Current Tax Issues

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Main Idea

The consequence of tax reform was to make the individual tax code more complex than ever.

Reading Strategy

Graphic Organizer As you read the section, complete a graphic organizer like the one below by listing the advantages and the disadvantages of the flat tax. Include a definition of flat tax in your own words.

Flat tax



Key Terms accelerated depreciation, investment tax credit, surcharge, alternative minimum tax, capital gains, value-added tax (VAT), flat tax


After studying this section, you will be able to: 1. 2.

Describe the major tax reforms since 1980.

Debate the advantages and disadvantages of the value-added tax.

Explain the features of a flat tax.

Discuss why future tax reforms will occur.

Applying Economic Concepts

Flat Tax Have you ever noticed how much time your parents spend filling out their income tax returns? Read to find out what a flat tax would mean to them.


How the Tax Code Got This Way

Every year at this time. Congress discovers, with a great public show of dismay and indignation, the existence of the American tax code and the agency that administers it, the Internal Revenue Service^ There are high-minded calls for abolishing the current tax system and replacing it. . . •

Around April 15, Congress likes to pretend that the tax code just sort of appeared or

Coi;gM wants u that way Hope you »joyed tbs year's tax day.

Rocky Mountain News, April 16, 1999

1RS employee sorts tax returns


The editorial in the cover story sums it up quite well. The complexity of our tax code is not accidental: it is the result of adjustments and amendments by Congress to both influence and reward behavior.

Tax Reform in the 1980s and 1990s

■M Tax reform has received considerable attention ^Ur in recent years, due to more changes in the tax code, and more changes in direction, than at any time in our nation's history.

Tax Reform in 1981

When Ronald Reagan was elected president in

1980, he believed that high taxes were the main stumbling block to economic growth. Accordingly, he proposed the Economic Recovery Tax Act of

1981, which substantially reduced taxes for individuals and businesses.

Before the Recovery Act, the individual tax code had 16 marginal tax brackets ranging from 14 percent to 70 percent. In comparison, today's tax code, shown in Figure 9.5, has five marginal brackets ranging from 15 to 39.6 percent. The 1981 act lowered the marginal rates in all brackets, but, more importantly, it capped the highest marginal tax wealthy individuals paid at 50 percent.

Businesses also got tax relief in the form of accelerated depreciation-larger than normal depreciation charges-which allowed firms to reduce federal income tax payments. Another section of the act introduced the investment tax credit-a reduction in business taxes that are tied to investment in new plant and equipment. For example, a company might purchase a $50,000 machine that qualified for a 10 percent, or $5,000, tax credit. If the firm owed $12,000 in taxes, the credit reduced the tax owed to $7,000.

These provisions produced a dramatic impact on the federal budget. In 1980, the proportion of total federal government revenues from the corporate income tax was 12.5 percent. This dropped to 10.2 percent in 1981, and then to 8.0 percent in 1982, and finally to 6.2 percent in 1983.

Tax Reform: 1986,1993

By the mid-1980s, the idea that the tax code favored the rich and powerful was gaining momentum. In 1983 more than 3,000 millionaires paid no income taxes. Additionally, many corporations were able to legally avoid paying taxes. Boeing, ITT, General Dynamics, Transamerica, and Greyhound were profitable from 1981 to 1984. Instead of paying corporate income taxes, however, these companies applied tax losses in earlier years to current profits-and then collected tax refunds during each of those four years.

In 1986 Congress passed the most sweeping tax reform act since income taxes were enacted in 1913. First, it ended the traditionally progressive individual income tax structure by reducing the 16 marginal tax brackets to two brackets (essentially the 15 percent and 28 percent brackets in Figure 9.5). Then, a 5 percent surcharge-or additional tax above and beyond the base rate-was added to bring the top bracket to 31 percent.

The law also made it difficult for the very rich to avoid taxes altogether. The alternative minimum tax-the personal income rate that applies whenever the amount of taxes paid falls below some designated level-was strengthened. Under this provision, people had to pay a minimum tax of 20 percent, regardless of other circumstances or loopholes in the tax code.

Finally, the reform act shifted about $120 billion of taxes from individuals to corporations over a five-year period by removing a number of tax breaks for business. As a result, the proportion of total federal government revenues from the corporate


Reform Some people think any tax is too high, but this viewpoint is not very realistic. What tax credits were part of the Taxpayer Relief Act of 1997?



income tax increased to 9.8 percent in 1987, and to 10.3 percent in 1988-percentages much closer to the 10.1 percent shown in Figure 9.4.

As the United States entered the 1990s, the impact of 10 years of tax cuts was beginning to show. Government spending was growing faster than revenues, and the government had to borrow more.

The Omnibus Budget Reconciliation Act of 1993 was driven more by the need for the government to balance its budget than to overhaul the tax brackets. As a result, the law added the two top marginal tax brackets of 36 and 39.6 percent, shown in Figure 9.5.

Tax Reform in 1997

In 1997 the largest tax reduction since the 1981 act was passed. The law was known as the Taxpayer Relief Act of 1997, and the forces that created it were both economic and political.

On the economic side, the government found itself with unexpectedly high tax revenues in 1997. The higher marginal tax brackets introduced in 1993, along with the closure of some tax loopholes, meant that individuals and corporations paid more taxes than before. In addition, unexpectedly strong economic growth resulted in an increased number of people and businesses paying taxes.

On the political side, the balance of power had dramatically shifted in the 1996 elections. Both political parties felt they had commitments to fulfill to the people who had voted them into office. For many Republicans, this meant a tax break for people with long-term investments in stocks, bonds, and other assets. The tax on capital gains-profits from the sale of an asset held for 12 months-was reduced from 28 to 20 percent. Inheritance taxes-the so-called "death taxes" discussed in the cover story on page 244-were also lowered, which tended to favor the well-to-do.

The tax reductions reflected the "family-friendly" theme of the 1996 elections. Tax credits of $500 per child and other deductions for educational expenses were included in the legislation. The marginal tax brackets in Figure 9.5 remained unchanged, however, which resulted in an unbalanced distribution of tax cuts. People who had neither children nor capital gains from the sale of houses, stocks, or bonds received virtually no benefit.

In the end, an analysis by the United States Treasury Department determined that nearly half of the benefits went to the top 20 percent of wage and income earners. The lowest 20 percent received less than 1 percent of the tax reductions. With all its categories, the 1997 federal tax law became the most complicated ever.

The Value-Added Tax

Some people want to change the personal income tax; others want to scrap it altogether. One controversial proposal is to shift the tax from income to consumption. This shift would be accomplished with the use of a value-added tax (VAT)-a tax placed on the value that manufacturers add at each stage of production.

The VAT has the potential to raise enormous amounts of revenues for the federal government. The United States currently does not have a VAT, although it is widely used in Europe.

The Concept of Value Added

The production of almost any good or service involves numerous steps. Consider wooden baseball bats. First, loggers cut the trees and sell the timber to lumber mills. Then the mills process the logs for sale to bat manufacturers. The manufacturers then shape the wood into baseball bats.

After the bats are painted or varnished, they are sold to a wholesaler. The wholesaler sells them to retailers, and retailers sell them to consumers. The whole process is illustrated in Figure 9.10. The first column of numbers shows the value added at each stage of production. With the VAT, the consumer ends up paying $11 for each bat.

Did you know?

Tax Freedom Day It takes 40 days, on average, for most Americans to earn enough money to pay for their food supply for the entire year. It takes the average American 129 days—until the second week of May—to earn enough money to pay federal, state, and local taxes for the year.


Advantages of a VAT

As a way of raising revenue, the VAT has several advantages. First, it is hard to avoid because the tax collector levies it on the total amount of sales less the cost of inputs. Second, the tax incidence is widely spread, which makes it harder for a single firm to shift the burden of the tax to another group.

Third, the VAT is easy to collect because firms make their VAT payments to the government along with their regular tax payments. Consequently, even a relatively small VAT can raise a tremendous amount of revenue, especially when it is applied to a broad range of products.


Finally, some supporters claim that the VAT would affect people's behavior in a manner that encourages them to save more than they do now. After all, if none of your money is taxed until it is spent, you might prefer to spend less—and save more—than you do now.

Disadvantages of a VAT

The main disadvantage of the VAT is that it tends to be invisible to consumers. In the baseball bat example, consumers may be aware that bat prices went from $10 to $11, but they might attribute this to a shortage of good wood, higher wages, or some other factor. In other words, consumers


E C O f


Figure 9.10





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