INTRODUCTION

On 16 July 1997, the United States requested consultations with India, pursuant to Article 4 of the Understanding on Rules and Procedures Governing the Settlement of Disputes (“DSU”), Article XXII:1 of the GATT, Article 19 of the Agreement on Agriculture (to the extent it incorporates by reference Article XXII of the GATT), and Article 6 of the Agreement on Import Licensing Procedures (to the extent it incorporates by reference Article XXII of the GATT), concerning quantitative restrictions maintained by India on the importation of a number of agricultural, textile and industrial products (WT/DS90/1). The United States considered that the quantitative restrictions maintained by India, including, but not limited to, those tariff lines notified in Annex I, Part B of WT/BOP/N/24, appeared to be inconsistent with India's obligations under Article XI:1 and XVIII:11 of the GATT 1994, Article 4.2 of the Agreement on Agriculture and Article 3 of the Agreement on Import Licensing Procedures. At the same time, Australia, Canada, the European Communities, New Zealand and Switzerland requested consultations with India on these quantitative restrictions (WT/DS91/1; WT/DS92/1; WT/DS93/1; WT/DS94/1; WT/DS96/1) on the basis of similar claims to those set forth by the United States. Subsequently, Japan, the European Communities, Canada, Australia, Switzerland and New Zealand asked to join in the consultations requested by the United States (WT/DS90/2, WT/DS90/3, WT/DS90/4, WT/DS90/5, WT/DS/90/6, WT/DS/90/7). The United States and India formally consulted on these measures in Geneva on 17 September 1997, and Japan participated as an interested third party under Article 4.11 of the DSU.

On 3 October 1997, the United States requested that the WTO Dispute Settlement Body (“DSB”) establish a panel to examine this dispute. In its request, the United States considered that quantitative restrictions maintained by India, including, but not limited to, the more than 2,700 agricultural and industrial product tariff lines notified to the WTO in Annex I, Part B of WT/BOP/N/24 dated 22 May 1997, appeared to be inconsistent with India's obligations under Articles XI:1 and XVIII:11 of GATT 1994 and Article 4.2 of the Agreement on Agriculture. Furthermore, the import licensing procedures and practices of the Government of India are inconsistent with fundamental WTO requirements as provided in Article XIII of GATT 1994 and Article 3 of the Agreement on Import Licensing Procedures.

INTRODUCTION

On 10 March 1997, Brazil requested consultations with the Government of Canada pursuant to Article 4 of the Agreement on Subsidies and Countervailing Measures (“SCM Agreement”) regarding certain alleged subsidies granted by the Government of Canada or its provinces that support the export of civilian aircraft from Canada.

Brazil and Canada held consultations on 30 April 1997, but failed to reach a mutually satisfactory solution.

On 10 July 1998, pursuant to Article 4.4 of the SCM Agreement and Article 6 of the Understanding on Rules and Procedures Governing the Settlement of Disputes (“DSU”), Brazil requested the immediate establishment of a panel with standard terms of reference.

At its meeting on 23 July 1998, the DSB established a panel pursuant to the request by Brazil (WT/DS70/2).

At that DSB meeting, parties agreed that the Panel should have standard terms of reference. The terms of reference of the Panel are the following:

The basic administrative goals of tax policy are uncontroversial: taxes should be easy to understand and comply with, and they should be enforced and administered in a competent and fair manner. Despite nearly universal agreement on these goals, administrative concerns raise difficult issues for researchers and policy makers. Researchers have not reached consensus regarding many of the most basic questions about the existing tax system, such as the costs of compliance and the determinants of tax evasion. Even when research does produce reliable answers to these questions, policy makers face difficult trade-offs both among various administrative goals and between administrative goals and other widely held goals of tax policy, such as equity and efficiency.

Administrative issues have also been in the forefront of efforts to reform taxes in recent years. Perhaps the most common complaint about the existing tax system is the level of complexity. The nature of activities undertaken by the Internal Revenue Service has also proved highly controversial. The desire to address these issues generates much of the impetus for fundamental tax reform – replacing the current system with either the flat tax or a national retail sales tax.

This chapter examines the role of administrative factors in tax policy and tax reform. After summarizing conceptual and measurement issues relating to tax complexity and tax evasion, we explore why complexity and evasion continue to exist.

The recent public saliency of fundamental tax reform – specifically a shift to a single-rate consumption-based form of federal taxation – reflects the confluence of three important contemporary trends. The first is the ideological ascendancy of conservatism, with its long-standing suspicion of activist government. The second is the political rise of the national Republican Party, fully competitive with the Democrats on both the congressional and presidential levels. The third is a growing body of theoretical and empirical research critical of the income tax and supportive of consumption-based taxation.

At first glance, this confluence would appear to put fundamental tax reform within reach. But while the climate for reform may have improved markedly, serious and perhaps insurmountable obstacles remain. At the ideological level, fundamental tax reform risks fracturing the coalition between economic and social conservatives that has created the right's current dominance. As reform moves from vague campaign promise to comprehensive legislative proposal, moreover, it may place the Republican Party in conflict with some of its most important constituencies. Finally, the economic literature on fundamental tax reform – though extensive, sophisticated and suggestive – remains inconclusive on a number of key issues.

Fundamental tax reform entails significant political and ideological risks for those promoting it. Given the expectations raised by the measures currently under discussion, the potential costs of failure are high. Prospects for reform are, on balance, poor.

Should the United States adopt a “fundamental tax reform” in the form of replacing its current personal and corporate income tax system with some form of consumption-based taxation? This question has been the central issue of debates on tax reform for the past twenty-five years. The discussion was kindled by a seminal article by Andrews (1974), who extolled the administrative advantages of taxation based on consumption rather than income. Shortly thereafter, the U.S. Treasury (1977) issued its much-cited report Blueprints for Basic Tax Reform, which described in detail the merits of consumption taxes relative to income taxes and discussed alternative methods of implementing consumption taxation; similar studies favorable to consumption-based taxes were published contemporaneously in Great Britain (Institute for Fiscal Studies, 1978), Australia (Matthews Committee, 1975), and Sweden (Lodin, 1978). These contributions were followed by the influential flat tax proposal developed by Hall and Rabushka (1983, [1985] 1995) and related studies in the U.S. and elsewhere, including Aaron and Galper (1985), Bradford (1986), McLure et al. (1990), R. Hall (1995), Weidenbaum (1996), McLure and Zodrow (1996a), and Seidman (1997). All of these studies argue that consumption-based tax systems are inherently superior to a tax system based on income in terms of the three standard criteria public finance economists use to evaluate alternative tax systems – efficiency, equity, and simplicity.

Scholarly interest in fundamental tax reform has been accompanied by heightened political interest in replacing the income tax with a consumption tax.

In this chapter we present a new intertemporal general equilibrium model for analyzing the economic impact of tax policies in the United States. We preserve the key features of more highly aggregated models like that of Jorgenson and Yun (1990, 1991a). One important dimension for disaggregation is to introduce a distinction between industries and commodities in order to model business responses to tax-induced price changes. We also distinguish among households by level of wealth and demographic characteristics, so that we can model differences in household responses to tax changes and examine the distributional effects of taxes.

We model demands for different types of capital services in each of thirty-five industrial sectors of the U.S. economy and the household sector. These demands depend on tax policies through measures of the cost of capital presented by Jorgenson and Yun (1991b) that incorporate the characteristic features of U.S. tax law. The cost of capital makes it possible to represent the economically relevant features of highly complex tax statutes in a very succinct form. The cost of capital also summarizes information about the future consequences of investment decisions required for current decisions about capital allocation.

To illustrate the application of our new model, we simulate the economic impacts of fundamental tax reforms. We focus on the effects of substituting a tax on consumption for corporate and individual income taxes at the federal, state, and local levels.

Many recent proposals for fundamental tax reform have advocated replacing the current tax system with a broad-based consumption tax. Economists' support for such proposals centers on the gains in economic well-being made possible by tax reform. Three sources of efficiency gains would, in principle, accompany a switch to consumption taxation. First, the removal of the current tax on returns to new saving would eliminate distortions of savings decisions, augment capital accumulation, and, eventually, per capita consumption. Second, a pure consumption tax would remove distortions in the allocation of capital across sectors and types of capital. Third, a broad-based consumption tax would avoid potentially costly distortions of firms' financial structures. Recent estimates suggest that the efficiency gains from consumption tax reform could be quite substantial (see, e.g., Auerbach, 1996; Jorgenson, 1996c; Jorgenson and Wilcoxen, Chapter 3 in this volume; and Gravelle, Chapter 2 in this volume).

Another group of proposals has suggested reforming capital taxation under the income tax, in particular toward taxing broad measures of income once (see, e.g., American Law Institute, 1993; and U.S. Department of the Treasury, 1992). Although the debate between these “income tax reforms” and “consumption tax reforms” often characterizes the differences between the two options for reform as significant, I argue that for distributional analysis, and possibly for efficiency analysis, the distinction between reform toward a broad-based income tax and reform toward a broad-based consumption tax is not as large as that suggested by models conventionally used to analyze tax reform.

Recent debate over fundamental tax reform has centered on consumption taxes. Proposals for thoroughgoing tax reform involving mending of the income tax have been much less in evidence. For example, the U.S. Treasury's proposal for a “Comprehensive Business Income Tax” (see Hubbard, Chapter 4 in this volume) has not generated much interest. Discussion of the relative merits of competing consumption tax proposals has centered on four alternatives: a national retail sales tax, the flat tax, the Unlimited Savings Allowance tax (USA Tax), and the value-added tax. Former chairman of the House Ways and Means Committee Bill Archer has expressed a desire to “tear out the income tax by its roots,” replacing it with a national retail sales tax (a tax on all final sales to consumers). The organization Americans for Fair Taxation (AFT) is the staunchest supporter of a broad-based single-stage national retail sales tax to replace personal and corporate income taxes and Social Security taxes. House Majority Leader Dick Armey is as ardent a supporter of the Hall-Rubushka flat tax as can be found anywhere. The Nunn-Domenici tax on consumption (USA Tax) is the only live proposal for a direct cash flow tax on consumption, but support for the proposal has been largely confined to academic economists. This alternative, along with the AFT proposal for a national retail sales tax, completely defers tax on all income saved, and could allow consumption taxes on low-income households to go to virtually zero.

Proposals for replacing the existing income tax with some form of consumption-based taxation, especially various versions of the Hall and Rabushka ([1985] 1995) flat tax or a national retail sales tax (NRST), have been the focus of much recent discussion in both the political and academic arenas. The debate regarding the desirability of such “fundamental tax reform” in the United States has proceeded in many dimensions. In particular, there is a large literature on the relative merits of income-based and consumption-based taxes, as well as on the relative advantages and disadvantages of direct or individual and firm-based taxes like the flat tax and indirect or transaction-based taxes like the NRST. These issues are not revisited in this study. Instead, the analysis focuses on an issue that arises often in the discussion of fundamental tax reform – the transitional problems associated with moving from the current income-based tax system to a consumption-based tax, especially the tendency of such a reform to impose a onetime windfall loss on the owners of existing capital.

Concerns about transitional problems have long been an impediment to fundamental tax reform. In particular, the U.S. Treasury (1984a) cited transitional issues as one of the primary reasons that consumption-based taxes were not seriously considered in the process that led to the Tax Reform Act of 1986. More generally, Pearlman (1996, p. 395) observes that in legislative discussions of tax reform it is often the case that “attention is refocused entirely to the design of politically acceptable transition relief, depriving substantive changes of adequate analysis.”

How regressive will a general, single-rate consumption-based tax system be relative to the existing federal income tax system? The popular perception is that the introduction of a national retail sales tax (NRST) or a Hall-Rabushka type flat tax (FT) in place of existing federal income taxes will significantly increase the tax burden on low- and middle-income groups, while decreasing it at the high end of the income distribution. Three reasons are usually given: (1) the progressivity of the rate structure under the individual income tax will be reduced, (2) the elimination of the corporate income tax will lower the effective tax rate on capital income, and (3) the switch to a consumption base will lower taxes on affluent households who typically save a relatively large proportion of their incomes.

The research surveyed in this chapter, including our own recent work, supports the view that a move to consumption-based taxation would shift tax burdens as just described. For example, our results on the introduction of an NRST indicate that flattening the rate structure decreases the tax burden on high-income families. After estimating the proportion of income saved at different levels of income, we find that a consumption-based tax system is regressive relative to a proportional income tax, though significant gains are found only for the very rich.

These results on saving and consumption are obtained using a newly released panel of households from the Survey of Consumer Finances (SCF) for the years 1983–89.

Tax reform debates in the United States have for some time been dominated by the question of whether the existing corporate and individual income tax system should be replaced with some form of a national consumption tax. Although opinion is far from unanimous, a wide variety of individuals in the academic, business, and government communities has long advocated such a reform, and Congress has recently been inundated with a host of consumption-based tax reform proposals. Nevertheless, the likelihood of passage of such “fundamental tax reform” currently does not seem particularly high. Thus a natural question is why the enactment of a consumption-based tax does not appear to be a viable tax reform option for the new millennium, despite the fact that the virtues of consumption taxation have been actively promoted, at least in some circles, for more than twenty-five years.

This critical issue is addressed in this volume, which contains essays by a group of internationally recognized tax experts who describe the current state of the art in economic thinking on the issue of whether fundamental tax reform is preferable to continued incremental reform of the existing income tax. The ten essays were commissioned by the James A. Baker III Institute for Public Policy at Rice University and were initially presented at a conference on Tax Reform for the Millennium held on November 5–6, 1998, at the Baker Institute on the campus of Rice University in Houston.