income; and (ii) $20,000 wage income 
and $100,000 investment income. 
Analyzing Proposals 
There are many considerations in 
evaluating tax reform proposals. One 
approach considers 10 principles of 
good tax policy; see the exhibit at 
right. Additional considerations 
include: 
1. What is the effect on state and 
local governments (incorporate into 
princi pie # 1 0)? For example, will 
they owe the national sales tax on 
their purchases? Will costs of bor­
rowing increase when interest 
mcome on all bonds is tax-exempt 
(rather than only on municipal 
bonds)? Will donations to charity 
decline, pressuring governments to 
provide some charitable services 
because charitable donations are no 
longer deductible? Will the tax gap 
increase for state sales tax systems 
when the sales tax rate becomes very 
high, due to the addition of a 
Federal sales tax? 
2. How will nonprofit organizations 
be taxed? 
3. Will the Federal government be 
able to raise the same amount of 
revenue (revenue neutrality)? 
4. Will there be winners and losers 
in terms of changed tax liabilities? 
5. How should the government tran­
sition from the old system to the 
new? Should relief be provided for 
loss and credit carryovers from the 
income tax system? Should spending 
from current savings be exempt 
under the assumption that it has 
already been subject to income tax 
when earned? 
6. Does the proposal use a destination 
basis or an origin basis, and what is the 
likely effect (if any) on international 
competitiveness? (Under a destination 
basis, goods and services are taxed 
Exhibit: AICPA's 10 guiding principles of good tax policy 
1. Equity and fairness 6. Neutrality 
2. Certainty 7. Economic growth and efficiency 
3. Convenience of payment 8. Transparency and visibility 
4. Economy in collection 9. Minimum tax gop 
5. Simplicity 1 0. Appropriate government revenues 
Source: AI CPA's Tax Policy Concept Statement!, Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax 
Proposals. For further details, see www.aicpa.org/download/members/div/tax/ 
Tax_Policy _simi !.pdf. 
where consumed; thus, imports would 
be taxed, but not exports.The destina­
tion principle is commonly used by 
countries employing a VAT and is 
supposed to prevent tax rates from 
influencing the decision of where to 
purchase goods and services. Under 
the origin basis, goods and services are 
taxed where value is produced.) 
Student assignments: 
1. Compare and contrast the flat tax 
and national sales tax systems as 
applied to individuals, using the 
principles of simplicity, transparency 
and minimum tax gap. 
2. Which is more "fair," a flat tax or 
a progressive income tax? Explain 
your position. 
3. List and explain two pros and cons 
for having your state conform to a 
national flat tax that replaces the 
Federal income tax. 
4. Will a change from the current 
income tax system to a national sales 
tax system cause the price of hous­
ing to increase or decrease (e.g., due 
to the loss of deductions for mort­
gage interest and property taxes)? 
Look for government reports to get 
a better understanding of how taxes 
apply to housing and their likely 
effect. 
References 
There are numerous government 
reports on tax reform, particularly 
from the JCT and Congressional 
Research Service. There are also 
nonprofit tax organizations, such as 
the Center for Budget & Policy 
Priorities and various trade associa­
tions, which have position papers on 
tax reform approaches . Many of the 
government reports, as well as links 
to legislative proposals, can be found 
at www.cob.sjsu.edu/nellen_a/txre 
fupd.html. A web search on tax 
reform and a particular issue (such as 
housing or international competi­
tiveness) should yield papers from 
other organizations on these topics 
as well. 
Student assignments: 
1. Conduct a web search for a par­
ticular industry association and tax 
reform to find a position paper. 
Briefly summarize the organization's 
position and explain whether it con­
sidered the principles of good tax 
policy (see exhibit above). 
2. Using information gained from 
this tax reform lesson, write an edi­
torial suitable for your school news­
paper on some aspect of tax reform, 
which includes your supported posi­
tion on the matter. 
3. D escribe the current status of the 
work of the President's Advisory 
Panel on Federal Tax Reform. 
Conclusion 
A great deal of information is 
readily available from the Federal 
government and other sources on 
major tax reform. Due to media cov­
erage, the topic is likely to pique the 
interest of tax and accounting stu­
dents and, thus, presents a great 
opportunity to help them under­
stand contemporary tax issues and to 
gain a better understanding of the 
types of taxes and principles of 
good tax policy. 
TTA 
THE TAX ADVISER/ MAY 2005 303 
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