Prospects for Fundamental Tax Reform: Comparisons Between the United States and Japan

Like unwanted relatives and Arnold Schwartzenegger in "Terminator" movies, the call for tax reform keeps coming back. In national legislatures, newspaper editorials and academic circles, there appears to be great urgency to change the tax regime applicable to individuals and business enterprises. In the United States, many political figures and most political factions, with the notable exception of the Clinton administration, have offered major tax reform proposals. ¹ In Japan, the continuing economic crisis has increased the calls for fundamental tax reform. ²

This article examines four questions:

• Why is the idea of tax reform so popular in Japan and the United States?

• If the idea of tax reform is so popular, why is it so hard to achieve?

• What are the alternatives for fundamental reform?

• If reform is to happen, what is the most likely alternative?

Tax systems, like El Nino, serve as convenient scapegoats. Taxes get blamed for low consumer spending in Japan or for reduced competitiveness of Japanese corporations. Similarly, in the United States, taxes emerge as the primary culprit for the high debt levels of U.S. corporations or for the low savings rates of Americans. ⁵

Most complaints are universal. Tax rates are too high. No matter how tax rates compare to past rates or rates of other countries, taxpayers seek rate reductions. Current generations of U.S. law students do not believe that nominal U.S. individual tax rates used to be 90 percent or 70 percent in the recent past or that aggregate tax burdens in the United States and Japan are low compared to other industrialized countries. ⁶

Another familiar refrain is that other taxpayers are not paying their fair share of taxes. Some taxpayers receive preferential treatment through legislative grace. The United States provides tax preferences for home ownership, retirement savings, and medical benefits. Corporate taxpayers benefit from a range of provisions providing special benefits for oil and gas exploration, timber, and farming. ⁷ In Japan, favorable tax treatment is provided for fringe benefits to employees, the elderly, small businesses, agriculture, and construction. ⁸ Other taxpayers pay less tax because of tax evasion. The primary determinant for tax evasion is the opportunity to evade taxes -- and the opportunity for tax evasion varies greatly by occupation and source of income. In the United States and Japan, compliance rates on taxes paid by salaried employees is quite high. In contrast, tax compliance among certain small businesses and independent contractors is quite low. ⁹

Certain complaints carry extra force in certain countries. In the United States, everyone agrees that the tax system is too complex. Recent legislation was proposed to repeal the current U.S. Internal Revenue Code and simply start over. ¹⁰ In contrast to most Japanese taxpayers, compliance costs for almost all U.S. taxpayers are too high in terms of monetary cost, time, and aggravation.

But it may be that one reason for the popularity of the latest call for tax reform is that everyone hears what he or she wants to hear. The only things many tax proposals have in common are the boasts of the sponsors. Though the substance of reform proposals vary greatly, the rhetoric behind the claims sounds remarkably similar. ¹¹

In the United States, and through my narrow window into the tax reform debate in Japan, the same three concepts keep appearing: fairness, efficiency, and simplicity. Yet, as discussed in the next section, these concepts mean different things to different people. So while participants can agree in general terms on the nature and course of fundamental tax reform, it may be inevitable that disagreements will arise when specific proposals are considered.

A. Common Words -- But Different Meanings

While participants in the tax reform debate often speak the same language, the words have different meanings. This section examines the concepts of fairness, efficiency, and simplicity to illustrate the range of meanings.

Fairness. In both the United States and Japan, many people agree that the current tax system is unfair. So while everyone can use common language that the tax system should be changed to be fairer than the current system, no agreement exists about what "fairness" means. Traditionally, tax scholars have defined fairness in terms of horizontal and vertical equity. Horizontal equity requires those in similar circumstances to pay the same amount of taxes. For apportioning tax liability, horizontal equity often embraces some notion of ability or capacity to pay. Vertical equity requires "appropriate" differences in tax liability among taxpayers in different economic circumstances.

On the surface, both concepts have great intuitive appeal. What could be fairer than treating those who are equal in an equal manner? Simply stated, those who have the same ability to pay should bear the same tax liability. And who could argue with appropriate differences for taxpayers in different situations? Unfortunately, both concepts may have limited usefulness in tax policy debates.

Horizontal equity requires tax laws that are neither arbitrary nor discriminatory. Everyone agrees that taxes should not vary by a person's race, religion, or hair color. Beyond that, however, much debate exists about the usefulness of the horizontal equity concept. ¹² The concept of horizontal equity has been challenged as being incomplete, not helpful, and derivative. ¹³ For example, an income tax can completely satisfy horizontal equity requirements only if we assume individuals have identical tastes and a single type of ability or income. Once we allow preferences to vary and provide for different types of ability or income, then only a tax based on an individual's ability to earn income, rather than actual earnings, can effectively provide for equal taxation for those in equal positions. Also, the concept of horizontal equity may be incomplete to the extent it focuses only on a short time period, such as one year, or fails to consider the impact of all taxes or ignores the provision of government services or other benefits. The concept of horizontal equity also may not be useful unless we can determine what differences are important and why these differences justify different tax treatment.

Similarly, much disagreement exists about the usefulness of the vertical equity concept and what constitutes appropriate differences in tax treatment. Consider several possible conceptions of fairness. To some, fairness could require that all individuals pay the same amount of tax. Thus, one could design a tax system that imposes a head tax on each individual over 18 years old. While a head tax may strike some as fair, the fall of Margaret Thatcher's government regarding replacing a property tax with a per person "community charge" illustrates the political costs of misreading what the public considers fair.

Fairness could also require all taxpayers to pay the same rate of tax on their income. In the United States, the "flat tax" or "single rate tax" rhetoric enjoys great popularity. While most flat rate proposals provide for a high threshold (zero rate bracket) before the imposition of the flat rate, the notion of one tax rate that fits all strikes many as an equitable manner of determining tax liability. To others, however, fairness requires those taxpayers with higher income to pay a higher percentage of their income in tax. Although the progressive rate structure may rest on a shaky theoretical foundation, ¹⁴ it has been the most common income tax rate structure. Many find a basic attraction to assessing tax on the basis of "ability to pay" with the result that the rich are better able to contribute to the financing of government operations.

Current tax reform proposals bring back into focus the question of the relative fairness of consumption taxes versus income taxes. Consumption tax proponents question whether any income tax system can be fair. ¹⁵ There are several, somewhat related, strands to their positions. One approach takes a societal view. Income is what individuals contribute to society; consumption is what they take away from the pot. Therefore, if we want a society that will continue to grow and prosper, we are better off taxing consumption rather than income. A second approach considers consumption as a better measure of a household's ability to pay. Because of the greater variations in income over a person's or household's lifetime, it may be better to use consumption as the base for taxation rather than income. Finally, income taxes impose higher taxes on households with higher savings. As such, the income tax system penalizes savers over those who consume currently. ¹⁶

In short, fairness discussions in general, or horizontal and vertical equity in particular, are, by themselves, virtually meaningless concepts. Simply saying we should accord equal treatment to equals adds little to tax policy discussions. We need to choose an ethical framework before making any comparisons -- whether comparing equals or making "appropriate" comparisons among unequals. ¹⁷

It is difficult to ascertain either the implicit or explicit framework of those offering tax reform proposals. It is just as difficult to imagine policymakers in the United States or Japan agreeing on a single normative ideal. Yet without a more fundamental framework, one cannot evaluate the relative fairness of different proposals or different tax regimes. Perhaps the best we can do is to determine the consequences of a proposal or regime and then evaluate them in the context of different ethical structures.

Efficiency. The concept of efficiency also takes on different meanings. Traditionally, efficiency in the tax debate has focused on neutrality, that is, minimizing distortions. Taxes affect individuals' behavior on such questions as whether to consume or save, to work or play, or, in some cases, whether to get married or have children. Taxes affect corporate behavior on such basic questions as the choice of form of organization, whether to retain earnings or pay dividends, or whether to use debt or equity in the capital structure. The tax system should interfere as little as possible with economic decisions in a capitalist, free-market system. In economic terms, a neutral tax system will improve the allocation of resources in society by minimizing the "deadweight" loss of distortions. Distortions come in many forms: a change in the selection of products, a choice between work and leisure, or a choice between present and future consumption.

Economists focus on three different effects in examining distortions: the income effect, the substitution effect, and the financial effect. The income effect arises because taxes reduce the amount of resources available to an individual. The substitution effect arises when individuals change behavior by choosing nontaxed activities over taxed activities, or lightly taxed activities over highly taxed activities. The financial effect arises as taxpayers change the organization or structure of their activities because of taxes.

With the possible exception of a lump sum head tax, all taxes distort against someone or something. Income taxes reduce incentives to work and save and consumption taxes reduce incentives to spend, as well as to work. ¹⁸ Even if we remove tax distortions, it is unclear given other distortions in the economy that we are actually improving the allocation of resources in society. One response to a world in which market conditions do not conform to a model of perfect competition is to seek to come as close as possible to the ideal model. Economists, however, recognize that making a noncompetitive economy more competitive does not guarantee an improved allocation of resources. The "theory of the second best" holds that unless a market satisfies all conditions of perfect competition, correcting one market imperfection does not necessarily move the economy closer to optimal resource allocation. ¹⁹

Those who call for tax reform may use efficiency to mean more than just removing distortions or "neutral" taxation. So while it has been common for reform proponents to advocate low tax rates to encourage work and savings, the United States has also experienced increased calls to reform the tax system to "unleash the country's economic potential" through increased capital formation and international competitiveness. ²⁰ The movement behind many consumption taxes is to reduce the tax rate on income from capital. So while the goal of some past tax reform efforts was to reduce the disparity among the effective rates of different types of business activities, consumption tax advocates seek to reduce to zero the tax rate on new capital investment.

Two other efficiency-related arguments appear, beneath or above the surface, in the tax reform discussion. Beneath the surface, the tax reform discussion sometimes contains within it a debate on the size of government or the level of government spending. There are those who contend that taxpayers can spend their own money better -- that is, more efficiently -- than Washington. They seek, through tax reform, to reduce the amount of tax revenue available to the government. Some liberal members of Congress contend that some tax proposals are deliberately crafted to produce revenue shortfalls that will result in reductions in government spending.

Above the surface, general consensus exists that there are potential efficiency gains from changing the tax system by making it simpler and eliminating many preferences and exclusions. Tax reformers focus on the costs of enforcing and complying with the tax system. In the United States, taxpayers may spend about 5.3 billion hours in one year complying with federal tax law. The dollar cost could be US $225 billion. ²¹ As discussed further in the following section, an efficient tax system would reduce or eliminate resources that go into tax compliance, enforcement, and tax minimization.

Simplicity. Simplicity also may mean different things to different people. In the United States, everyone agrees that the current tax system is too complicated. Some complexity is unavoidable. An income tax applies to a large spectrum of business, investment, and personal events and transactions. We use income tax systems to adjust tax liability for personal characteristics of taxpayers and to encourage or discourage certain activities or conduct. ²² Other complexity is self-inflicted. Taxpayers engage in complex transactions for nontax, as well as for tax, reasons. As taxpayers and their advisors get more sophisticated and aggressive, it becomes necessary for taxing authorities to promulgate detailed statutes and regulations to combat real or perceived abuses. It is, therefore, not surprising that income tax systems are more complex than sales taxes, poll taxes, or property taxes. ²³

But it is troubling that many ordinary taxpayers cannot complete a tax return without professional assistance. Disagreement exists on how to simplify the tax system. Proponents of major tax reform have hit a responsive chord in calling for a simpler tax system. Some U.S. politicians brandish a postcard -- hailing it as the tax return of the future. There is general consensus that the U.S. tax system must be changed to relieve many more taxpayers of the burden of filing tax returns. ²⁴

For the last several years, there have been calls to move to a flat tax system, partly based on the notion that a single-rate tax structure would be simpler and easier. At one level, the claim lacks merit. The extra difficulty of determining the tax that applies with a progressive rate schedule as opposed to a single-rate tax is relatively minor. The vast majority of the complexity in the Internal Revenue Code relating to individuals arises from provisions that either seek to adjust tax liability to better reflect a taxpayer's unique circumstances for ability to pay or to provide special benefits.

In three important ways, however, a single-rate tax system will make the tax system simpler. First, it will decrease incentives to shift income from high-bracket to low-bracket taxpayers. Second, it may allow for increased withholding at the source for several different types of income. If all taxpayers are subject to tax at the same rate, the government can collect the tax directly from the payor of the income without regard to the unique characteristics of the recipient and without the necessity of the recipients' filing tax returns. Third, a single-rate tax system that did not provide for a capital gains rate preference will eliminate the complications caused by defining assets eligible for preferential treatment and by preventing taxpayers from converting ordinary income into capital gains.

The reform proposals examined in the next part differ in their efforts to simplify the U.S. tax system. Some proposals radically change the face of the tax system. For example, the national retail sales tax simplifies the tax system by repealing the individual and corporate income tax systems and expanding the existing state sales taxes. Several proposals seek to simplify the tax system by exempting from tax income from new capital investment. Other proposals make the tax system simpler by eliminating personal deductions or repealing special provisions or incentives. Finally, many proposals change the coverage of the income tax by raising the income threshold for which taxpayers are subject to tax.

B. What We Do Not Know About Taxes

Despite efforts of tax scholars, we still lack good answers to many important tax policy questions. We lack definitive answers to such important questions as the relationship between taxes and the level of savings, the relationship between taxes and economic growth, and the relationship between taxes and labor supply. We also do not have a complete understanding of the incidence of different types of taxes, particularly the important question of who actually bears the corporate income tax.

The United States leads the world in consumer spending. U.S. policymakers, unlike those in Japan, often express concern that Americans do not save enough. Among the reasons usually given for Americans' bad saving habits is a high tax on income from capital. The argument is relatively straightforward: if we increase the after- tax return from savings, Americans will save more. Unfortunately, at least in the United States, the empirical evidence does not support this claim. In the United States, little correlation exists between the private savings rates and the real after-tax rate of return. ²⁵

The relationship between tax rates and level of savings is quite complex. There are many different reasons to save: for retirement (life-cycle savings), to have extra funds if things go wrong (precautionary savings), or to provide an estate for one's heirs (bequest savings). ²⁶ To the extent individuals are target savers - - that is, they are trying to accumulate a specific total amount -- reducing the level of taxes may actually cause them to save less. As in many areas, changing the level of taxes provides competing incentives to taxpayers. Also, once we recognize that many types of savings exist, it is likely that taxes may affect individuals differently, depending on their reasons for savings.

We also lack a good understanding about the relationship between taxes and economic growth. At first glance, one may think lower taxes would mean higher economic growth. At least before the current economic downturn, advocates of low taxes and high economic growth often cite the Asian Tigers as a model of sound tax policy. Calls for lower tax rates often arise when economies falter.

Yet, at least in the United States, the evidence does not support the claim. The United States has experienced its greatest economic growth during the time periods when the tax rates have been the highest. For example, the U.S. economy grew at an annual rate of 3.1 percent when the highest marginal tax rates were about 90 percent (1951-1963), an annual rate of 2.3 percent when the highest marginal tax rates were about 70 percent (1964-1980), an annual rate of 1.9 percent when the highest marginal tax rates were about 50 percent (1981-1986), but only 1.0 percent when the highest marginal tax rates were about 33 percent (1987-1995). ²⁷ These figures do not suggest that high taxes are the key to economic prosperity. They merely show that the relationship is much more complex than would initially appear.

We also lack a good understanding of the incidence of taxes. It is often not clear whether the person who actually pays the tax is the person who bears the economic burden of the tax. For example, the traditional view of the incidence of a consumption tax provides that the tax is passed forward in the prices of goods and services and, therefore, is borne by consumers in proportion to their consumption of taxed goods. Note, however, this view is not without dissenters, especially when a consumption tax, such as a VAT, replaces a general corporate income tax.

Consider also the corporate income tax. Despite years of study by economists and lawyers, it is not clear who actually bears the tax. ²⁸ Although the corporation nominally pays the tax, the burden of the tax is borne either by shareholders (or all providers of capital) in the form of lower returns, workers in the form of lower wages, or consumers in the form of higher prices. Relative to other countries, Japan relies much more heavily on corporate tax revenue, rather than other tax revenues, to finance government operations. One policy option in Japan is to lower the tax burden on corporations and raise the lost tax revenues by increasing the rate on consumption taxes. The policy implications, in both the short and long run, of reducing corporate taxes and increasing consumption taxes are quite different depending on incidence assumptions regarding both taxes.

C. Large Gorilla -- Social Security Taxes

In both the United States and Japan, it is no longer possible to examine tax reform proposals without considering social security taxes. The role of social security taxes on both the taxing and spending side is just too big to ignore. For many individuals in both the United States and Japan, social security taxes are their largest tax payments. We cannot determine the aggregate distribution of tax burdens of major tax reform proposals without including social security taxes and benefits into the tax mix equation.

Social security taxes constitute about 35 percent of all Japanese tax revenue (9.8 percent of gross domestic product) and about 25 percent of all U.S. tax revenue (7 percent of GDP). With an aging population, absent some fundamental changes in both taxes and benefits, the relative role of social security taxes will continue to grow.

The United States has three different types of social security payroll taxes. The first tax is designed to fund the Old Age and Survivors Insurance (OASI) trust fund, the fund that provides monthly benefits for the elderly. ²⁹ The second tax provides monthly disability benefits to the nonelderly through the Disability Insurance (DI) trust fund. The final tax funds hospital insurance for the elderly through the Medicare Hospital Insurance (HI) trust fund. These taxes are imposed on both wages of employees and self- employment income. Employers and employees each pay 7.65 percent of tax on the first US $61,200 of wages and 1.45 percent on wages above this amount. Self-employed individuals pay 15.3 percent on the first US $72,600 of self-employment income and 2.9 percent on self- employment income above this amount. These three taxes constitute the second largest source of revenue for the federal government. While the statutory burden of social security taxes is shared equally by employers and employees, economists generally agree that the economic burden is borne entirely by employees. ³⁰

In 1995, the U.S. congressional Joint Committee on Taxation estimated that 131 million individual tax returns were filed, of which 31.8 percent paid no tax and 47 percent were in the 15 percent tax bracket. If the social security taxes are actually borne entirely by workers, this means that more than three-quarters of all taxpayers pay more social security taxes than income taxes. ³¹

The social security tax rate is 17.35 percent in Japan and, as in the United States, the cost is split between the employer and the employee. While the U.S. system is solely funded by employer and employee contributions, the Japanese government covers a third of the benefits costs and all administrative costs.

Although some tax reform proposals discussed in the next section, such as the USA Tax System, consider social security taxes, most do not. Because of the effect of social security taxes on the tax system, in general, and on low-income workers, in particular, it is not possible to have meaningful reform of the tax system without considering the role of social security taxes.

D. Transition Considerations -- Fundamental Reform Generates Too Many Winners and Losers

Any change in a tax system generates winners and losers. Sometimes policymakers provide for a delayed effective date or a gradual phase-in of tax rules to minimize the effect. Other times, lucky taxpayers are allowed to keep their favorable tax provisions through "grandfather" provisions.

Fundamental reform increases both the number of winners and losers, as well as the stakes. ³² The devil is in the details. Tax reform proposals that appear attractive in grand concept turn ugly when reduced to specific, detailed proposals. Major tax changes will affect the relative tax burden between the rich and the poor, between the young and the old, among different sectors of the economy, and among different industries. To the extent fundamental reform covers more than one type of tax, it is not possible to consider the consequences without examining the interaction of the changes in the tax systems. In the United States, tax reform efforts are further retarded because of the necessity to adhere to distribution of tax burdens among different portions of the population, as well as the need to maintain revenue neutrality from tax law changes. ³³

Consider replacing the income tax with a consumption tax. Under most proposals, low-income households would lose because they pay little or no income tax (or in some cases, receive a refundable earned-income tax credit) but would pay a consumption tax on all, or most, of their purchases. Some elderly would lose as they paid income tax while they worked and now would pay consumption taxes as they use savings to fund their retirement. Most high-income households would gain because their marginal rates would fall and they consume relatively less of their income. However, high-income households holding substantial capital assets, absent any transitional relief for old capital, would lose because the change would effectively place a one-time tax on previously invested capital.

Changing the way corporations are taxed would have different effects on capital-intensive industries, retailers with large existing inventories, and high-tech and service industries. Removing the deduction for real estate taxes and interest on mortgages for owner-occupied housing might cause housing values to fall precipitously.

Finally, any major tax reform that fundamentally changed the method or basis for taxation may have a substantial phase-in or transition period. The move from an income tax to a consumption tax may require a 5-year or a 10-year period in which the income tax is gradually phased out and the consumption tax is gradually phased in. During this period, taxpayers and the taxing authority would face the difficult and costly task of complying and enforcing two different tax systems.

Each of the reform proposals discussed in the next part has provisions that will help or harm certain groups in society as compared to the current tax regime. So while it is not easy to design a tax system starting from a clean slate, it is even more difficult to reform an existing tax system. Given political realities, policymakers must consider the effect of proposed reforms on efficiency, equity, and existing property rights at the time of the reform. ³⁴

Most of the proposals move the focus of taxation to taxing individuals on what they spend, rather than on what they earn. Some, like the retail sales tax and the VAT, tax consumption directly by imposing tax at the point of purchase. Other proposals, like the Hall-Rabushka flat tax and the USA tax, tax consumption indirectly by exempting from tax income from capital.

A. National Retail Sales Tax

A retail sales tax is the simplest point of purchase tax on consumption. In its pure form, the retail sales tax taxes all final purchases of goods and services by households from businesses at one uniform rate. To avoid a double tax or a cascading tax on transfers prior to final sale, transfers between businesses would not be subject to tax.

In the United States, the individual states traditionally impose taxes on the sale of goods to final consumers. A total of 45 out of 50 states impose some form of retail sales tax with rates, in general, between 4 and 8 percent. Senator Richard Lugar, a one-time presidential contender in the 1996 Republican primaries, proposed expanding the existing state tax structure to tax goods and services at a sufficiently high rate to allow for the repeal of the individual and corporate income tax. Senator Lugar estimated that a retail sales tax at 17 percent would generate sufficient revenue to allow for the repeal of the individual and corporate income tax. ³⁶ The rate, of course, depends on how broad the tax base is. ³⁷ Because the existing state tax collection authorities would administer the retail sales tax, the U.S. Internal Revenue Service could be abolished, much to the delight of many Americans.

The conventional wisdom is that retail sales tax at high rates pose substantial administrative problems. Because many retail businesses sell both to taxable households and tax-exempt businesses, it is difficult to police the taxable and tax-exempt distinction. At high tax rates, great incentives exist for households to avoid paying the tax by claiming tax-exempt status. For this reason, countries that have consumption tax rates above the 10 percent range have followed the VAT approach.

In general, a retail sales tax is imposed without regard to any special characteristics of the consumer, ³⁸ resulting in lower- income households paying a greater proportion of their income in sales taxes than higher-income households. Although many states do provide for reduced rates or exemptions for food and medicine, this approach raises additional administrative complications and is probably an inefficient method of providing relief to lower-income households.

B. VAT

The VAT and the retail sales tax both seek to tax sales of goods and services to the final consumer. The difference is in the way the tax is collected. The retail sales tax imposes the tax only on the final transaction. In contrast, the VAT imposes the tax at every stage of production.

VATs come in two basic flavors: the credit method and the subtraction method. Most countries use the credit method whereby a credit invoice is issued for each transaction. Firms remit to the government the difference between the amount of tax it collects for its sales, shown on the invoices, and the amount of tax it pays on its purchases. The advantage of the credit method approach is compliance. A credit method VAT provides for a degree of self- enforcement because firms can claim credits for taxes paid only if they can substantiate the transaction. The use of invoices allows the taxing authorities to trace the amount of taxes previously paid by other firms on purchases by taxpayers, greatly facilitating audits of taxpayers for both VAT and income tax purposes.

The subtraction method requires a firm to compute the total amount of sales less the cost of purchases. This method requires the same type of financial recordkeeping and auditing as the existing corporate tax system. Unlike the credit-method VAT, it does not provide for a self- enforcing mechanism between buyers and sellers.

Although Japan's VAT is structured as a credit-method VAT, the original 1988 legislation allowed taxpayers to substantiate tax credits either through books and records or by producing invoices showing VAT paid. This alternative treatment resulted from a political compromise that served to placate medium- and small-sized traders. To no one's surprise, not requiring taxpayers to maintain invoices seriously hampered enforcement efforts. For tax years after April 1, 1997, however, taxpayers are required to retain invoices to claim the VAT credit.

In the United States, VAT proposals have surfaced several times with remarkably little success. In the 1970s, the Nixon administration proposed a VAT to replace the payroll and corporate income tax. In 1979, congressional Representative Al Ullman, D-Ore., proposed a 10 percent VAT to a resounding lack of enthusiasm. Recent attempts have followed the lead of other countries and abandoned the VAT and sought to impose a similar tax, but with a different name. Recent proposals have included a "subtraction" method VAT masquerading as a business transfer tax, or with some modifications, as the Hall-Rabushka tax described below.

The VAT, like the retail sales tax, imposes disproportionate burdens on low-income households. One approach to minimize the regressivity is for the government to effectively exempt from taxation a level of consumption by providing a cash grant to each household to refund the VAT paid on this level of consumption (for example, if the VAT is 15 percent and the exempt level of purchases is US $20,000, the cash refund to the household would be US $3,000). Many countries, particularly the European countries, have sought to reduce the regressivity by either providing for lower rates of exemptions for food and other necessities or through direct assistance through public services, family allowances, or other forms of public assistance.

C. Hall-Rabushka Flat Tax

The Hall-Rabushka flat tax is a thinly disguised consumption tax with several quite interesting features. ³⁹ It combines a single rate for businesses and individuals with a relatively clean tax base. The authors seek to tax income once, but only once, at a proposed 19 percent tax rate.

For business taxpayers, the flat tax applies the same tax base as the VAT, but businesses can subtract the cost of wage payments and contributions to pensions (but not other fringe benefits). Thus, the tax base for business is the total revenue from sales of goods and services less purchase of inputs from other firms less wages, salaries, and pensions paid to workers, less purchases of plant and equipment. It may be useful to view this tax not as a tax on the income of the business, but as a comprehensive withholding tax on all types of income other than wages, salaries, and pensions.

The flat tax business proposal differs from current business taxation in several major respects. First, all businesses, regardless of organizational form, are taxed the same. Thus, the flat tax eliminates the current differential treatment of corporations, S corporations, partnerships, and sole proprietorships. Second, the flat tax allows for immediate expensing of all capital investment. Rather than depreciate acquisitions of plant and equipment over the useful lives of these assets, businesses can deduct the entire costs in the year of the acquisition. Finally, the flat tax imposes a final withholding tax on interest income paid by the corporation to providers of debt capital. This aspect of the flat tax shares much in common with the proposal by the U.S. Treasury Department to reform the taxation of corporations through its comprehensive business income tax proposal. ⁴⁰

For individuals, the tax base is narrowly crafted to cover only actual payments of wages, salaries, and pensions. For those taxpayers who do not operate businesses, this is the only part of the tax system that would directly apply to them. There would be no further taxation of dividends, interest, or rents. Removed from the tax system are deductions for such items as charitable contributions, mortgage interest, and medical and casualty losses. To achieve a significant amount of progressivity, a large zero-rate tax bracket is imposed and additional personal allowances are allowed for dependents. The authors contend that the individual income tax return could be contained on a postcard.

D. The USA Tax System

As discussed above, consumption can be directly taxed through a retail sales tax or a VAT, or indirectly by removing the taxation of capital from the income tax base. Personal consumption taxes, like the USA tax, avoid taxing capital income by allowing an unlimited deduction for new savings (and by taxing any dissavings).

The USA tax system replaces the existing U.S. individual and corporate income taxes with (1) a flat-rate tax on business, regardless of form of organization that allows a deduction for capital investment and (2) a graduated- rate individual tax that allows a deduction for personal savings. ⁴¹ The key to this system is the unlimited savings allowance. Although individuals must include income from all sources in determining their tax liability, they receive an unlimited deduction for all new net savings.

The USA tax system retains some existing personal deductions, such as the charitable deduction and the deduction for interest on owner-occupied housing, and it provides a new deduction for certain qualified education expenses. The USA tax system coordinates income and payroll taxes by allowing lower- and middle-income taxpayers to claim a tax credit for any payroll taxes paid and by allowing business taxpayers a credit for payroll taxes paid against the business tax.

For businesses, financial receipts and payments (such as dividends and interest) are excluded from income and are not deductible. In contrast to the flat tax, businesses cannot deduct compensation payments to employees. Proponents of the USA tax system contend that this tax regime will make American businesses more competitive because its territorial approach excludes income related to goods sold and services rendered outside the United States. The USA tax system also contains an import tax that seeks to ensure that foreign companies doing business in the United States bear the same tax burden as domestic businesses.

E. Representative Richard Gephardt's 10 Percent Tax

While all the above proposals are variations of a consumption tax, U.S. congressional Representative Richard Gephardt proposes to retain the basic income tax structure for both individuals and corporations. His proposal calls for a broader tax base and lower tax rates than the present income tax. Gephardt's proposal eliminates personal deductions for state and local taxes and exemptions for interest on municipal bonds, but retains the earned income tax credit and the mortgage interest deduction on owner-occupied housing. His proposal significantly broadens the tax base by eliminating many deductions for pension contributions and taxing employees on the value of employer-provided health insurance. Gephardt also proposes to eliminate "corporate welfare" by repealing some preferential corporate tax provisions.

The broadening of the tax base allows for significant rate reductions. The proposed rate schedule follows the U.K. model whereby most of the population with income above an exempt amount would be taxed at the same rate (10 percent). Additional progressive tax rates rising to a maximum of 34 percent would apply to high-income individuals.

A. Observations and Insights

There have been several developments since the last round of major tax reform in the mid-1980s. This part sets forth four factors that may influence the shape of tax reform.

Equivalence of different types of taxes. Current tax reform proposals cause tax policymakers to focus on how tricky tax labels have become, and perhaps, how insignificant. Traditionally, many countries have approached tax reform in a piecemeal manner. This approach may rest, in part, on the somewhat artificial academic distinction between direct and indirect taxes and partly on the difficulty in achieving tax reform for even a small part of the tax system, as opposed to the challenges of more comprehensive reform.

But recent proposals illustrate the substantial economic equivalence of different types of taxes. For example, for a substantial part of the population that has no net savings, a consumption tax and an income tax are equivalent. One can treat a flat-rate VAT as the equivalent of a flat-rate tax on labor plus a flat-rate tax on wealth. Similarly, a business transfer tax on business is substantially similar to a corporate income tax with immediate deductibility for capital investment.

Hybrid tax systems. It may be time to put aside the continuing academic debate over the relative superiority of either income taxes or consumption taxes. As a practical matter, a better approach may be to try to design the best hybrid system. ⁴² In terms of fairness and administrative considerations, particularly those associated with switching from an income tax system to a consumption tax system, substantial support may exist for a hybrid system.

The United States, like Japan, never had a pure income tax system. The current systems of both countries contain both income and consumption tax features. ⁴³ Consumption-type tax treatment applies in varying degrees to pensions, life insurance, residential housing, and certain types of like-kind exchanges and roll over provisions. Evidence exists that under the current U.S. tax system, at least half of the U.S. economy is already under the consumption tax model. ⁴⁴ In Japan, before recent tax reforms imposed taxes on interest payments and capital gains, the portion of the economy effectively taxed under a consumption tax model (nominally an income tax system) was likely even higher. As discussed in the next section, there may be substantial merit in a combination approach to tax reform, rather than relying on a single type of tax.

Globalization of income and the return of scheduler taxation. Countries no longer have the luxury of changing their tax systems without considering how their systems compare to tax systems in other countries. The increased pressures of operating in a global economy and the increase in the mobility of capital will make it more difficult to tax income, especially income from capital. The growth of electronic commerce presents similar challenges in the taxation of sales of goods.

A new round of tax reform may produce an increased willingness to de-link the taxation of labor income and capital income. ⁴⁵ There is increased recognition that no uniform treatment of capital and labor income exists under the current system (merely applying the same tax rate in the United States does not result in equal treatment) and that there may be advantages for explicit differential treatment for different types of income. As such, more countries may adopt a dual system approach that explicitly provides for taxing labor income (most likely under a progressive rate schedule) and a flat tax on income from capital. ⁴⁶ This allows countries to impose higher taxes on more inelastic sources of income, such as labor, and lower taxes on more elastic sources, such as many different types of capital income. It also may allow countries to expand the final withholding regime to cover additional types of capital income.

Fiscal federalism. The current round of tax reform requires addressing fiscal federalism issues -- that is, the allocation of spending and taxing authority among different levels of government. All the tax proposals discussed in the previous section would have a dramatic impact on state and local governments. ⁴⁷ For example, adopting a VAT in the United States or reducing corporate tax rates in Japan cannot be achieved without coordination between the federal and local governments. Radical changes in the federal tax base or changes in the collection of taxes could severely affect local governments' revenue-raising capabilities. In short, federal tax reform cannot be achieved in a vacuum, as any major change in tax structure will impact all levels of government.

B. Comparisons Between United States and Japan

It used to be that one could say that the United States and Japan took very different approaches to taxation. ⁴⁸ For one, the United States follows a global approach that aggregates income from all sources and applies a tax rate or rate schedule to determine tax liability. In contrast, Japan follows a scheduler approach that separates income into discrete categories of income and applies different tax rules and rates to each category. Also, the United States has traditionally imposed significant tax burdens on income from capital. The Japanese tax system, for most of the post-war period, provided for major exclusions and tax preferences for capital income and, as such, operated more as a consumption tax system than an income tax system. ⁴⁹

But times have changed. The U.S. global tax system has substantial scheduler elements, ⁵⁰ and the Japanese tax system, though scheduler in form, has substantial global characteristics. In part because of changes in the taxation of capital gains and interest income and in part because of Japan's heavy reliance on taxing income from corporations, Japan has increased the tax burden on capital income in recent years. Although the Japanese tax system previously provided some relief from the double taxation of distributed corporate income, both the United States and Japan currently provide no meaningful integration of the individual and corporate tax systems.

A review of aggregate statistics reveals many similarities between the U.S. and Japanese tax systems. The aggregate tax burdens, expressed as a percentage of GDP, are remarkably similar (29.7 percent for the United States and 29.1 percent for Japan), and well below the average tax burden of 38.7 percent of the 29 OECD nations. The United States and Japan rely more on income taxes than consumption taxes when compared to almost all other industrialized countries. As a percentage of GDP, Japan's consumption taxes comprise only 3.7 percent of GDP. Consumption taxes (mostly state retail sales taxes) in the United States are 4.5 percent of GDP. In contrast, the average for the OECD countries is 11 percent of GDP. Both countries face the growing problem of social security tax costs being a major component of tax collections and future disbursements.

The United States and Japan face similar challenges in tax compliance. For the portion of income subject to withholding, such as wages, dividends, and interest, compliance rates are high. However, for privately held businesses, particularly small service industries, tax evasion is often a significant problem.

Both countries face obstacles to tax reform because of the assignment of taxing and spending responsibilities to different levels of government. For example, the adoption of a national VAT in the United States is complicated because almost all of the states use retail sales taxes. Similarly, a change in the aggregate corporate tax rate in Japan is difficult because the prefectures impose local enterprise taxes based on a percentage of the national corporate tax.

There are also major differences between the two tax systems. Despite the same relative aggregate tax burdens, the combined Japanese top marginal tax rates (national and prefecture) for both individuals and corporations have traditionally been higher than in the United States.51 Only the 1999 Japanese tax rate cuts substantially narrow the gap.

Japan and the United States are experiencing different results in the collection of tax revenues. Due to a strong economy and a rising stock market in the United States, tax collections are at record levels. Japan, however, is experiencing declining receipts, particularly from corporate taxpayers whose profits are eroded. This shortfall in tax collections is a major component fueling Japan's budget deficit.

Japan is under much greater pressure than the United States, both internally and externally, to use tax measures to stimulate the economy, particularly through increasing consumer demand. Both the 1998 tax reform measures and the 1999 tax reform proposals seek to reduce tax barriers to trading land and securities, to reduce individual and corporate tax rates, and to encourage consumer spending. In contrast, U.S. tax legislation and proposals provide targeted tax benefits for specific groups or activities.

Another prominent difference in the tax systems is the level of transparency. The two most visible taxes for most Japanese are the consumption tax and the inheritance tax. As a percentage of total tax collections, these taxes are relatively small. However, partly because of the success of the administration of the individual income tax in Japan, and largely due to the preference by politicians to place the tax burden on corporations, the tax system is not particularly transparent. Even though the corporate tax burden in Japan is ultimately borne by individuals (either consumers in the form of higher prices, labor in the form of lower wages, or shareholders in the form of a lower return on capital), the traditional preference has been to increase corporate taxes rather than taxes on individuals.

C. Modest Predictions

If fundamental tax reform comes to pass, it is unlikely that the U.S. Congress would adopt either a pure consumption or a pure income tax proposal. The transition problems involved in moving to a consumption tax system are too great. Politically, it may be very difficult to get the American people to abandon an income tax system. The alternative is again life in the middle lane. In both the United States and Japan, tax reform likely means more explicit use of consumption taxes, specifically point of purchase taxes.

A VAT with a 10 percent rate in the United States would raise about US $400 billion, which constitutes about half of the revenue requirements of the tax system. This revenue could provide the resources to allow for a substantial reduction in the U.S. individual and corporate tax rates, a removal of many low-income individuals from the income tax system, and a reform of the social security tax system.

Although some contend that the increase from 3 to 5 percent in Japan's consumption tax rate in 1997 contributed greatly to the slowdown in consumer spending, a further increase in the rate may be good tax policy. Further changes in the VAT could include reducing eligibility for simplified procedures available to small traders and further strengthening enforcement procedures to improve tax compliance. Increased consumption taxes have the additional advantage of effectively serving as a minimum tax for those taxpayers who currently pay no taxes, either because of having income below the income tax threshold or because of tax evasion.

The increase in collections generated from higher consumption taxes could be used to substantially reduce Japan's individual and corporate income tax rates, coupled with other reforms to eliminate certain tax preferences. ⁵² The additional revenues generated by an increase in consumption taxes also could allow tax benefits to be expanded in areas requiring meaningful reform. For example, tax- motivated schemes for individuals to establish retirement accounts similar to 401(k) plans in the United States could be considered as part of reforming Japan's social insurance tax policy.

It would not be possible to adopt a VAT in the United States or to substantially raise the tax rate in Japan without addressing the regressivity concerns of a consumption tax. The alternatives for addressing regressivity bring on their own set of complications and political problems. It is likely that relief could be provided to working poor through changes in existing direct assistance programs in the United States.

In both the United States and Japan, fundamental reform may involve a package approach. The "big trade" could involve a major change in the coverage of the individual income tax whereby several million additional families are exempted from paying income taxes. In the United States, the initial threshold rate for a family of four could be increased to as high as US $100,000. Further relief could be provided through making all or part of the social security taxes refundable to individuals with income below a certain level. For those covered under the individual income tax, certain personal deductions, such as for home mortgage interest, charitable contributions, local and state taxes, and medical and casualty losses, could be removed or subject to limits and certain tax-exempt items could be taxable. A package could also require individuals to include in income the value of employer- provided medical, life, and pension plans.

In Japan, fundamental tax reform may include changes in tax enforcement. For tax professionals familiar with the United States and other compliance systems, it is surprising that Japan can administer its tax system as well as it does without a taxpayer identification number (TIN) system. Japan can successfully collect taxes without a TIN system through withholding collection at the source for certain types of income, such as wages, interest, and certain capital gains. For other types of income, however, TINs have been essential in aiding collection efforts. Tax compliance methods have evolved globally during the last 30 years from an audit-based approach to one of document matching and information retrieval. For example, the U.S. IRS receives over one billion documents a year, so that the tracking of this information would be virtually impossible without an effective TIN system. Although the assignment of numbers to taxpayers is essential to improve the collection of taxes and ensure accurate and fair reporting of income, Japan has failed on several occasions to adopt a TIN system.

In both countries, a VAT in the 10 to 15 percent range may be the key to raising tax revenue to make other major changes in the tax system. With a reduced role in the tax mix, the individual income tax could be designed to cover a substantially smaller portion of the current tax population and at rates substantially lower than existing rates in the United States and Japan. With a higher tax threshold, many individual tax preferences and exclusions could be repealed or curtailed. Similarly, the social security tax regime could be changed to lower tax rates and to provide for refundability for low-income workers. Finally, reducing the revenue requirements for the corporate income tax would allow for substantially reduced corporate tax rates to aid in international tax competition, and it may provide the government with increased flexibility to use the tax system to stimulate corporate investment.

² See Japan Federation of Economic Organizations, Proposals for the 1999 Tax Reform, Sept. 16, 1998; Haruo Shimada, Corporate Tax Reform (1998); and Naomasa Ishikawa, Proposals for Japanese Tax Reform (1997).

³ Itami directed "A Taxing Woman" (Fox/Lorber 1987) and "A Taxing Woman's Return" (New Yorker Films 1988) in which Nobuko Miyamoto plays Ryoko, a likeable, diligent, and resourceful tax inspector.

⁴ Dissatisfaction with certain activities of the U.S. Internal Revenue Service, and the actions of several members of Congress turning tax collection into a political campaign issue, led to the passage of the Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. No. 105-206, 112 Stat. 685 (1998). This act requires a reorganization of the IRS to be more responsive to taxpayers and the creation of an independent oversight board, and it provides for several provisions that seek to protect taxpayers from "abusive" IRS activities.

⁵ See, for example, Joint Comm. on Taxation, Federal Income Aspects of Mergers and Acquisitions (JCS-6-85) (1985); Michael J. Boskin, "Taxation, Saving and the Rate of Interest," 86 J. Pol. Econ. S3 (1978).

⁶ See Ken Messere, "Tax Policy Forum: Taxation in Ten Industrialized Countries Over the Last Decade: An Overview," Tax Notes Int'l, Aug. 21, 1995, 512, or 95 TNI 161-1 .

⁷ In the United States, the most costly tax expenditures are the exclusion of pension contributions and earnings for employer plans; the exclusion of employer contributions for medical care, health insurance premiums, and long-term care insurance premiums; mortgage interest deductions on owner-occupied residences; and accelerated depreciation for equipment. See Joint Comm. on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 1998-2002 (JCS-22-97).

⁸ Hiromitsu Ishi, The Japanese Tax System 379-80 (2d ed. 1993).

⁹ The IRS determines the "voluntary reporting percentages" (VRPs) for different types of income. This attempts to measure the relationship between the total amount of income voluntarily reported for any given year and the IRS estimates of the amounts that should have been reported. For 1987, the IRS estimated VRPs for the following types of income: wages and salary (99.5 percent), dividends and interest (94.6 percent), capital gains (88.3 percent), and the income of informal suppliers (13.1 percent). See Internal Revenue Service, Income Tax Compliance Research: Gross Tax Gap Estimates and Projections for 1973-1992 (Publication 7285, 1988).

¹⁰ The House of Representatives voted to repeal the current Internal Revenue Code and create an entirely new tax code by July 4, 2002 (H.R. 3097). This action was largely symbolic because there was little chance that such a measure would pass the Senate or escape a presidential veto.

¹¹ See, for example, the comments of House Majority Leader Richard K. Armey, R-Texas, in introducing the "Freedom and Fairness Restoration Act," H.R. 2060, 104th Cong. (1995), see 95 TNI 143-19 , (July 25, 1995) ("The flat tax will restore fairness to the tax law by treating everyone the same....By eliminating the bias against saving, slashing marginal tax rates, and allowing resources to seek their most efficient use, the bill will spur investment and economic growth."); comments of Sen. Sam Nunn, D-Ga., in introducing the "USA Tax Act," S. 722, 104th Cong. (1995), see 95 TNI 86-11 , (May 3, 1995) ("[I]t will make our Tax Code more understandable and more efficient...without sacrificing the principle of fairness in allocating the tax burden."); and statement of former Senate majority leader and GOP presidential nominee Bob Dole in "Bob Dole's Plan for Economic Growth, Restoring the American Dream," see Doc 96-22149 (14 pages), (Aug. 6, 1996) ("This new tax system, which is lower, flatter, fairer, simpler and more savings-oriented, will provide immediate tax relief to every taxpayer and stimulate economic growth now.").

¹² Compare Louis Kaplow, "Horizontal Equity: Measures in Search of a Principle," 42 Nat'l Tax J. 139, 148-50 (1989), with Richard A. Musgrave, "Horizontal Equity, Once More," 43 Nat'l Tax J. 113 (1990). See also Thomas D. Griffith, "Should 'Tax Norms' Be Abandoned? Rethinking Tax Policy Analysis and the Taxation of Personal Injury Recoveries," 1993 Wis. L. Rev. 1115, 1155-59 (1993).

¹³ See, generally, Eric M. Zolt, "The Uneasy Case for Uniform Taxation," 16 Va. Tax Rev. 39, 86-98 (1996).

¹⁴ See Walter J. Blum and Harry Kalven, Jr., "The Uneasy Case for Progressive Taxation," 19 U. Chi. L. Rev. 417 (1952); and Joseph Bankman and Thomas Griffith, "Social Welfare and the Rate Structure: A New Look at Progressive Taxation," 75 Cal. L. Rev. 1905 (1987).

¹⁵ See William G. Gale, "Building a Better Tax System: Can a Consumption Tax Deliver the Goods?" Tax Notes, Nov. 6, 1995, p. 781 or 95 TNI 215-5 .

¹⁶ Note, however, the market rate of interest may compensate savers for deferring consumption. For a rich discussion questioning the equity advantages of a consumption tax, see Alvin C. Warren, "Fairness and a Consumption-Type or Cash Flow Personal Income Tax," 88 Harv. L. Rev. 931 (1975), and Barbara H. Fried, "Fairness and the Consumption Tax," 44 Stan. L. Rev. 961 (1994).

¹⁷ Different theories include entitlement theory, utilitarian, and Rawlesian-based theory. For a discussion of these theories in the context of progressive taxation, see Bankman and Griffith, supra note 14.

¹⁸ A consumption tax has the same effect on the incentive to work as an income tax if we assume common lifetime savings and consumption preferences.

¹⁹ See R. G. Lipsey and K. Lancaster, "The General Theory of Second Best," 24 Rev. Econ. Stud. 11 (1956-1957); Edward A. Zelinsky, "Efficiency and Income Taxes: The Rehabilitation of Tax Incentives," 64 Tex. L. Rev. 973, 996-97 (1986).

²⁰ See The National Commission on Economic Growth and Tax Reform, "Unleashing America's Potential: A Pro-Growth, Pro-Family Tax System for the 21st Century," Tax Notes, Jan. 22, 1996, p. 413, or Doc 96-1637 (31 pages).

²¹ See Arthur P. Hall, "Compliance Costs of Alternative Tax Systems," Tax Notes, May 20, 1996, p. 1081.

²² See Eric M. Zolt, "Deterrence Via Taxation: A Critical Analysis of Tax Penalty Provisions," 37 UCLA L. Rev. 343 (1989).

²³ See, generally, Boris I. Bittker, "Tax Reform and Tax Simplification," 29 U. Miami L. Rev. 1 (1974); and Edward J. McCaffery, "The Holy Grail of Tax Simplification," 1990 Wis. L. Rev. 1267 (1990).

²⁴ For a good review of the feasibility of a return-free tax system, see Ernest S. Christian, "How Much Simplification Is Enough? Is a Returnless Tax Realistic?" Tax Notes, Dec. 23, 1996, p. 1481, or Doc 96-32798 (16 pages).

²⁵ The long-term personal savings rate in the United States may vary inversely with returns on capital. See Jonathan Skinner and Daniel Feenberg, "The Impact of 1986 Tax Reform on Personal Savings," in Do Taxes Matter? The Impact of the Tax Reform Act of 1986 50, 58- 63 (Joel Slemrod ed., 1990); Slemrod and Bakija, infra note 35, Figure 4.4 at 111.

²⁶ For an excellent discussion of the different types of savings and the implications for taxing under an income or consumption tax system, see Edward J. McCaffery, "Tax Policy Under a Hybrid Income-Consumption Tax," 70 Tex. L. Rev. 1145 (1992). See also Deborah M. Weiss, "Can Capital Tax Policy Be Fair? Stimulating Savings Through Differentiated Tax Rates," 78 Cornell. L. Rev. 206 (1993), for a discussion of using different tax rates to encourage savings in a manner that considers distribution concerns.

²⁷ Slemrod and Bakija, infra note 35, Figure 4.1 at 98. Similarly, little correlation exists between the level of taxes in a country (as a percentage of gross domestic product) and the level of annual growth in real GDP per capita. Id. at 100-01.

²⁸ See Arnold C. Harberger, "The Incidence of the Corporation Income Tax," 70 J. Pol. Econ. 215 (1962); and William A. Klein, "The Incidence of the Corporation Income Tax: A Lawyer's View of a Problem in Economics," 1965 Wis. L. Rev. 576 (1965).

²⁹ For a good discussion of social security payroll taxes, see Martin A. Sullivan, "Social Security Taxes: No Room to Grow?" Tax Notes, Apr. 1, 1996, p. 133, or Doc 96-9858 (4 pages).

³⁰ See Joseph A. Pechman and Benjamin A. Okner, Who Bears the Tax Burden? 33 (1974).

³¹ Sullivan, supra note 29, at 134.

³² See Joseph Bankman and Barbara H. Fried, "Winners and Losers in the Shift to a Consumption Tax," 86 Geo. L.J. 539 (1998).

³³ See Michael J. Graetz, "Paint-By- Numbers Tax Lawmaking," 95 Colum. L. Rev. 609 (1995).

³⁴ See Martin Feldstein, "On the Theory of Tax Reform," 6 J. Pub. Econ. 77, 90-94 (1976); and "Compensation in Tax Reform," 29 Nat'l Tax J. 123, 124-26 (1976).

³⁵ This discussion draws heavily from Joel Slemrod and Jon Bakija, Taxing Ourselves: A Citizen's Guide to the Great Debate Over Tax Reform 195-208 (1996).

³⁶ The Treasury Department estimates that a 24 percent rate would generate sufficient revenue.

³⁷ A tax rate of 21 percent is required if the tax base excludes food and medicine, and a 27 percent rate is required if housing is also excluded. See Gale, supra note 15, at 784.

³⁸ Some states do provide for refunds for purchasers who are elderly or whose income is below a certain threshold.

³⁹ For a complete description of this proposal, see Robert E. Hall and Alvin Rabushka, The Flat Tax (2d ed. 1995).

⁴⁰ U.S. Treasury Department, Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once (1992).

⁴¹ For a complete description of the USA tax see Alliance USA, "USA Tax System: Description and Explanation of the Unlimited Savings Allowance [USA] Income Tax System," Tax Notes, Special Supplement, Mar. 10, 1995, p. 1485.

⁴² Several commentators advocate a combination approach to tax reform. See Michael J. Graetz, The Decline (and Fall?) of the Income Tax 275-76 (1997), and McCaffery, supra note 26.

⁴³ See McCaffery, supra note 26, at 1152-55.

⁴⁴ See McCaffery, supra note 26, at 1153; and Don Fullerton, "The Consumption Tax: An Idea Whose Time Has Come?" Tax Notes, Apr. 22, 1985, p. 435.

⁴⁵ The tax systems of Sweden and Finland provide for a scheduler tax system for income from capital. See Kari S. Tikka, "A 25% Flat Rate Tax on Capital Income: The Finnish Reaction to International Tax Competition," in Tax Reform in the Nordic Countries 91 (1993); and Krister Andersson and Leif Muten, "The Tax System of Sweden," Tax Notes Int'l, Oct. 10, 1994, pp. 1147, 1148, or 94 TNI 196-18 .

⁴⁶ Optimal tax theory may provide valuable insights to the separate taxation of income from capital and income from labor. Optimal taxation has emerged as a different approach to tax policy and design. The seminal article that generated renewed interest in optimal taxation is J. A. Mirrlees, "An Exploration in the Theory of Optimal Income Taxation," 38 Rev. of Econ. Stud. 175 (1971). See, generally, A.B. Atkinson and J.E. Stiglitz, Lectures on Public Economics 366-93, 407-51 (1980), for a review of the optimal tax literature.

⁴⁷ See, generally, Peter L. Faber, "Effect of Federal Tax Reform on State and Local Governments," Tax Notes, Apr. 6, 1998, p. 109 (1998), or Doc 98-9216 (5 pages).

⁴⁸ See J. Mark Ramseyer and Minoru Nakazato, Japanese Law: An Economic Approach, Ch. 9, 220-47 (1998), for an excellent discussion of the Japanese tax system and the changes from the proposals of the Shoup mission.

⁴⁹ See Minoru Nakazato, "The Impact of the Shoup Report on Japanese Economic Development," in Retrospectives on Public Finance 51 (1991).

⁵⁰ See Zolt, supra note 13, at 49-51.

⁵¹ A simple comparison of tax rates between countries can be misleading because of, among other things, the differences in relative tax bases and the effect of state and local taxes. For 1998, the combined federal and state U.S. top marginal tax rates for individuals is about 20 percentage points lower than Japan, and the top tax rates for corporations is about 10 percentage points lower than Japan.

⁵² For example, other reforms could include taxing employees on residential rent paid by employers, changing the treatment of employee stock options, or removing certain tax preferences for the elderly.