Simplifying Federal Taxes: The Advantages of Consumption‐​Based Taxation

October 17, 2001 • Policy Analysis No. 416

This year’s $1.35 trillion tax cut reduced income tax rates and modestly liberalized the tax rules for retirement saving plans. However, the new tax law did not slow the progression of the tax code toward increasing levels of complexity. In fact, the law made 441 changes to the tax code and created a complicated series of phase‐​in periods for tax changes. Meanwhile, the congressional Joint Committee on Taxation released a 1,300-page study cataloging the excessive complexity of federal taxes but providing only limited proposals for reform.

Minor simplification reforms will not be enough. The tax system is caught in a spiral of continual change and nonstop growth in rules. Since the mid‐​1980s there have been 7,000 federal tax code changes and a 74 percent increase in the number of pages of tax rules. Complying with federal tax requirements wastes 6 billion hours each year as families and businesses fill out tax forms, keep records, and learn tax rules.

The key factor that causes rising income tax complexity is that the tax base is inherently difficult to measure. The Haig‐​Simons measure of income favored by many academic theorists is economically damaging and too impractical to use in the real world. As a result, policymakers have fallen back on ad hoc and inconsistent rules to define the income tax base. That intensifies complexity and creates instability as policymakers gyrate between different definitions of the tax base. In addition, the lack of a consistently defined tax base increases the use of the tax code for special‐​interest tax breaks, thus further adding to the system’s complexity.

The complexity and inefficiency of the individual and corporate income taxes have led to great interest in replacing them with a consumption‐​based tax. The leading consumption‐​based tax proposals, including the national retail sales tax and the Hall‐​Rabushka flat tax, could dramatically simplify federal taxation. Those tax systems would eliminate many of the most complex aspects of federal taxation, including depreciation accounting and capital gains taxation.

Imposing the largest federal tax on income was a historic mistake: no simple, efficient, and stable measure of income has been found in nine decades of the income tax. It is time to recognize this mistake and replace the income tax with a consumption‐​based alternative.

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About the Author
Chris Edwards

Director of Tax Policy Studies and Editor, Down​siz​ing​Gov​ern​ment​.org