SPEAKERS CONTENTS INSERTS Tables
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47–448 CC
1998
THE IMPACT ON INDIVIDUALS AND FAMILIES OF REPLACING THE FEDERAL INCOME TAX
HEARING
before the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTH CONGRESS
FIRST SESSION
APRIL 15, 1997
Serial 105–15
Printed for the use of the Committee on Ways and Means
COMMITTEE ON WAYS AND MEANS
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BILL ARCHER, Texas, Chairman
PHILIP M. CRANE, Illinois
BILL THOMAS, California
E. CLAY SHAW, Jr., Florida
NANCY L. JOHNSON, Connecticut
JIM BUNNING, Kentucky
AMO HOUGHTON, New York
WALLY HERGER, California
JIM McCRERY, Louisiana
DAVE CAMP, Michigan
JIM RAMSTAD, Minnesota
JIM NUSSLE, Iowa
SAM JOHNSON, Texas
JENNIFER DUNN, Washington
MAC COLLINS, Georgia
ROB PORTMAN, Ohio
PHILIP S. ENGLISH, Pennsylvania
JOHN ENSIGN, Nevada
JON CHRISTENSEN, Nebraska
WES WATKINS, Oklahoma
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
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CHARLES B. RANGEL, New York
FORTNEY PETE STARK, California
ROBERT T. MATSUI, California
BARBARA B. KENNELLY, Connecticut
WILLIAM J. COYNE, Pennsylvania
SANDER M. LEVIN, Michigan
BENJAMIN L. CARDIN, Maryland
JIM McDERMOTT, Washington
GERALD D. KLECZKA, Wisconsin
JOHN LEWIS, Georgia
RICHARD E. NEAL, Massachusetts
MICHAEL R. McNULTY, New York
WILLIAM J. JEFFERSON, Louisiana
JOHN S. TANNER, Tennessee
XAVIER BECERRA, California
KAREN L. THURMAN, Florida
A.L. Singleton, Chief of Staff
Janice Mays, Minority Chief Counsel
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public hearing records of the Committee on Ways and Means are also published in electronic form. The printed hearing record remains the official version. Because electronic submissions are used to prepare both printed and electronic versions of the hearing record, the process of converting between various electronic formats may introduce unintentional errors or omissions. Such occurrences are inherent in the current publication process and should diminish as the process is further refined. The electronic version of the hearing record does not include materials which were not submitted in an electronic format. These materials are kept on file in the official Committee records.
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C O N T E N T S
Advisory of April 8, 1997, announcing the hearing
WITNESSES
Armey, Hon. Richard, K., a Representative in Congress from the State of Texas
Family Research Council, Martin J. Dannenfelser, Jr.
Hubbard, R. Glenn, Columbia University
Mitchell, Daniel J., Heritage Foundation
National Center for Policy Analysis, Barry Asmus
Steuerle, C. Eugene, Urban Institute
Tax Analysts, Martin A. Sullivan
SUBMISSIONS FOR THE RECORD
Center for the Study of Economics, Columbia, MD, Steven Cord, statement
Ramstad, Hon. Jim, a Representative in Congress from the State of Minnesota, statement
Schaefer, Hon. Dan, a Representative in Congress from the State of Colorado, statement
Tauzin, Hon. W.J. ''Billy,'' a Representative in Congress from the State of Louisiana, statement
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THE IMPACT ON INDIVIDUALS AND FAMILIES OF REPLACING THE FEDERAL INCOME TAX
TUESDAY, APRIL 15, 1997
House of Representatives,
Committee on Ways and Means,
Washington, DC.
The Committee met, pursuant to notice, at 10:08 a.m., in room 1100, Longworth House Office Building, Hon. Bill Archer (Chairman of the Committee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE COMMITTEE ON WAYS AND MEANS
CONTACT: (202) 225–1721
FOR IMMEDIATE RELEASE
April 8, 1997
No. FC–6
Archer Announces Hearing on the Impact
on Individuals and Families
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of Replacing the Federal Income Tax
Congressman Bill Archer (R–TX), Chairman of the Committee on Ways and Means, today announced that the Committee will hold a hearing on the impact on individuals and families on replacing the Federal Income Tax. The hearing will take place on Tuesday, April 15, 1997, in the main Committee hearing room, 1100 Longworth House Office Building, beginning at 10:00 a.m.
Oral testimony at this hearing will be from invited witnesses only. However, any individual or organization not scheduled for an oral appearance may submit a written statement for consideration by the Committee and for inclusion in the printed record of the hearing.
BACKGROUND:
In the 104th Congress, the Committee held five days of hearings on problems caused by the current Federal income tax system and proposals to replace the Federal income tax. The Committee then began to examine how the proposed replacement systems would affect specific segments of society and the economy, holding hearings on the impact of replacing the income tax on small businesses, State and local governments, tax-exempt entities, international competitiveness, domestic manufacturing, energy and natural resources.
In announcing the next hearing, Chairman Archer stated: Two years ago, this Committee began a careful examination of how we could replace--in its entirety--our current income tax system. Now the Committee picks up on where it left off last year. Following this hearing, the Committee will continue to examine the impact of proposed alternatives, including the effects on employee benefits and retirement and personal savings incentives; home ownership and real estate generally; agriculture; retail sales; financial services; service industries; and health care.'' Dates for hearings on these topics will be announced in future advisories.
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FOCUS OF THE HEARING:
The focus of this hearing will be on the impact on individuals and families of replacing the Federal income tax with one or more of the proposed alternative tax systems. The basic alternatives are an income tax (with one or more rates); a flat tax (such as the one introduced by House Majority Leader Dick Armey); a national sales tax (such as the one introduced by Reps. Schaefer and Tauzin); a value added tax (both invoice-credit and subtraction methods); and an income tax system with an unlimited savings deduction (such as the USA tax system introduced by Senator Domenici and former Senator Nunn). The witnesses should assume that any new tax system would replace, on a deficit-neutral basis, the individual income tax, the corporate income tax, and estate and gift taxes.
DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:
Any person or organization wishing to submit a written statement for the printed record of the hearing should submit at least six (6) copies of their statement and a 3.5-inch diskette in WordPerfect or ASCII format, with their address and date of hearing noted, by the close of business, Tuesday, April 29, 1997, to A.L. Singleton, Chief of Staff, Committee on Ways and Means, U.S. House of Representatives, 1102 Longworth House Office Building, Washington, D.C. 20515. If those filing written statements wish to have their statements distributed to the press and interested public at the hearing, they may deliver 200 additional copies for this purpose to the Committee office, room 1102 Longworth House Office Building, at least one hour before the hearing begins.
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FORMATTING REQUIREMENTS:
Each statement presented for printing to the Committee by a witness, any written statement or exhibit submitted for the printed record or any written comments in response to a request for written comments must conform to the guidelines listed below. Any statement or exhibit not in compliance with these guidelines will not be printed, but will be maintained in the Committee files for review and use by the Committee.
1. All statements and any accompanying exhibits for printing must be typed in single space on legal-size paper and may not exceed a total of 10 pages including attachments. At the same time written statements are submitted to the Committee, witnesses are now requested to submit their statements on a 3.5-inch diskette in WordPerfect or ASCII format.
2. Copies of whole documents submitted as exhibit material will not be accepted for printing. Instead, exhibit material should be referenced and quoted or paraphrased. All exhibit material not meeting these specifications will be maintained in the Committee files for review and use by the Committee.
3. A witness appearing at a public hearing, or submitting a statement for the record of a public hearing, or submitting written comments in response to a published request for comments by the Committee, must include on his statement or submission a list of all clients, persons, or organizations on whose behalf the witness appears.
4. A supplemental sheet must accompany each statement listing the name, full address, a telephone number where the witness or the designated representative may be reached and a topical outline or summary of the comments and recommendations in the full statement. This supplemental sheet will not be included in the printed record.
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The above restrictions and limitations apply only to material being submitted for printing. Statements and exhibits or supplementary material submitted solely for distribution to the Members, the press and the public during the course of a public hearing may be submitted in other forms.
Note: All Committee advisories and news releases are available on the World Wide Web at 'HTTP://WWW.HOUSE.GOV/WAYS_MEANS/'.
The Committee seeks to make its facilities accessible to persons with disabilities. If you are in need of special accommodations, please call 202–225–1721 or 202–225–1904 TTD/TTY in advance of the event (four business days notice is requested). Questions with regard to special accommodation needs in general (including availability of Committee materials in alternative formats) may be directed to the Committee as noted above.
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Chairman ARCHER. The Committee will come to order. Today I'm pleased to continue our series of hearings on alternative tax systems for structural reform of our current income tax. Over the past 2 years, the Committee has heard expert testimony on the shortcomings of the current income tax and the impact of proposed alternative tax systems on various sectors of our economy.
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We covered a lot of ground in the 104th Congress, but we still have much work ahead of us. Today, April 15, is a fitting day to examine the impact of fundamental tax reform on individuals and families.
As most people by now in this country know, I continue to do my own income tax, so I understand first hand the frustrations of millions of taxpayers as they struggle to figure out their income tax forms.
That's why it's so important that Congress respond when public sentiment about our tax system turns critically negative. If our income tax is perceived as unfair, inefficient and complex, it's time to reevaluate how we fund government. Without public confidence in our tax system and the administration of pertinent laws, our system of voluntary compliance cannot survive.
I've come to the conclusion that the Tax Code is so broken that it can't be fixed. I don't think better management at the IRS will do the trick, and I don't think minor reforms of the Tax Code will work. Instead, I believe we need to fundamentally overhaul and simplify the Federal Tax Code.
The current code is unfair, riddled with loopholes, excessively complicated, overly intrusive and antigrowth. We can and we must do better. I think we should pull the income tax out by its roots and throw it away so that it never grows back, and remove the Federal tax collector, the IRS, from any direct contact with every individual American citizen, that is, to get the IRS completely and totally out of the lives of every individual American.
I favor replacing the income tax with a tax on consumption that is fairer and simpler and more conducive to economic growth.
Our witnesses today will address the many key questions about how families and individuals fare under current law, and whether alternative tax proposals may improve or worsen their lives.
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I'm also extremely pleased that our Majority Leader, and my very close friend, Dick Armey, has joined us today to discuss the merits of his bill, H.R. 1040.
I am now pleased to yield to Barbara Kennelly, the Acting Ranking Democrat on the Committee for any comments she might like to make.
Ms. KENNELLY. Thank you, Mr. Chairman. Good morning. This morning, the Committee is scheduled to hear testimony on the possibility of reforming the income tax and the impact on families. We would do well to recall that for all the complexity of the Code, the majority of all individual filers are in the 15 percent tax bracket, or pay no income tax at all.
First and foremost, any serious tax reform proposal should do no harm, and not leave these American families any worse off than they are today. It would be a cruel hoax to tell citizens a flat tax is possible, and not highlight the loss of a progressive tax system or the transition costs involved.
The second tax reform test ought to be deficit neutrality, or at least not increasing the deficit. There are those who would advocate a flat tax, which the Treasury Department projects would lose on average $138 billion annually. When the Federal budget deficit has come down in each of the last 4 years, such an approach borders on the irresponsible if this loss of progress is not factored in.
This Committee has a longstanding interest in tax fairness and simplicity. After careful thought and thousands of hours of work, we enacted the Tax Reform Act of 1986 which reduced taxes on individuals by $280 billion over 5 years, and took 6 million low-income families off the income tax rolls. The country is certainly very different economically than it was then, we have to admit today that we are dealing in a truly global economy.
And so I would say, yes, it is time to conduct another thorough review. However, we would do well to recall that the largest deductions are home mortgage, state and local taxes, and charitable contributions, and that the largest exclusions, employer provided health and pension benefits, dwarf the largest deductions.
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Taken together, these items account for the bulk of tax preferences in dollar terms. The Members, Democrat and Republican, House and Senate, were well unwilling to tackle these items in 1985 and 1986.
I do not see any reason to believe that any legislation that would reach the President's desk in 1997 or 1998 would be any different.
In the absence of such action, fundamental reform is unlikely in this session. I, however, feel that we should continue to look for possible doable tax reform, and obviously listening to the Chairman's remarks, I agree with him on simplicity.
It is also agreed that the 1986 Tax Reform Act, while dropping people from the rolls, also made business taxation even more complicated with the Alternate Minimum Tax, AMT, and passive loss changes. We should learn from these actions.
Having said that, I would welcome proposals to simplify the Internal Revenue Code, correct errors or rid the Code of outdated, unworkable provisions. In that vein, I am hopeful that the witnesses before us today will offer us constructive suggestions to do just that.
Thank you, Mr. Chairman, and, I, too, welcome the Majority Leader who is appearing before us, and who is so active in this question. Thank you.
Chairman ARCHER. Thank, you, Ms. Kennelly.
[The opening statement of Mr. Ramstad follows:]
Opening Statement of Hon. Jim Ramstad
Mr. Chairman, thank you for your continued leadership in exploring fundamental reform of our deeply flawed tax system.
Last year this committee had the opportunity to examine the impact of replacing our current system on several segments of society—from local governments, to large and small businesses, to tax-exempt organizations. But no group is more fundamental to our nation's well being than the one we are highlighting today—individual Americans and their families.
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Providing relief to American families is what major tax reform should be all about.
Our current system hurts families by being overly complex, costing billions of dollars and billions of hours to comply. Our current system also hurts families by creating disincentives to work, save and invest for their futures.
Replacing our present tax system could mean a much lower tax burden for American families, allowing them to keep more of what they earn. Tax reform could also help us reach our economic potential, which would mean more jobs and a better standard of living for American families.
Again, Mr. Chairman, thank you for this opportunity to examine how American taxpayers and their families could be affected by fundamental tax reform.
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Chairman ARCHER. I would like to invite our honored Majority Leader to take the witness chair, and to tell him that the reception will be warm here, in spite of our minor differences on this issue, and welcome to the Committee.
Without objection your entire printed statement will be put into the record, and you may summarize in any way that you see fit verbally, and you may proceed.
STATEMENT OF HON. RICHARD K. ARMEY, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF TEXAS, AND MAJORITY LEADER, HOUSE OF REPRESENTATIVES
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Mr. ARMEY. Thank you, Mr. Chairman. First of all let me thank you for holding these hearings. You alluded to our minor differences, and I would say, Mr. Chairman, they are minor. I think on the big things you and I are in perfect agreement.
We do find ourselves in agreement with the proposition that the current Tax Code is no longer acceptable to the American people. That proposition gets increasingly more verified each time we take a poll on the matter.
I first engaged this subject in January 1994 when I became convinced that the American people were fed up with the Tax Code, and would not tolerate a continued Tax Code of this type very much longer.
I should tell you, looking at some of the reasons why I found that they are fed up with it, the first is its complexity. And I was laughing at myself this morning. Mr. Chairman, my mother, who had only a high school education, spent most of her time, most of the years when I was a youngster at home, doing taxes for people throughout the community—individual taxes, taxes often for farmers and small businesses.
And in those days she was able, even with a high school education, to help people do their taxes, and they would then feel that they had some opportunity for things to come out right.
Today we find that the Tax Code is so complex that in a recent poll of IRS agents, the agents themselves answered only 78 percent of the questions correctly. The people that are mandated to enforce the Code can't get it right. This is a new story.
But here's my latest iteration of that story, Mr. Chairman.
As you know, I have a Ph.D. in economics. I've been studying these sorts of things all my life, and I, too, do my own taxes. My own taxes are somewhat simple. I am not a wealthy person. And one would think that I could do my taxes.
I have here today my tax refund check—$400 less than what I thought it would be when I sent my forms in to the IRS. I meticulously worked my way through the 1040 form, and the instructions. I thought I had covered all my bases. I filed my taxes a month and a half ago, and just 2 days ago I received a notification from the IRS that I had failed to decrease the value of my itemized deductions relative to my adjusted gross income, and they were making the adjustment on my behalf, and that I would get my refund check at some amount.
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I can't imagine having to go to heaven some day and face my mother and explain how I could make a mistake like that, especially when she's sure to remind me that that requirement in the Tax Code was put into effect during a period of time in which I was a Member of Congress. My only plea can be, Well, Mom, I didn't vote for it.
But at any rate, this shows me, I think, on a daily basis, the complexity is too much. We have all kinds of statistics on that which you'll find in my statement.
Seventy percent of people recently polled said they want a new Tax Code. Only one out of ten people said that they felt the current Tax Code could be repaired.
Taxes as we have them today are too high. There's no doubt about it. And, quite frankly, we believe that you can lower people's taxes and still retain the aggregate earnings.
Taxes are not neutral, and they do hinder economic opportunity. Taxes undermine good government. Now, I started studying this in January 1994. At that time, the unrest among the public had been consolidated primarily and almost singularly into an organization called Citizens for an Alternative Tax System. Mr. Chairman, you know them as principal advocates of a national sales tax.
I, naturally, in 1994 began to study the sales tax as an alternative to the existing Tax Code. And I felt frustrated in my efforts to respond in that way. At that point I rediscovered the work of Professors Hall and Rabushka, and began to restudy the flat tax, and as you know, I settled on the flat tax as a solution.
The problem is simple: the current Tax Code will not work. It is no longer acceptable to the American people. The solution is to replace it, and replace it altogether.
Why the flat tax? You get the simplicity that we're looking for, you get fairness, in that everybody's treated the same as everybody else. You will get an encouraged growth rate, because we end the double taxation of savings and investment that you have under the current Tax Code, and virtually everybody who has studied the flat tax is in agreement on that.
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There will be lower taxes. There is a de facto progressivity that's due to the generous family allowance that for a family of four is $33,800. This means that if you earn $25,000 you owe no tax. A family of four earning $50,000 will pay only 6 percent of its income in taxes, and a family earning $200,000 would pay 14 percent.
The flat tax is profamily in many ways, not the least of which, it relieves the family of the burden of just dealing with this complexity which if you do your own taxes you know can be a difficult thing.
It is an honest way to tax. I have to tell you, Mr. Chairman, I believe that in the end all taxes are paid by people, and all taxes are paid out of current income. And the flat tax, as a direct, honest income tax, accepts that proposition.
We are told by even the Federal Reserve Bank of Kansas City that the flat tax will lower interest rates by as much as 25 percent, and nobody that has examined the flat tax disputes that it will lower interest rates. The only dispute is in the estimators view of how much.
And let me just say very quickly that I believe very profoundly that in a flat tax world, charitable giving will go up because I think charitable giving is first a function of what charity is in your heart, and second, a function of what you have to give.
And in a flat tax world, where more people have better jobs, with more promotions and more take-home pay, they will give more. That is what happened in the eighties, where the tax value of charitable deductions went down, charitable deductions more than doubled, and charitable deductions to faith-based institutions more than tripled.
Those are my comments, Mr. Chairman, and I'll be happy to answer any questions.
[The prepared statement follows:]
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Statement of Representative Dick Armey
Mr. Chairman, I appreciate you affording me the opportunity to testify before the committee today on the subject of tax reform. I would also like to commend you for holding these hearings and focusing attention on the need to end the tax code and the IRS as we know it.
The Tax Code is Broken
As you have stated so many times yourself, Mr. Chairman, our current tax system is broken and needs to be scrapped and replaced with a system that is fair, simple and honest. The current tax code is complex; unfair; inhibits saving, investment and job creation; imposes a heavy burden on families; and undermines the integrity of the democratic process. It must go.
I'd like to focus my remarks today on the effect government taxation has had on America's families. Unfortunately, during the past few decades the tax system has become more complex, less fair, more destructive to the economy, and, in the process, more of a burden on American families.
Complex
The complexity of the tax system is incomparably worse than when I was growing up. When I was a child, during tax season my mother prepared tax returns for farmers and other small businessmen in Cando, North Dakota. Though she only had an eighth grade education, she was able to prepare tax returns and feel comfortable that they were correct.
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Today, even the best-trained tax attorney must question his ability to accurately complete a tax return. During the past forty years, the tax code has grown mind-numbingly complex. The number of words in the income tax code has increased more than four-fold to 800,000. There are more than 6,000 pages of accompanying tax regulations for the income tax.
Each year Americans devote 5.4 billion hours complying with the tax code, which is more time than it takes to build every car, truck and van built in the United States. The IRS sends out more than 8 billion pages of forms and instructions which, if laid end to end, would circle the earth 28 times.
In my own family we have experienced the costs of complexity. Like so many other American families, time we spend searching for receipts and studying tax law could be spent with our children.
Unfair
The main reason the tax code is complex, of course, is the proliferation of deductions, credits and other special preferences in the law. Because of these loopholes, taxpayers with similar incomes can pay vastly different amounts in taxes. This uneven treatment of taxpayers is fundamentally unfair and is at odds with the American value of equality before the law.
According to a recent poll by Luntz Research, three-quarters of Americans believe it is common for taxpayers with similar incomes to pay vastly different amounts in taxes. Perhaps this is why more than two-thirds support a fundamental overhaul of the tax system.
Heavy Taxes
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The American people are beleaguered by the highest tax burden in American history. Taxes represent a larger share of the economy than ever before. As a result, American families now pay more in taxes than they spend on food, clothing and shelter combined.
According to the Tax Foundation, in 1955 the typical family paid about 27 percent of its income in total taxes. Today, the typical family pays about 38 percent of its income in taxes—a 40 percent increase in the tax burden.
The Tax Foundation data reveal the key truth to why so many families feel as though two incomes are needed to do what one income accomplished a generation ago. While per capita income has doubled in the past generation, a majority of the higher income families have earned has gone to pay taxes.
Since 1955, 52 percent of the growth in wages for the typical single-earner family has gone to the government. For a two-earner family, 59 percent of the growth in wages has gone to pay higher taxes. The fact is, the second earner today works not to support the family, but to support the government.
But the tax code's anti-family bias doesn't stop there. The code often places a stiff cost on marriage through the so-called marriage penalty, under which people getting married face a tax increase. In addition, for years the value of the personal exemption, which includes the exemption for children, fell as inflation slowly but, over time, dramatically diminished the value of the personal exemption.
As you know, Mr. Chairman, most of the growth in the tax burden has come from higher payroll taxes and higher taxes at the state and local level. The only good news for families came in 1981. Were it not for President Reagan's 25 percent reduction in income tax rates and indexing of personal exemptions and the tax brackets to inflation, Americans would be paying significantly more in taxes than they do today.
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Hinders Economic Opportunity
While the economy has been generally healthy, it is not growing at its potential because of a tax policy that is biased against work, saving, investment and entrepreneurial activity. In fact, recent growth has sparked fears of inflation. When Alan Greenspan raised interest rates last month, he was indicting our current tax code, which prevents our economy from sustaining robust growth levels. By placing multiple layers on saving, the tax code reduces the amount of investments in new machines and technology that make American workers more efficient and competitive. By favoring certain economic activities over others, the tax code distorts financial decisions and reduces economic efficiency.
According to a study by Jane Gravelle, an economist with the Congressional Research Service, and Larry Kotlikoff, an economist at Boston University, the corporate income tax costs the economy more in lost production than it raises in revenue for the Treasury. Dale Jorgenson, the chairman of the Economics Department at Harvard University, found that each extra dollar the government raises in revenue through the current system costs the economy $1.39.
Undermines Good Government
In 1956, then Senator John F. Kennedy said, ''The lobbyists who speak for the various economic, commercial and other functional interests of this country serve a very useful purpose and have assumed an important role in the legislative process.'' Today, the lobbying industry is more than three times as large as it was when John Kennedy was President.
But as the government has grown and tax burdens and tax favoritism has proliferated, the lobbying industry has flourished. Today, the lobbying industry is the largest private sector employer in Washington. One out of every six private sector workers—62,072 people—work in the lobbying industry.
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The lobbying industry generates $8.4 billion in revenue each year, making it larger than the entire economies of 57 countries. Data from the Clerk of the House show that more lobbyists work on taxes than any other issue. The lobbying industry is no longer as innocuous as in John Kennedy's day. As tax favoritism has increased, so has the number and influence of lobbyists. As I have said many times before, it is not healthy for our economy or our democracy that so much talent, energy and resources are diverted toward securing special consideration under the tax system.
The Flat Tax Solution
Last month I introduced with Senator Shelby H.R. 1040, which would scrap the entire income tax code and replace it with a flat-rate income tax that treats all Americans the same. This plan would simplify the tax code, promote economic opportunity, and restore fairness and integrity to the tax system. The flat rate would be phased-in over a three-year period, with a 20 percent rate for the first two years and a 17 percent rate for subsequent years.
Individuals and businesses would pay the same rate. The plan eliminates all deductions and credits. The only income not subject to tax would be a generous personal exemption that every American would receive. For a family of four, the first $33,800 in income would be exempt from tax. There are no breaks for special interests. No loopholes for powerful lobbies. Just a simple tax system that treats every American the same.
What a Flat Tax Means for America
Simplicity
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The flat tax replaces the current income tax code, with its maze of exemptions, loopholes, and targeted breaks, with a system so simple Americans could file their taxes on a postcard-size form. The Tax Foundation estimates that a flat tax would reduce compliance costs by 94 percent, saving taxpayers more than $100 billion in compliance costs each year.
Fairness
The flat tax will restore fairness to tax law by treating everyone the same. No matter how much money you make, what kind of business you're in, whether or not you have a lobbyist in Washington, you will be taxed at the same rate as every other taxpayer.
Prosperity
Because the flat tax treats all economic activity equally, it will promote greater economic efficiency and increased prosperity. When saving is no longer taxed twice, people will save and invest more, leading to higher productivity and greater take-home pay. When marginal tax rates are lower, people will work more, start more businesses and devote fewer resources to tax avoidance and evasion. And because tax rules will be uniform, people will base their financial decisions on common-sense economics, not arcane tax law.
As you know, Mr. Chairman, the Joint Committee on Taxation hosted a conference in January at which a broad group of economists forecasted the results of tax reform proposals. Every economist who attended reported that a flat tax would result in a larger economy. Economists affiliated with the Brookings Institution, Federal Reserve, CBO, Coopers & Lybrand, DRI/McGraw-Hill, Harvard University and others all found that a flat tax would lead to higher living standards. The unanimous finding of such a diverse group of economists shows that there is virtually no debate as to whether the flat tax would increase economic growth, but only by how much.
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According to one study by a former chief economist for Congress' Joint Committee on Taxation, under the flat tax the economy would be 5.7 percent larger after five years than under the current system. That translates into $522 billion in higher output, or $3,000 in higher income for the typical family of four. Michael Boskin, a former chairman of the Council of Economic Advisors, estimates that the flat tax would increase the size of the economy by ten percent.
Lower Taxes
According to data by the U.S. Treasury Department, the bill would cut taxes by about $30 billion in the first year of enactment. When the rate is reduced to 17 percent in the third year of the proposal, there would be significant further tax reduction. The bill is carefully designed, however, to safeguard taxpayers against higher deficits. Rigid spending caps are included in the plan. Coupled with the additional economic growth the flat tax will spur, the tight spending controls will ensure that the budget reaches balance by 2002.
Progressivity
Under the flat tax, the more you earn, the more you pay. In fact, because of the high family exemption, the more a taxpayer earns, the greater the share of his income he pays in tax. A family of four earning $25,000 would owe no tax under the proposal. A family of four earning $50,000 would pay only six percent of its income in income taxes, while a family earning $200,000 would pay 14 percent.
Pro-Family
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The flat tax eliminates the marriage penalty and nearly doubles the deduction for dependent children. By ending the multiple taxation of saving, the flat tax provides all Americans with the tax equivalent of an unlimited IRA. This will make it easier for families to save for a home, a family vacation, a college education for their children, or for their retirement years.
Pro-Taxpayer
The flat tax trusts average Americans by giving them the freedom to make their own economic decisions. In addition, the flat tax includes a special safeguard against higher taxes. It requires a three-fifths supermajority vote of Congress to raise the tax rate, lower the family allowance or add loopholes.
Honesty
By eliminating itemized deductions and special breaks, the flat tax would have a chilling effect on special-interest lobbying and transform the political culture in Washington. Under a simple, transparent system that taxes all income one time at one rate—and requires a supermajority vote to add a loophole—there will be far fewer lobbyists than under today's system. Instead of being divided into numerous special-interest groups, the flat tax will make every American equal under the tax code with a shared interest in lower rates and continued fairness.
Lower Interest Rates
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According to a study by an economist at the Federal Reserve Bank of Kansas City, published in the Kansas City Federal Reserve's Economic Review, the flat tax would reduce interest rates by 25 percent, or about two percentage points. Lower interest rates under the flat tax will not only reduce the costs of student, car and credit card loans, they will also offset the loss of the home mortgage interest deduction. According to reports by the Congressional Research Service and the Tax Foundation, the flat tax will have no meaningful effect on home values.
Consider how a sharp reduction in interest rates would affect the average family that earns $50,000 and deducts $5,000 in mortgage interest. The home mortgage deduction saves this family $750 in taxes, where a 25 percent drop in interest rates saves it $1,250 in lower interest payments. That family is $500 better off under the flat tax with lower interest rates—even without the home mortgage interest deduction (and not counting the higher personal exemptions).
More to Give
As incomes rise under the flat tax, so too will donations to America's charities. Over the past several decades, increases in giving have closely tracked increases in personal income. This trend continued during the 1980s when, even as the tax value of the deduction declined and fewer taxpayers were able to take the charitable deduction, charitable giving increased. Because incomes will increase significantly under the flat tax, giving will rise in the long run as well, even without the charitable deduction.
I believe the flat tax would represent a tremendous step forward for American families. It would simplify the tax system, saving taxpayers countless hours and resources, freeing up time and money to meet more important family needs. A flat tax would also lead to increased prosperity and higher wages. Coupled with a tax cut, the higher incomes under the flat tax would significantly increase the take-home pay, allowing parents to meet the important needs of their family.
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Perhaps most importantly, a flat tax would be true to our values. A tax system under which every American is treated the same and special-interest provisions are removed would do a lot to increase the American public's faith in their government.
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Chairman ARCHER. Thank you, Mr. Majority Leader. Have you done your income tax for this year?
Mr. ARMEY. Yes, I have.
Chairman ARCHER. Because I was going to volunteer to help you work through the work table on how you lose your itemized deductions, in the event you needed any consultation or help.
Mr. ARMEY. Well, I'm going to go back and review that part, because I certainly don't want to suffer this embarrassment next year.
Chairman ARCHER. It's so typical of what we have in the Tax Code today, you're given something with one hand and it's taken away with the other hand. And we see that over and over in the Code.
You and I both agree that we need to do that. We need to do something about that and change it.
Could you tell the Committee what the maximum tax rate would be under your flat tax proposal?
Mr. ARMEY. If we were to implement the flat tax today, Mr. Chairman, we would start with a 20-percent rate. We would hold that rate for 2 years, and on the third year it would be lowered to 17 percent.
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We believe that gives the growth effect of the flat tax time to work its way into the economy and allows us to move to the 17 percent and stay there indefinitely.
Chairman ARCHER. Do you have revenue estimates on your proposal? Will a 20-percent rate in the first 2 years duplicate the revenue from the current code?
Mr. ARMEY. I believe the 20-percent rate, given the family allowance at the level we have it, gets us within $30 billion of current revenue.
Chairman ARCHER. $30 billion?
Mr. ARMEY. $30 billion.
Chairman ARCHER. Per year. Because the comments that were made by Ms. Kennelly early on were that you would lose $138 billion in the first year.
Mr. ARMEY. My bill, as I've written it, does not score that way. I know a lot of people have raised their eyebrows about the $30 billion, but I have to tell you, Mr. Chairman, if I were to endorse revenue neutrality I would be endorsing spending at its current levels, and I believe spending must come down anyway, so the flat tax as I've written it would provide further incentive for that.
And we have written in there spending caps to see to it that we would not worsen the deficit.
Chairman ARCHER. I have just one last question. In the event that your proposal were considered by this Committee, and in the event that a majority on the Committee believed that it would be appropriate to add some limited number of deductions, like charitable contributions, or home mortgage interest, would you be able to support such a bill, as a final package?
Mr. ARMEY. One would never want to turn their back on it altogether. I would resist that. I believe that the way you get simplicity and you make it stick is that you eliminate the whole playing field for special exemptions and itemized deductions.
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Once you've done that, then you've broken the Code. If you put in the homeowners' deduction, you've got now in place the first best reason to add charitable deductions. Once you have that in place, you've got two good first best reasons to do something, you're back in the same game.
If the Committee were to report a bill to the floor that reinstated in the new flat Tax Code these deductions—they would obviously have to adjust the rates to compensate for the revenue loss that would attend that—and I would petition the Rules Committee for the opportunity to offer an amendment in the form of a substitute that would give me a chance to have a vote on the flat tax written as I wrote it.
Chairman ARCHER. Well, you have just confirmed what you and I have privately talked about and confirmed my respect for you, in that you believe that this should be a pure flat tax, and not be dolled up with any kind of additional deductions, no matter how appealing, nor be extended to tax dividends, interests, or what we might call unearned income. And I greatly respect you for that.
Mr. ARMEY. Let me just say, Mr. Chairman, that I developed this model while making a trip to New Hampshire, not as a candidate last year, where having read their license plates, I decided to say the motto is Stay Flat or Die. But if you want tax reform to stick, you better stick with it.
Chairman ARCHER. Ms. Kennelly.
Ms. KENNELLY. Thank you, Mr. Chairman. And I salute your mother for doing those tax returns. I think, though, probably the fact that she got a good high school education had as much to do with it as the simplicity of the Tax Code, and that's something we'd like to get back to.
Mr. Armey, I'm still interested in the $138 billion figure, because I know that last year we had a lot of trouble getting the cuts we were looking for to balance the budget. I think we have to be realistic.
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I respect both of your opinions—the Chairman and the Majority Leader. But I have to say to you, though, that the American people have to understand very, very much up front that they could lose their home mortgage deduction and they have structured their finances based on that. They could lose other deductions, and that's why we have to make sure that the public understands.
But I am very interested in the charitable deduction. I come from a town, Hartford, that used to be well off. It's now on the list of the poorest cities in the United States of America, and I have met with people in the charitable world.
And they deal with the goodness of people's hearts constantly. As you mentioned, that's how people give to charity. But I have to tell you something, Mr. Majority Leader, a lot of it has had to do with the Tax Code.
And I would like you to explain once more what you just said, that when the tax rates go down the giving doubled, is that what you said?
Mr. ARMEY. Let me just relate, I believe the $138 billion figure you have comes from someone who scored me at 17 percent in the first year. I'm at 20 percent in the first year.
Ms. KENNELLY. Somebody at Treasury.
Mr. ARMEY. The home mortgage deduction is a worry to people, and what I have done, and people have done it by as many as 180,000 hits on the flat tax home page in a single month, when people try the current Tax Code with their home mortgage deduction and try the new Tax Code without it, more often than not they'll say I'd rather change.
In fact, I think in a recent poll, 54 percent of new mortgage holders said that for the other advantages they would get in a flat tax, they would happily give up their home mortgage deduction. That, I think, is quite manageable by education.
Now, the charitable thing, I think you have to rely on the empirical observation and some common sense. First of all, no intelligent, rational person is going to be willing to give $100 in order to gain a $33 reduction in their taxes.
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So clearly they're not making charitable contributions for the tax advantage. They make the contribution out of their belief in the purpose at hand, and how much money they have available.
What we saw in the eighties, when the tax value of a charitable contribution was cut to one third of its prior level, we saw that in fact charitable contributions doubled nationwide in the eighties, and tripled for faith-based organizations.
Faith-based charities, I think, are perhaps more often more reliant on the smaller denomination gifts of low-income people and clearly as they had more they gave more.
Ms. KENNELLY. Mr. Majority Leader, I still think the jury is out on that mortgage interest question, and we're going to have to be discussing this more, but you and I both know that we don't have a simplified tax system yet. And no, someone doesn't give $100 to get $33. But when someone earns $50 million and they would rather give to a charitable institution than give to the government, other things come into play.
And so that's another area I think we have to continue to look at. I'm not arguing with you that the system is not too complicated. It's much too complicated. It's antiquated. So I'm not here saying we don't need tax simplification, we don't need more tax fairness. I just want to make sure that the American people know what they're getting into when they give up a progressive tax system.
Mr. ARMEY. I agree. They should. That's why I wrote the book. That's why I put it on the home page.
Ms. KENNELLY. I bought it.
Mr. ARMEY. And that's why I invite people, try it for yourself.
Ms. KENNELLY. Thank you, Mr. Chairman.
Chairman ARCHER. Thank you. Mr. Collins.
Mr. COLLINS. Thank you, Mr. Chairman. Thank you, Mr. Armey for your comments and the proposals you've put forward, because it does give us some interesting data to talk about.
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My area of concern is that of small business, and how small businesses may be affected by either the consumption tax or by the flat tax. What have you determined or what have your studies shown a small business with profits between $75,000 and $150,000, how would they be affected? That seems to be a major concern of small businesses.
Mr. ARMEY. Mr. Collins, the first reaction I have is that under the flat tax we would expense inventory and capital expenditures. So obviously the simplicity of the Code shows up right away for a small business.
I have not worked out anything in particular, but the long and the short of it is that they would take any legitimate, necessary business expense, deduct that from gross earnings, and then pay the flat rate on the net earnings of the business, while they expense capital and inventory.
At this point, that's the best answer I can give you. I can't resist saying, by contrast, the small business organization in a flat tax world is not asked to be the tax collector for the State as a retailer, and they would hold no responsibility for any taxes other than their own, as opposed to a national sales tax, where they would be asked to collect taxes on behalf of the government.
Mr. COLLINS. But in contrast, a lot of small businesses do collect consumption tax on behalf of State government or local government. So that would be just adding one more entity line to the collection there.
But on the small business, and the difference seems to be, the concern is between the graduated tax rates on the smaller profits, versus the competitive edge that larger business may have with the flat tax. Now they will have the same flat tax rate as the larger business.
Mr. ARMEY. They would have the same rate. And obviously their business expenses are enumerated, but whether you're a small business or a large business, you must get to net earnings, and then you pay the same rate as anybody else.
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The object of the flat tax is to tax each dollar earned in the country in a tax year irrespective of its source at exactly the same rate as every other dollar that's earned.
Mr. COLLINS. In the area of small business—and I've been in small business—I'm still a small business man. I've had some type of small business for 35 years. I know I don't look that old. But I have.
But, you know, with the incentives that are there for the small investor to take a risk, and with the graduated tax rates and then of course the competitive edge that a lot of people with the resources and wherewithal that are in bigger businesses trying to compete with, I have some concern, too, that the flat rate may impose a higher or larger tax liability on small business.
Now, one thing I do like is your loss carry forward, because I've suffered some of those years when I had some loss carry forward that would not have been beneficial to me.
Now, under the individual taxpayer under the flat tax, what are your deductions there?
Mr. ARMEY. Well, let me just again remind you that any time you have high marginal rates you punish success and you discourage people from growing. The rates being the same, people would have all the incentive in the world to grow.
If you file the flat tax as an individual, it's a very simple calculation. You take your personal or your family exemption. For a family of four it's $33,800. You deduct that from your gross earnings, you get then your adjusted gross earnings, you apply the flat rate of 17 percent times that. In two simple calculations you're out of there and you go on, and you don't need to have all of the IRS records to find out what your brother-in-law is paying. All you have to know is the size of his income, and the size of his family, and you can calculate his taxes, and know that he's paying the same as you, and therefore you feel like there's justice in the world.
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Mr. COLLINS. Well, I can appreciate the simplicity. I am concerned that there may be a higher tax liability on small business, and that's one of the areas that I really want to focus in on.
I'm filing today. This is the first time. I told my brother, who is my CPA, that we're making history this year. I am actually filing on time. I will be sick at midnight tonight, but I'm still filing.
Mr. ARMEY. Well, I appreciate that, and you know, in the old days when you first started your business, it was easier to file on time.
Chairman ARCHER. Mr. Christensen.
Mr. CHRISTENSEN. Thank you, Mr. Chairman. And thank you, Mr. Armey, for your testimony and also for the fact that you've been leading the charge with our Chairman on this whole issue of restructuring the Tax Code.
I'm interested in hearing your opinion on whether or not tax policy should have any affect on social policy. You know, our code obviously plays a large role in the development of social policy, everywhere from tax credits for low-income housing to myriad deductions, for home mortgage, charitable and life insurance and everything else.
Let me ask you specifically, though, there's a lot of momentum right now on the Senate side in terms of some of the sin taxes, and also trying to affect the way some of the cigarette companies are targeting our children, and especially women.
I mean, it's deplorable what I see Philip Morris doing right now in a campaign to go after the younger females in an ad campaign. I really struggle with it, and I really am frustrated.
I am not of the opinion right now though that the way to effect change is through tax policy, but a lot of people are jumping on that band wagon. How do you feel about the social policy aspect?
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Mr. ARMEY. Well, as often I do, I take my instruction from Milton Friedman who once made the observation that once you set the rate everything else is social policy. I believe that the object of a Tax Code should be to raise that necessary revenue for the government in that manner which is the least meddlesome against the freedom of individuals.
I do not believe you ought to use the Tax Code in order to try to direct human action and human behavior in one way or another. Now, when you get down to the so called sin tax doctrine, that is, of course, a very heavy decision that carries with it a tone of morality, and often plays against some of our very heartfelt concerns, such as children and cigarette consumption, and so forth.
But in the end, we have discovered that the States and other areas tend to levy higher excise taxes in these areas of consumption precisely because they are price inelastic, that the principal motivation for the consumption is so compelling that they are hardly mitigated against by pecuniary influences.
So insofar as you say, for example, we're going to raise revenue and decrease smoking, you can't do both. It's going to be one or the other. And we have found that in many of these areas, there's just a lack of responsiveness.
Now there may be, and certainly must be things to address there, but I don't think that you—should I say, compromise the integrity of your Tax Code with respect to the question of neutrality in order to fulfill social objectives that might otherwise in fact be better fulfilled with other measures.
Mr. CHRISTENSEN. Thank you. Thank you, Mr. Chairman.
Chairman ARCHER. Mr. Jefferson.
Mr. JEFFERSON. Thank you, Mr. Chairman. Good morning, Mr. Armey. I want to ask you a question that I've run across in some of the studies that I have been provided which suggests that a totally flat rate, although it simplifies the Code, would involve a substantial shift of the tax burden from those in the highest income tax brackets to lower and middle income tax payers.
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The flat rate would raise the share of taxes paid by low- and middle-income tax families, and sharply reduce the share of taxes paid by the wealthy. And the reason for it is that for those people who are characterized as the working poor, this eliminates the Earned Income Tax Credit or EITC.
Now, I recognize that you have a higher floor where your taxation would start, but still above the limit that you're dealing with, that presents something of a problem. Is your limit now $33,000?
Mr. ARMEY. $33,800 for a family of four.
Mr. JEFFERSON. OK. The other is with respect to the effect on Federal Insurance Contributions Act, FICA, on employer paid health policies, and on other employee benefits that an employer may now exempt. Am I correct in thinking there may be a problem with this shifting, or do you have another answer for it?
Mr. ARMEY. Any time you're examining any change in the Tax Code, the redistribution charts are always the most difficult thing to measure out. You can say that anybody today who files a standard deduction, irrespective of the size of their family and the number of dependents, is going to be better off in a flat tax world than they are in today's world by virtue of the lower rate and the higher relative family exemption.
Many people at the low-income bracket would find their loss of earned income tax credit compensated for by that gain. Insofar as they're not compensated, then if you're engaging in a program of income maintenance for the low income, we think that should be transferred to the spending side of the ledger, not to the taxing side of the ledger. It's just a value judgment we make.
We know that as many as 10 million low-income families, or low-income individuals will be taken off the tax rolls in the flat tax world by the analysis that's been made of it. And, finally, what we've seen is, for example, Ross Perot last year who only paid 9 percent of his income in taxes, under the flat tax he would pay 17 percent of his income.
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If, in fact, as it is generally alleged, loopholes and exemptions are things that are most advantageous to the wealthy, then, of course, a Tax Code that eliminates them should have its greater impact on the wealthy. I believe the flat tax as I've written it is at least as fair as the current Tax Code relative to the question of progressivity, and I believe it is clearly more fair relative to a more widely held view of fairness, that fairness is when everyone is treated the same as everyone else.
And so I am perfectly willing to advance the flat tax as I've written it, on the fairness question, with great confidence that it holds up under scrutiny by individuals.
Mr. JEFFERSON. It appears that there is some question about it, because most of the loopholes, things we characterize as loopholes are really enjoyed by taxpayers who are not in the upper brackets, as it turns out.
Let me ask you one other thing, if I might. On the issue of shifting the way we characterize income, there's been a problem under previous codes that when you have a class of income that has a lower tax rate, or no tax rate, and it can be characterized from the type of income that has a higher rate to that which has a lower. That's when the escaping of the tax liability takes place.
If you have a system where you have no income tax on capital gains, no capital gains tax, and no tax in a few other areas, but that taxes everything that comes in wages and salaries, won't that be a powerful incentive to mischaracterize or to recharacterize the title you put on the income source to avoid paying tax altogether? Won't we have more tax avoidance problems under something like that?
Mr. ARMEY. Frankly just quite the contrary. Since the rate applies the same to every dollar irrespective of the source, there would be no reason to say I got it from this source versus that source. What we do with capital gains taxation is very important. We do not double tax that income.
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That income right now is doubled taxed at a very prejudicial rate. We would collect the taxes on capital earnings at the source in the same way as they are collected at their source now.
And I can give you a quick illustration. I have been filing my taxes with the IRS every year of my life since I was 16. I have never in all those years written a check to the IRS. The reason being my taxes were collected at the source, they were held on my account by the IRS, and at the end of the year I filed in such a way as to clean up my account with them, and they gave me, sometimes grudgingly, a refund of that extra money with no credit for interest earned during the time they were holding what is my savings.
Now, we're doing the same thing with investment earnings. We'll collect the tax at its source. We'll make the remittance at its source, but we won't ask you to suffer taxation on that same earnings a second time.
Mr. JEFFERSON. Thank you, Mr. Chairman.
Chairman ARCHER. Thank you. Dick, I understand that you've got an 11 o'clock appointment. Is that correct?
Mr. ARMEY. I imagine. I don't know.
Chairman ARCHER. Could you take two more questions before you have to leave?
Mr. ARMEY. Yes, I could.
Chairman ARCHER. Ms. Dunn.
Mr. ARMEY. As long as they're not too tough.
Ms. DUNN. I'll give you a couple of easy ones, Mr. Leader. Thank you, Mr. Chairman. I'm interested on behalf of the taxpayers in my district, and as a small business owner and the owner of a small family business in several areas.
And I am wondering if you could briefly tell us the effect of the flat tax, your flat tax with regards to what happens to the IRS, and estate taxes and savings.
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Mr. ARMEY. The IRS, I think—there's been an analysis. I forget where it was done—that as much as 94 percent of the current compliance costs with the IRS would be eliminated under the flat tax. I would guess—and I know I've heard the Speaker talk about a goal of reducing the size of the IRS by 60 percent. I would guess the flat tax would more than fulfill that goal.
Now, obviously, you will always have an enforcement agency any time you have a Tax Code. The question is, if you have a minimal code and a civilized code, can you have a minimal and a civilized IRS? I think you can accomplish that with a flat tax.
Ms. DUNN. And estate tax, and savings.
Mr. ARMEY. Under the flat tax, there is no estate tax. Again, we're trying to end double taxation. You should collect every dollar, gather every dollar into the tax base, tax it once in the year it's earned, and it should never be taxed the second time.
Savings, again, you paid taxes on your earnings in this year, you save them in any multiple number of ways, and you would not be taxed on that a second time.
Ms. DUNN. Thank you, Mr. Chairman.
Chairman ARCHER. Mr. Portman.
Mr. PORTMAN. Just a quick question, Mr. Leader. First, thank you for being here today, and thank you for testifying before the Commission to Restructure the IRS. That was very helpful to us.
We spent, as you know, about the last year looking into the problems at the Internal Revenue Service, and there is a consensus now, I think it's fair to say, among our 17 Commissioners, including Senator Kerry and myself, who are the cochairs, that until you simplify the Tax Code, you're really not going to be able to ultimately improve the IRS in the way all of us would like to see.
As long as you have the current Tax Code, it will be very difficult to administer it. That being said, there are things we should do with the IRS to make it work better, and we appreciate your testimony on that, and your giving us some pointers on simplification.
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One of the concerns that we have focused on with this commission is the EITC, and the degree to which that causes problems of administration at the IRS. Of course, there's a good deal of fraud with the program as well. And in our interviews with over 300 online IRS employees, the EITC came up time and time again as a problematic part of what they have to do.
In response to the question of Mr. Jefferson, you talked about the fact that with a more generous exemption, up to, I think, $33,800, you wouldn't be having an EITC. There wouldn't be the process of taxpayers filing and receiving a refund.
But that doesn't pick up everybody among the working poor. And you mentioned on the spending side addressing it. Is your thought that the tax system might not be the best place to address some of those problems, but rather you'd do it in terms of new spending from Congress? How do you respond to that?
Mr. ARMEY. That is my thought. I mean, we're basically making a decision that we have certain levels of income, given certain family sizes and so forth, that are insufficient to achieve an acceptable level of living for that family, and that we want to supplement that family's income.
Now, there are two ways you can do that. You can either do it directly through the expenditure way, which I think is the more clear, direct and honest way to do it, or you can do it through the Tax Code. We tried that with the EITC, and I think one of the heartbreaking things about our effort to work that way is the fact that it's resulted in an enormous amount of fraud, and has driven up the compliance frustrations of the agency enormously.
But it's also fed a certain cynicism among the taxpayers. When, you know, people frankly don't need to read your tax forms, like the IRS has been doing quite frankly illegitimately, but they know, the word goes through a community that somebody is getting away with something, and there's a resentment from that.
Either somebody resents it or they mimic it. And when those things happen I think that creates a cynicism throughout the country. We pride ourselves with the concept of a voluntary tax system. I think if you're going to have a system of voluntary compliance, people are going to have to believe it's simple, it's fair, it's honest, and nobody has an opportunity to game it.
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And if I don't believe somebody else is doing it, then I will restrain myself from doing it. But once you allow that cynicism to creep in, I think you have a self-defeating process.
Mr. PORTMAN. Thank you. Thank you, Mr. Chairman.
Chairman ARCHER. Dick, one last question, and then we will release you. Mr. Hayworth.
Mr. HAYWORTH. I thank the Chairman, and the Leader. Thanks for coming by to see us today, and I appreciate this preview of the great debate that will take place in terms of tax reform.
You touched earlier on a subject of great concern to me, especially on April 15, in your response to the question from our colleague from Washington State, in terms of the flat tax and its impact on the IRS.
One of the stated goals of the new majority in Congress is to end the IRS as we know it. Indeed, Chairman Kasich of the Budget Committee this weekend on national television talked about abolishing the Internal Revenue Service as it exists today.
And while you offered a projection that seemed to align with the estimation of the Speaker, in terms of reducing the size of the Internal Revenue Service by some 60 percent, or perhaps in excess of that, one of the criticisms of the flat tax I am hearing is that perhaps it would not alter the role of the IRS enough in terms of its intrusive nature.
Indeed, some of the work done by Raymond Keating of the Center for Small Business Survival as reported in the Journal of the Foundation for Economic Education, talked about the institution of the income tax and how it has grown to this leviathan stature in our society.
What safeguards should we take if we end up with a flat tax to in fact make sure that the system does not grow back again at some future date for future generations?
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Mr. ARMEY. I think it goes back, frankly, to the question asked earlier by Chairman Archer. It seems to me you have to write the flat tax with enormous discipline. I mean, make it as simple as you can make it. And I think we've done that. And then stick by your guns. Resist all the temptations.
Ninety-nine percent of all the enemies of the flat tax make their living in Washington, DC. A great many of them are tax lobbyists, and they make their living making it more complex.
And so somebody is going to have to be stubborn about this. I am stubborn about it, because I think you have to be.
Then you have to write in safeguards. For example, we said it takes a three fifths vote in either house to either raise the rate, reduce the family exemption, restore any itemized deductions, or create multiple rates.
Now, no Congress can completely protect America from a future Congress. But you can write in those safeguards that will make it as difficult as can be. And I think anybody, whether it be my plan or any other plan, that got enacted into law, you would have to have those safeguards in place.
Trust me on this: you can write a national sales tax, and if you don't have that discipline, vigilance, it, too, can grow into the same kind of horrible monstrosity that we have today.
Any Tax Code can grow that way unless you put in the discipline at its outset, and then the safeguards against easy change.
Mr. HAYWORTH. I thank the Leader. And that certainly points up the importance of today's vote later, when we talk about a two-thirds majority needed to increase taxes.
Again, thank you, Mr. Leader. And I thank the Chairman.
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Mr. ARMEY. Thank you.
Chairman ARCHER. Thank you, Mr. Armey.
Mr. ARMEY. Thank you, Mr. Chairman.
Chairman ARCHER. I told you that you would have a warm reception, and I think that you have left unscathed.
Mr. ARMEY. I thought you were referring to the hot seat. I do appreciate it. Thank you all.
Chairman ARCHER. Our next witnesses are in a panel. Messrs. Steuerle, Hubbard, Dr. Asmus, Dr. Sullivan, Mr. Mitchell and Mr. Dannenfelser. If you could come to the witness table please.
Welcome, gentlemen. Most of you, I'm sure, are aware of the rules of the Committee, that we're going ask you to limit your oral testimony to 5 minutes, and the little lights there will tell you how you're proceeding.
The yellow light comes on, that means you have 1 minute left, and the red light means, as is always the case in our society, stop.
Your entire printed statements, without objection, will be inserted in the record. And we're most pleased to have you with us this morning, and, Mr. Steuerle, if you would lead off, we'd be pleased to receive your testimony. If you would each identify yourselves for the record, then you may get into your oral testimony.
Mr. Steuerle.
STATEMENT OF C. EUGENE STEUERLE, SENIOR FELLOW, URBAN INSTITUTE
Mr. STEUERLE. Good morning. Thank you, Mr. Chairman. My name is Gene Steuerle, and I'm a senior fellow at the Urban Institute here in Washington, DC.
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When it comes to tax reform, family issues are often among the last to be considered. In practice, however, these issues often dominate the revenue adjustments that might be required in moving to any different type of system.
I should indicate, by the way, that my testimony deals primarily with family issues defined as those adjustments that are required according to such things as family size and the distribution of income and resources within the family.
Having served as economic coordinator of the Treasury's 1984 to 1986 tax reform effort, I can warn anyone trying to redesign tax reform that these types of family issues at times will drive the process, if for no other reason than that so much money is involved.
Now, many provisions of the current Federal income tax are specifically designed to take into account the economic circumstances of the family. My testimony deals with the dependency exemption, a child credit such as proposed by both political parties, but not enacted; the earned income credit; the child dependent care credit; the so-called kiddie tax; the standard deduction; the special rate schedule for heads of household; marital income splitting, and the treatment of alimony and child support.
All of these are the family type issues which I am going to try to deal with briefly. However, I will speak only to the first three of these issues, given the time constraint, and the rest of the issues are discussed in my testimony.
Over the 48-year period from 1948 to 1996, the dependency exemption has grown four fold. During that same period, however, per capita personal income has grown sixteen fold. As a consequence, the dependency exemption fell from about 42 percent of per capita personal income in 1948 to less than 11 percent by 1996.
The dependency exemption for 1996 would need to be set at about $10,000 for it to represent the same percentage of per capita income as it represented in 1948. If converted to a credit that offset taxes, the exemption would need to be about $1,500 per child.
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This decline in the dependency exemption, along with increases in Social Security taxes, has increased the tax burden of families with children relative to almost all other taxpayers. It is one of the major reasons for consideration today of a child credit.
Now, a child credit is a possible alternative mechanism for delivering tax relief to families with dependent children. And although both political parties have proposed such child credits, none has been enacted to date.
Significant simplification gains are possible if tax relief for dependent children is provided through one mechanism rather than several. A credit mechanism that combined the benefits of an earned income credit and the dependency exemption could be coordinated better also with rules for phasing out welfare benefits.
Congress may also have a very unique opportunity today to link some unified child credit with a requirement that a credit is available only to families who purchase health insurance for their children. That is, in one combined effort, Congress could partially reverse the historic trend toward increasing the relative tax burden on families with children, could reduce dramatically the lack of health insurance among children and among some adults as well, and reduce some of the very high implicit tax rates on those who decide not to go on welfare in the first place.
Proponents of any type of tax reform have a major difficult issue to deal with when dealing with the earned income credit, some of which came up in the previous questions and answers. For example, it is impossible to remove many low-income families from filing returns as long as the earned income credit is designed in its current form.
For those who favor many types of consumption taxes, the earned income credit also affects dramatically the simplification gains they hope to achieve because the earned income credit is necessarily income based, that is, it's phased out for high income individuals on the basis of their income, not on the basis of their wages or consumption.
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The problem is not solved by making the issue of relief for low-income workers a problem for the welfare system, because those systems also contain implicit income taxes that require income reporting.
My testimony today had dealt with the many family sensitive issues that must be dealt with in major tax reform. Several of these issues affect large numbers of taxpayers and affects significant amounts of revenues. While certain types of reform efforts technically may be beyond an income tax, you really cannot bypass these family issues.
Thus, earned income credits and welfare programs have income phase outs that operate like income taxes, even in the presence of a consumption tax. And a consumption tax, or a value-added tax or retail sales tax that did not allow for a child care deduction, a decision would still have to be made as to whether child care expenses will be taxable as consumption services.
Some divorce settlements would have to be renegotiated under any major tax reform, even though they might be based on an allocation of tax benefits under former law.
Of all the issues I've raised, perhaps the largest and the most important are those that relate to the way the tax system adjusts for the presence of children through tax credits, dependent exemptions and the earned income credit.
Recent bipartisan support for child credits, and the push for tax reform create a unique opportunity to lessen the increasing reliance of our tax system on families with children, to expand significantly health insurance for children, and at the same time to reduce the extraordinarily high tax rates and marriage penalties on many low-income individuals. Thank you.
[The prepared statement follows:]
Statement of C. Eugene Steuerle, Senior Fellow, The Urban Institute
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Any opinions expressed herein are solely the author's and should not be attributed to The Urban Institute, its officers or funders.
The family is the primary social structure in the United States for nurturing, raising and paying for the needs of children. Support for families, however, has long been an expressed policy goal of both major U.S. political parties. Whether U.S. tax policy—as opposed to expenditure policy—should be designed specifically to benefit families is an issue of legitimate debate. In a recent article with Professor Michael McIntyre of Wright State University, we subscribed to the traditional view that a personal tax system should be designed primarily to distribute tax burdens in a way that is fair to all individuals, irrespective of their family circumstances. At the same time we concluded that a tax system cannot be fair to individuals unless it takes into account the differences in ability to pay that result from the way that resources are shared within families of different sizes and types.
When it comes to tax reform, ''family'' issues are often among the last to be considered. In practice, however, these issues often dominate the revenue adjustments that might be required in moving to any different type of system. Having served as the Economic Coordinator for the Treasury Department's 1984 to 1986 tax reform effort, I can warn anyone trying to redesign the tax system that ''family'' issues at times will drive the process if for no other reason than that so much money is at stake. Congress' recent debate over a child credit demonstrates just how expensive changes here can be. One reason is that decisions over how to treat children or spouses in the tax Code typically involve millions, tens of millions, or even hundreds of millions of people. A change of $500 for 50 million taxpayers, for instance, might require that $25 billion in tax liabilities be shifted annually. By way of contrast, most other reform issues involve far smaller numbers of taxpayers.
Many provisions of the current federal income tax are specifically designed to take into account the economic circumstances of the family. Examples of some family-sensitive tax issues follow:
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• the dependency exemption;
• a child credit (proposed by both major political parties, but not enacted);
• the earned income tax credit;
• the child and dependent care credit; the ''kiddie'' tax;
• the standard deduction and tax-free levels of income that vary in amount for different types of households;
• the special rate schedule for heads of households;
• marital income splitting and the rate schedule for single taxpayers; and
• the deduction for alimony payments and the nondeductibility of child support payments.
Obviously, all tax issues affect the family in some manner or another. For instance, the home mortgage interest deduction and the charitable contributions deduction affect families in different ways. However, I will confine my discussion today mainly to those issues where adjustments in tax burden are made according to the size of the family—in particular, the presence of children.
One major source of complication must be admitted up front. Current tax law includes several measures designed to benefit low-income families. Some of these measures are defended on tax policy grounds, whereas others are defended on spending policy grounds. A major objective of family taxation reform—indeed, one that has become unavoidable—should be to coordinate the tax measures that are designed to benefit low-income families with children with the various direct expenditure programs targeted at such families. Indeed, as I will demonstrate, tax administration often requires this coordination whether we desire it or not.
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A. Dependency Exemption
The dependency exemption is a major mechanism for adjusting tax burdens for the costs of supporting children and is the only mechanism that provides tax benefits to all middle-income families with dependent children. The dependency exemption for 1996 was $2,550 per dependent child. Since 1987, it has been phased out for high-income taxpayers. For tax year 1994, taxpayers claimed a total of approximately 70 million dependency exemptions.
Few changes in federal income tax laws over the past four decades have had as far-reaching effects on the distribution of federal tax burdens as the shift in the relative tax burdens from taxpayers without dependent children to taxpayers with dependent children. The increase in relative tax burdens has been particularly marked for middle-income taxpayers with children.
The increase in relative burdens on families with dependent children did not occur because policymakers, after careful study, concluded that parents with dependent children were being taxed too lightly. Instead, it happened primarily because the chief mechanism for granting tax relief to families with dependent children—the dependency exemption—was not adjusted sufficiently to keep up with economic growth.
Over the 48-year period from 1948 to 1996, the dependency exemption has grown from $600 to $2,550—slightly more than a four-fold increase. During that same period, per capita personal income has grown from $1,425 to $23,882, which is more than a sixteen-fold increase. As a consequence of economic growth, the dependency exemption fell from about 42 percent of per capita personal income in 1948 to less than 11 percent by 1996.
The dependency exemption for 1996 would need to be set at approximately $10,000 for it to represent the same percentage of per capita income as it represented in 1948 (Figure 1). Simply to adjust the dependency exemption for post-1948 inflation would require that it be increased to nearly $4,000. If converted to a credit that offset taxes, the exemption would need to equal $1,500 or more per child to reduce taxes for the same proportion of income as in 1948.
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This decline in the dependency exemption, along with increases in Social Security taxes, has increased the tax burden of families with children relative to almost all other taxpayers and is one of the major reasons today for the consideration of a child credit.
B. Tax Credit for Dependent Children (Child Credit)
A child dependency credit, generally referred to as a child credit, is a possible alternative mechanism for delivering tax relief to parents with dependent children. The credit might be a fixed amount per dependent child, or the amount of the credit might vary with family size. It could be fixed in amount at all income levels; some would phase out at middle-or high-income levels, although phase outs by their very nature involve implicit rather than explicit tax rates. Although both political parties have proposed child credits, most major reform proposals do not deal with this issue.
Significant simplification gains are possible if tax relief to families with dependent children is provided through one mechanism that integrates the benefits of current law and any new benefits that policymakers are prepared to give to families with dependent children. Under current law, relief is now targeted at families with children through the dependency exemption and, for low-income families, through the earned income tax credit (EITC). Adding a third relief mechanism with a different set of eligibility rules appears needlessly complex. Nonetheless, rolling two and perhaps all three mechanisms into a single mechanism would require some changes in policy—for example, a uniform definition of ''dependent'' would probably be required. Such changes may create some additional winners and losers in order to achieve gains in administrative economy.
In tax theory, there is no strong case in favor of a credit over a deduction or vice-versa. Indeed, as a technical matter, for families of one size but different incomes, it is possible to develop a credit-based system that would replicate exactly an exemption-based system. Assuming the continuation of the EITC and the commitment of the nation to provide minimal levels of support to many low-income individuals, the use of a unified credit would seem to be the preferred approach. In addition, a credit mechanism that combined the benefits of the EITC and the dependency exemption could be coordinated better with various rules for phasing out welfare benefits than is possible under current law.
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Finally, I have also suggested that Congress may have a unique opportunity today to link some unified child credit with a requirement that the credit is only available to families that purchase health insurance for their children. In one combined effort, Congress could partiality reverse the historical trend toward increasing the relative tax burden placed on families with children, reduce dramatically the lack of health insurance among children (and among some adults as well), and reduce some of the high implicit tax rates imposed on those who decide not to take welfare or who move off of welfare.
C. Earned Income Tax Credit
Current law provides low-income workers with a refundable tax credit—that is, besides reducing the tax liability for low-income families, the government sends a check to the taxpayer for any amount by which the allowable credit exceeds that taxpayer's liability for taxes payable on his or her income tax return. This earned income tax credit (EITC) provides significant benefits to low-income families with dependent children and more limited relief to other low-income individuals. Taxpayers with income over specified income thresholds are not eligible for the EITC.
The EITC began as a limited program in 1975 during the Ford administration and has been expanded several times since then, with large increases enacted in 1986, 1990, and 1993 and some modest adjustments in 1996. The 1993 additions were only scheduled to become fully effective in 1996. Most of the credits represent amounts refunded to households.
Historically, the EITC has been promoted as a useful mechanism for lowering income taxes and offsetting FICA (Social Security) taxes for low-income individuals with dependent children; for some it also offset the work disincentives associated with welfare. Both of these goals continue to be invoked to justify the EITC. Today, the EITC probably should be considered primarily as an extension of a combined welfare/tax system. That is, it has important tax and welfare features that to some extent are inseparable.
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Proponents of many types of tax reform have many difficult issues to face with the EITC. For example, it is impossible to remove most low-income families from filing returns as long as the EITC is designed in its current fashion. For those who favor many types of consumption taxes, the EITC also affects the simplification gains that they hope to achieve by eliminating requirements to measure capital income for tax purposes. The EITC is necessarily income-based, unless high-income individuals with low wages or low levels of consumption are to be made eligible for the EITC. To administer the EITC, therefore, the tax authorities must obtain substantial information about the capital income of prospective recipients of the EITC. A similar constraint applies to welfare authorities administering Food Stamps, Supplemental Security Income, and other programs. The problem is not solved by making the issue of relief for low-income workers a problem for the welfare system. Those systems contain implicit income taxes that affect millions. Meanwhile, businesses, banks, and other institutions would still need to perform income reporting even if the main body of the income tax were converted to a consumption tax.
Revision of the EITC is likely to be a topic on the public agenda for some time, whatever the political fate of the major reform plans. The EITC has received political support from many sources, including, at various times, from the leadership of the two major political parties. In my view, it represents an intermediate step as the nation searches for a way to convert welfare into work support. It has been favored both because of the work incentives that it provides compared to welfare, as well as the relief that it delivers to low-income families. Some supporters have seen it as a politically viable alternative to an increase in the minimum wage. The EITC, however, has also received criticisms from a range of sources, partly because of problems with its implementation and partly because it is not well integrated with income-tested welfare programs. Congress and the IRS have attempted to deal with the problem of ineligible participants receiving the credit by reforming eligibility criteria and by checking more closely with taxpayers over the existence of dependents. Error rates, however, remain very high.
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An additional problem in the EITC remains to be addressed: the ability of taxpayers to overdeclare income to receive higher credit amounts. This problem, which I have labeled the ''superterranean economy'' (as opposed to the underreporting of income in the subterrranean economy), does not require cheating. Two neighbors could baby-sit for each other and generate significant EITCs as a consequence.
Coordination of Tax Provisions with Implicit Taxes Embedded in Welfare Programs.
I recognize that your focus today is on tax reform, while a focus on family issues keeps pulling us toward discussion of transfer programs as well. For low and moderate income individuals, however, tax and transfer issues simply can no longer be separated. An important objective of public policy, whether characterized as tax policy or welfare policy, should be to substantially reduce the high marginal ''tax'' rates that low income individuals typically face when they attempt to enter the workforce or the effective tax rates that low income workers face simply by choosing never to go on welfare. A reduction in those rates presumably would discourage long-term dependence on welfare. It would also reduce the extent to which low-income workers perceive that they are being treated unfairly.
Figure 2 shows the combined tax rates derived from tax and welfare programs just before the enactment of welfare reform—although it is doubtful that these rates have changed much since then. In effect, welfare recipients who worked faced combined tax rates of 70 percent not just when they went to work at minimum wage but all the way up toward three times the minimum wage (the effective marginal rate on additional work is often even higher than this ''average'' rate on all earnings). At one to three times minimum wage for a full-time worker, few individuals receive much in what is commonly thought of as welfare: AFDC or its replacement, TANF (Temporary Assistance to Needy Families). The high tax rates at those income levels derive from federal income tax, phase out of the EITC, state income tax, phase out of housing benefits for those who receive them, phase out of Food Stamps, and phase out of eligibility for Medicaid. All phase outs, remember, basically take away benefits as income increases. Avoidance of such poverty traps should be an important, long-term, objective of any major tax reform.
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In addition to the large tax rates on work, marriage penalties are enormous for low-income individuals. For a typical welfare recipient who married someone with a modest paying job, their combined income would fall by an additional 30 percent or so just from marriage alone. Many marriage penalties are caused by welfare, but some are in the tax code itself due to the earned income tax credit and the standard deduction. Thus, another potential advantage of a unified approach to tax and welfare issues is the opportunity provided for reducing marriage penalties. Although, as discussed later, there are also marriage penalties for higher income individuals due to the rate structure, but these are smaller relative to income than those faced by low income individuals.
Let me return briefly to how a child credit provides a means of linking together these concerns between the welfare system and the tax system. Just as a welfare payment operates as a refundable tax credit that is phased out as income increases, so also a child credit could be designed to be there when the welfare payment was no longer available. Once the credit is fully phased in, it can be allowed to remain constant throughout the low-and middle-income ranges, thereby avoiding the implicit taxes that result under current law from the phase-out of the EITC or welfare credits.
In effect, a child credit can be explicitly designed to reduce, although not eliminate, some of the poverty traps and marriage penalties faced by low income individuals. As far as I can tell, none of the major tax reform proposals on the national agenda attempt to address the poverty traps created by the interplay of tax and welfare policies. Several of them attempt to replicate the distribution of taxes at low-income levels and simply to leave these issues to another time and place.
D. Child-Care Credit
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Parents with one or more children under age 13 may claim a tax credit under current law for a portion of the expenses for child care and household services that they incur in pursuing gainful employment outside the home. The allowable credit is a percentage (30 percent at low-income levels, phased down to 20 percent) of qualifying expenses. Qualifying expenses are capped at $2,400 (one qualifying dependent) or at $4,800 (two or more qualifying dependents). In the case of a two-job married couple, the expenses eligible for the credit generally cannot exceed the income of the lower-earner spouse. Taxpayers claiming the credit must provide the Internal Revenue Service with the name, address, and taxpayer identification number of their provider.
A deduction for child-care expenses was introduced in 1954, during the Eisenhower administration, primarily as a mechanism for encouraging mothers on welfare to work outside the home. The deduction was capped at $600 and was phased out at rather low income levels. The allowance has been expanded several times and was converted into a credit in 1976. The child-care credit was claimed in 1995 by just over 6 million taxpayers for total credits of under $3 billion. For a taxpayer with adjusted gross income of $10,000 or less and two qualifying dependents, the maximum credit is $1,440. The maximum credit is $960 for parents with income of $30,000 or more.
The case for repeal on efficiency grounds is at best mixed. An initial and continuing purpose of a child-care allowance has been to mitigate the tax and welfare disincentives that some parents face in taking a job in the labor market. The efficiency problem arises if the tax system tries to be neutral between child care provided in the home and child care provided outside of the home. The current credit generally favors child care outside of the home for those with low and middle incomes, but favors child care in the home for taxpayers with above average incomes. Eliminating any adjustment for child care clearly would favor child care in the home, as can be seen most readily by examining the circumstances of a single parent who must obtain child care in order to work. Maintaining an adjustment, on the other hand, would cause some modest increase in the tax rate, which could have some efficiency costs.
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The case for a child-care allowance on fairness grounds also is mixed. One argument for a child-care allowance is that it constitutes a legitimate cost of earning income and ought to be deductible in a tax system seeking to measure net income (or net consumption). Those arguing that child-care expenses constitute a business cost can show that the costs of child care are closely analogous to certain expenses, such as the costs of travel away from home, that are deductible as a cost of earning income. On the other hand, those costs are also analogous to certain other expenses, such as the cost of most types of personal clothing, that are not deductible, notwithstanding a close relationship to business. Because child-care costs arise from the quintessentially personal decision to have and raise children, a case for the deduction on business-expense grounds can never be conclusively made.
As a practical matter, I believe that some adjustment is appropriate but needs to be limited and kept simple. Nonetheless, any reform proposal that attempts to eliminate filing requirements cannot maintain a child care credit or deduction unless these could be channeled directly through employers.
E. Kiddie Tax
Under current law, as amended in 1986, children under the age of 14 are taxable on their unearned income at the marginal tax rate of their parents. This rule is popularly, if inexactly, referred to as the ''kiddie tax.'' Its point is to prevent parents from avoiding the bite of the graduated rate structure by shifting investment income to their children. Its initial purpose was to simplify tax planning costs. Its adoption, indeed, did reduce the tax planning benefits obtaining from establishing certain family trusts, thereby reducing the complexity for the taxpayer and the tax authorities that is associated with such tax planning. Earned income—e.g., income that children earn from babysitting or delivering newspapers—is not subject to the kiddie tax rule. Nonetheless, in 1986 Congress went much further than the initial ''kiddie tax'' goals when it dramatically reduced or eliminated the personal exemption for children with earnings who were also claimed by their parents. This created much additional filing complexity and a significant increase in children required to file. Simplification requires a restoration of something like an additional personal exemption for children, even though on strict equity grounds some children would thereby generate more personal exemption than others.
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F. The Standard Deduction and Tax Free Levels of Income
The tax-free level under current law is determined by two mechanisms: the taxpayer exemption and the standard deduction. For 1996, the taxpayer exemption was set at $2,550. This is the same amount as the dependency deduction. These personal exemptions were set at $2,000 after the phase-in of the 1986 tax act (1989) and have been adjusted upwards for inflation since then.
Each type of filing unit has its own standard deduction level. For married couples in 1996 it was $6,700 for a per capita standard deduction of $3,350. Heads of household received a standard deduction of $5,900, while single individuals could claim a standard deduction of $4,000. Relative to being single, the standard deduction creates a modest marriage penalty for many moderate income couples typically amounting to $195 in extra tax liability.
Personal exemptions, on the other hand, are of equal size for all persons. Together with the standard deduction they provide for a tax-free level of income of $6,550 for a single individual, $8,450 for a head of household, and $5,900 for each member of a couple (Table 1). Excluding the earned income tax credit (EITC), most reform proposals would increase this tax exempt amount. Only flat and retail sales tax proposals usually remove marriage penalties from this source, although there is no reason that other reforms could not also achieve that goal.
G. The Head of Household Schedule
The head-of-household schedule was introduced into the tax code in 1951. Its purpose was to extend to one-parent families some portion of the tax benefits that two-parent families received under the marital income splitting regime adopted nationally in 1948. Under that regime, marital partners were allowed to report one-half of the total income of their marital partnership on the same rate schedule used by single individuals. In contrast to the head of household schedule, the benefits of marital income splitting were available to all marital couples, whether or not they had dependent children.
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The purpose of the head-of-household schedule is to take account of the differences in ability to pay of heads of households relative to equal-income single individuals due to the difference in their support obligations. In effect, the head of a one-parent family is allowed to split income with a dependent child, with the child's portion of the parent's income being taxed at a low or zero rate. The head-of-household schedule operates like a dependency exemption that increases in value with increases n the total income level of the one-parent family.
The special rate schedule for one-parent families creates the potential for marriage penalty because a husband and wife with children could reduce their taxes under current law by getting a divorce, using the deduction for alimony to equalize their individual incomes, and then having one former spouse file as a head of household and the other spouse file as a single person. The former spouses cannot both file as a head of household under current law and still live together, because a head of household is defined as a person providing more than half of the cost of maintaining the household. It does not appear that significant numbers of married couples have availed themselves of this tax-avoidance opportunity.
Heads of household bore significantly higher tax burdens because of the decline in dependent exemptions noted above. If child allowances were raised significantly, this would reduce the need for a separate head of household rate schedule.
H. Marital Income Splitting
The modern history of the current federal system of marital taxation begins in 1948, when Congress adopted marital income splitting as a conscious federal policy. Before the 1948 reform, federal family taxation policy was in disarray.
In a tax system that provides for full marital income splitting, each spouse is taxable as an individual on one-half of the total income of their marital partnership. Such a system is not designed primarily to benefit dependent children. It is available, after all, to childless couples and to couples with adult children no longer dependent on their parents. Its purpose is to tax each spouse on that share of the total income of their marital partnership that is used to enhance their material well-being. It can be viewed as implementing the traditional income tax policy goal of relating the burdens of taxation to the consumption and net savings of individual taxpayers.
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In 1969, Congress adopted a special tax rate for single individuals that guaranteed that they would pay no more than 120 percent of the tax imposed on marital partners having the same aggregate income. This 120-percent rule reflected a political compromise between those who contended that equal-income marital couples should bear equal taxes and those who contended that individuals with equal income or equal earnings should pay equal taxes notwithstanding differences in their marital status. The revenue cost of introducing the ''singles'' rate schedule was modest—on the order of $200 million per year in forgone revenue. Despite the low cost, the implications of this change for federal tax policy were very large, for reasons explained below.
Under the system adopted in 1969, marital partners became taxable on their aggregate incomes as a unit, under a rate schedule with brackets exactly twice as wide as the brackets under the rate schedule of prior law. The tax brackets on the marital unit schedule, however, were less than twice as wide as the brackets on the newly created schedule for single persons. The effect was that two marital partners having approximately equal separate incomes would pay less in tax if they were allowed to file separate tax returns and to compute their separate tax liabilities on the new singles schedule. The only way to do so, however, was to terminate their marriage. The tax savings that marital partners could obtain from getting a divorce and filing separately came to be called a ''tax on marriage'' or a ''marriage penalty.''
Congress has adopted legislation from time to time to reduce the marriage penalties created by the 1969 act. Other legislation, unfortunately, has increased those penalties. Marriage penalties were reduced sharply under the 1986 tax act, due to the flattening of the rate structure and the introduction of fuller income splitting at middle-income levels. Marriage penalties were increased significantly by the way that the 1993 tax act increased tax rates for high-income individuals. No changes have been made in the basic system of multiple graduated rate schedules introduced in 1969, which necessarily produces marriage penalties. Plans that attempt to replicate the existing distribution of tax burdens, such as the USA plan and Gephardt 10-percent tax, tend to continue that basic structure.
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A perfectly flat tax would eliminate all marriage penalties created by the graduated structure. This approach, combined with the equal per capita standard deductions provided to single and married persons, would eliminate almost all marriage penalties created by the rate structure, although not—as mentioned above—the very large penalties due to welfare and EITC type of provisions. To eliminate marriage penalties, one also needs to eliminate phase-outs such as the phase out of itemized deductions and the personal exemption phase out.
I. Alimony and Child Support Payments
Under current law, alimony is deductible to the payor and taxable to the recipient. The effect of this arrangement is to extend some degree of income splitting to formerly married individuals. Thus, the treatment of current law is consistent with the income splitting approach to family taxation.
In the typical case, alimony flows from the higher-earner taxpayer to the lower-earner taxpayer. In a tax system having graduated rates, therefore, taxing the recipient of alimony rather than the payor results in a net reduction in the aggregate tax burdens of the two former spouses. If the tax savings to the payor and the tax detriment to the recipient are properly taken into account in setting the level of the alimony payments, the alimony recipient should obtain a net benefit from having been made taxable on the alimony payments. That is, the recipient would receive an additional alimony payment sufficient to pay the tax and to give that individual some fair share of the resulting tax savings. Divorce settlements that provide for the payment of alimony are typically structured so that they deflect some or all of the tax savings from the alimony deduction to the alimony recipient.
The proper tax policy treatment of child-support payments is unclear. Those who hold that the earner is the proper taxpayer on earned income presumably would oppose the deduction of support payments. The earner rule, however, is inconsistent with marital income splitting—an approach endorsed under current law and under several reform proposals. If an income splitting approach is carried over to children, then child-support payments would be deductible to the payor and taxable to the child, not to the custodial parent. It certainly would be an odd result, however, to allow income splitting between separated parents and their children and to not allow it within fully intact families.
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As discussed above, the dependency exemption can be understood as a mechanism for allowing limited income splitting with children. If the dependency exemption, or a child credit, is generous, then the issue of who to tax on support payments has reduced importance, because the parent taxable on the support payments presumably would be the one who would be allowed to claim the dependency exemption or credit.
Despite all of these arguments, perhaps the simplest system administratively, and the one with the fewest enforcement problems, is to tax income to the earner and to grant exemptions and credits primarily upon the basis of with whom the child lives most of the year. In a tax system with graduated tax rates, a rule that taxed child-support payments to the recipient parent and made them deductible by the payor parent typically would result in lower aggregate taxes on those parents, assuming that the payments flow from the higher-bracket taxpayer to the lower-bracket taxpayer. The point is similar to one that can be made with respect to alimony payments. Both parents would be better off under a deduction rule as long as some mechanism was in place that would require them to share fairly the net tax savings. Even in a single-rate system, such as a flat tax, divorced or separated parents would obtain a net benefit from the deduction rule whenever the recipient parent's income otherwise would have been below the tax-exempt level. For simplification purposes, however, most flat and consumption-based taxes would assume that the flat rate structure eliminated most concerns over who paid tax and would rely upon withholding of the tax at the source of payment, such as the employer or business.
Conclusion
My testimony today has dealt with the many family-sensitive provisions that must be dealt with in any major tax reform effort. Several of these family related issues affect very large numbers of taxpayers and involve significant amounts of revenues. While certain types of reform efforts technically may move beyond an income tax, they often cannot bypass these family issues. Thus, earned income tax credits and welfare programs have income phase outs that operate like income taxes even in the presence of a consumption tax. In a consumption tax or value-added tax or retail sales tax that did not allow for a child care deduction, a decision would still have to be made as to whether child care expenses were to be taxable as consumption services. Some divorce settlements would have to be renegotiated under major tax reform, especially when they were based on the allocation of tax benefits under current law.
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Of all the issues I have raised, perhaps the largest and most important are those that relate to the ways that any tax system adjusts for the presence of children through child credits, dependent exemptions, and the earned income tax credit. Recent bipartisan support for child credits and the push for tax reform create a unique opportunity to lessen the increasing reliance of our tax system on families with children, to expand significantly health insurance for children, and, at the same time, to reduce the extraordinarily high tax rates and marriage penalties on those low-income individuals who decide to work rather than rely on welfare.