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RELEASESj
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WS-1238
TO
B-67
JANUARY 4, 197 7
THROUGH
FEBRUARY 28, 197 7
LIBRARY
0CT2 61978
ROOM 5004
TREASURY DEPARTMENT
FOR IMMEDIATE RELEASE
WEDNESDAY, JANUARY 5, 197 7
CONTACT: PRISCILLA CRANE (202) 634-5248
THIRD QUARTER ANTIRECESSION FUNDS PAID TODAY
The third quarterly payment of antirecession funds
authorized to be distributed to States and local units
of general government under Title II of the Public Works
Employment Act of 1976 (P.L. 94-369) is being made today
by the Department of the TreasuryTs Office of Revenue
Sharing.
A total of $310,937,539 was allocated to eligible
recipient governments for the third quarter. Because
some governments also are being paid their first and
second quarter amounts this month, however, the Office
of Revenue Sharing is issuing payments totaling
$328,593,465 to 17,145 units of State and local general
.government today. Approximately $1.8 million in first,
second and third quarter funds is still being held for
808 eligible recipients which have yet to return to the
Office of Revenue Sharing certain assurance forms which
are required by the antirecession law.
TodayTs payment brings to $868,752,794 the total
distributed thus far under the new program. A total of
$870,625,060 has been allocated to eligible recipients
for the first three quarters, including the $1.8 million
being held for eligible recipients mentioned above.
In addition, the Office of Revenue Sharing is holding
$5.1 million in a reserve fund which will be used to make
required adjustment payments in the future. Reserve funds
not required for such adjustments will be distributed to
eligible governments at a future time.
Antirecession law authorizes the distribution of $1.25
billion in five calendar quarters, beginning July 1, 1976.
"No funds will be distributed for a quarter if the applicable national unemployment rates fall below six percent
or if the funds authorized by Congress for the program
have been exhausted in prior quarters," Jeanna D. Tully,
Director of the Office of Revenue Sharing, announced today.
WS-1238
-2-
Allocations of funds to individual units of government are based on applicable unemployment rates and on
final entitlement amounts for Federal fiscal year 1976 in
the General Revenue Sharing Program.
The money is to be used to maintain ongoing, basic
services in recipient communities.
"The next quarterly payment of antirecession funds
will be made in April 1977," according to Miss Tully.
"Governments which return their required assurance forms
by March 11, 1977 will receive all money to which they are
entitled for the first four quarters of the program in the
April payment," she added.
-- 30 --
FOR IMMEDIATE RELEASE
December 30, 1976
The Acting Secretary of the Treasury issued today additional
guidelines relating to certain provisions of the Tax Reform Act of
1976 which deny certain tax benefits for participation in or cooperation
with international boycotts. A n earlier set of guidelines, consisting
of questions and answers, was issued on November 4, 1976 (Treasury
News Release WS-1156) and was published in the Federal Register
of November 11, 1976 (41 F.R. 49923). These guidelines relate
only to parts A through G of the earlier guidelines and add a new
part N, relating to the computation of the foreign tax credit. These
guidelines do not deal with those provisions of the Tax Reform Act
of 1976 which define what constitutes participation in or cooperation
with an international boycott. Some of the guidelines issued today are
new while others are revisions of earlier questions and answers. The
same numbering system is used, and the same introductory material
is applicable.
This announcement and the guidelines will appear in the Federal
Register of January 5, 1977.
oOo
WS-1239
A.
Boycott Reports.
A-l. Q: Who must report as required by section 999(a)?
A. Generally, any United States person (within the
meaning of section 7701(a)(30)), or any other person (within the
meaning of section 7701(a)(1)) that either claims the benefit of the
foreign tax credit under section 901, or owns stock of a DISC, is
required to report under section 999(a) if it -1. has operations; or
2. is a member of a controlled group, a member
of which has operations; or
3. is a United States shareholder (within the
meaning of section 951(b)) of a foreign corporation
that has operations; or
4. is a partner in a partnership that has operations; or
5. is treated under section 671 as the owner of a
trust that has operations
in or related to a boycotting country (or with the government, a company, or a national of a boycotting country). Additionally, if a
person controls a corporation (within the meaning of section 304(c))
and either that person or the controlled corporation is required to
report under section 999(a), then under section 999(e) that person
must report whether the corporation had reportable operations and
whether the corporation participated in or cooperated with the boycott.
The controlled corporation must make the same reports with respect
to the operations of the person controlling it.
A boycotting country is
(i) any country that is on the list maintained by the
Secretary under section 999(a)(3), or
(ii) any country not on the list maintained by the
Secretary under section 999(a)(3), in which the
person required to file the report (or a m e m b e r
of the controlled group which includes that
person) has operations, and which that person
knows or has reason to know requires any
person to participate in or cooperate with an
international boycott that is not excepted by section 999(b)(4)(A), (B), or (C). Thus, even if
the boycott participation required of the person
reporting the operation is excepted by section
-2999(b)(4)(A), (B), or (C), if that person knows or
has reason to know that boycott participation not
excepted by section 999(b)(4)(A), (B), or (C) is
required of any other person, the country is a
boycotting country.
If the person required to file the report (or a member of the controlled
group which includes that person) has operations related to a country,
but not operations in that country, that country is not a boycotting
country unless it is on the list maintained by the Secretary under section
999(a)(3). (For the definition of operations in or related to a country,
see the questions and answers under part B. )
A-ll. Q: If Company A sells goods or services to Company
B (or does other business with Company B ) and Company B and
Company A are unrelated, and Company A knows or has reason
to know that Company B in turn will sell these goods or services
for use in a boycotting country, and further, Company B participates in or cooperates with such boycott, is Company A required
to report with respect to such operations?
A: Although such operations are related to a boycotting
country (see the answer to Question B-l), the reporting requirements
are waived for Company A, provided that Company A does not receive
a request to participate in or cooperate with an international boycott
under section 999(a)(2), Company A does not participate in or cooperate
with an international boycott under section 999(b)(3), and Company A's
relationship with Company B is not established to facilitate participation
in or cooperation with an international boycott.
A-13. Q: In the case of a controlled group, what period of time
is the international boycott report to cover, and when is the "international Boycott Report Form, " F o r m 5713, to be filed?
A: For purposes of reporting, all persons described in
the answer to Question A-l are to report all reportable operations
by all m e m b e r s of the controlled group (or by any foreign corporation
with a United States shareholder who is a m e m b e r of the controlled
group) for the taxable years of such m e m b e r s which end with or within
the taxable year of the controlled group!s c o m m o n parent. The international boycott factor is computed on the basis of the operations of all
m e m b e r s of the controlled group for the taxable years of such m e m b e r s
which end with or within the taxable year of the controlled group!s
c o m m o n parent. In the event no c o m m o n parent exists, the m e m b e r s
of the controlled group are to elect the tax year of one of the m e m b e r s
to serve as the c o m m o n tax year for the group. It is contemplated
that procedures for making an election will be specified in the instructions of the "International Boycott Report F o r m , " F o r m 5713. The
taxable year election is a binding election to be made once, with
subsequent elections for alternative tax years granted only with
the approval of the Secretary of the Treasury or his delegate.
-3Individual m e m b e r s of the controlled group will continue to
use their normal tax years for all other purposes, including
adjustments required under sections 908, 952(a), and 995(b)(1).
W h e n the international boycott factor is used, the controlled group
boycott factor, for that year, will be applied to the normal tax
year of each taxpayer for determining adjustments under sections
908, 952(a) and 995(b)(1).
The income tax year of a taxpayer may differ from the reporting
period covered by the "International Boycott Report Form." Therefore, the F o r m 5713 which is attached to, and filed with, the income
tax return of the taxpayer will be the F o r m 5713 for the reporting year
ending with or within the tax year of the taxpayer.
A-14. Q: Is a United States subsidiary of a foreign corporation
or a United States sister corporation of a foreign corporation required
under section 999 to report the operations of the foreign parent or
sister corporation?
A: Generally, under section 999 a United States person must report the operations of all m e m b e r s of the controlled
group of which it is a m e m b e r . However, if the foreign parent or
sister corporation is not otherwise required to report, the requirement that the United States subsidiary or sister corporation report
the operations of the foreign parent or sister corporation will be
waived for any United States subsidiary or sister corporation which-1. is entitled to no benefits of deferral, DISC, or the
foreign tax credit, or
2. applies the international boycott factor, and forfeits
all the benefits of deferral, DISC and the foreign tax
credit to which it is entitled (i.e., applies an international
boycott factor of one under sections 908(a), 952(a)(3), and
995(b)(1)), or
3. identifies specifically attributable taxes and income, and
forfeits all the benefits of deferral, DISC, and the foreign
tax credit in respect of which it is unable to demonstrate
that the foreign taxes paid and the income earned are attributable to specific operations in which there was no participation in or cooperation with an international boycott.
A-15. Q: Company A receives from Country X an unsolicited
invitation to tender for a contract for the construction of an industrial
plant in Country X. The tender documents contain a provision
stating that Country X will not enter into the contract unless the
successful tenderer agrees that it will do no business in connection
-4with the project with any blacklisted United States company. Company
A does not respond to the unsolicited invitation. Is Company A
required to report the invitation under section 999(a)(2) as a request
to participate in or cooperate with an international boycott?
A: No. The section 999(a)(2) reporting requirement
will be waived provided that Company A neither solicited the invitation to tender nor responded to the invitation.
A-16. Q: Company A receives requests to comply with boycotts prior to the issuance of F o r m 5713. Company A preserves
the requests which were evidenced in writing and preserves the
notations it makes concerning the details of oral requests. W h e n
F o r m 5713 is issued, it requires more details concerning the
requests made of Company A than were preserved, and many of those
details can no'longer be ascertained. Will Company A's report
under section 999(a)(2) be deemed deficient?
A: On October 4, 1976, Company A was put on
notice that it would be required to document boycott requests
received after November 3, 1977. F o r m 5713 will not require
any details that would not have been preserved by a prudent person
having such notice. In addition, under the answer to Question
A-15, the reporting requirements of section 999(a)(2) have been
waived for certain unsolicited boycott requests. Therefore, if
Company A does not supply the required information with respect
to the remaining requests that were either solicited or responded
to, its report will be deficient.
A-17. Q: A United States partnership consisting of 100
United States partners has operations in a boycotting country.
Is each partner required to file F o r m 5713?
A: Generally, if a partnership has operations in a
boycotting country, each partner is required to file F o r m 5713.
However, if the partnership files F o r m 5713 with its information
return and has no operations for the taxable year that constitute
participation in or cooperation with an international boycott, then
the requirement that each partner file F o r m 5713 will be waived
for each partner that satisfies the following conditions:
1. The partner has no operations in or related to a
boycotting country, or with the government, a
company, or a national of a boycotting country
other than operations that are reported on the
F o r m 5713 filed by the partnership; and
2. The partner attaches to his individual return a
certificate signed by a person authorized to sign
5the partnership return certifying that the partnership filed the F o r m 5713 and that the partnership
had no operations that constituted participation in
or cooperation with an international boycott.
A-18. Q: Company A owns 10 percent or more of the outstanding stock of Company C, a foreign corporation that has operations
in Country X , but Company A does not have effective control over
Company C. Company C participates in or cooperates with an
international boycott. Company A requests information from Company
C in order to meet its reporting obligations under section 999(a).
Company C refuses to provide (or is prohibited by local law, regulation, or practice from providing) that information. Will Company
A be subject to the section 999(f) penalties for willful failure to
report the activities of Company C ?
A: Company A must report on the basis of that
information that is reasonably available to it. For example, in
most cases Company A will be aware that Company C has operations in Country X, even though Company A is not aware of the
operational details. Company A must report on F o r m 5713 that
Company C has operations in Country X. Company A should also
describe in a statement attached to F o r m 5713 the good faith
efforts that it has made to obtain all the information required under
section 999(a). Although each case must be resolved on the basis
of the particular facts and circumstances, Company A will not be
subject to the section 999(f) penalties for willful failure to provide
information if it can demonstrate that it made good faith efforts
to obtain the information but was denied the information by
Company C. The answer to this question would be the same if
Company C were a domestic corporation.
A-19. Q: The facts are the same as in A-18 above except
that Company A owns less than 50 percent of the stock of Company C.
What are the tax sanctions to which Company A will be subject?
A: Since Company C is neither a DISC nor a controlled foreign corporation, the sanctions of section 952(a)(3) and
995(b)(1) are not relevant. However, Company A will be subject
to the sanctions of section 908(a). Thus, if Company A applies
an international boycott factor, that factor is applied to Company
A's foreign tax credit in accordance with the answers to Questions
F-5, N-l and N-2. If Company A identifies specifically attributable
taxes and income under section 999(c)(2), Company A will lose its
section 902 indirect foreign tax credit for the taxes paid by Company
C which Company A cannot demonstrate are attributable to specific
operations in which there was no boycott participation or cooperation.
(To determine whether Company A will lose its section 901 direct
foreign credit for income tax withheld by Country X on dividends
paid by Company C to Company A, see the answer to Question N-3. )
-6A-20.
Q: Individual G is a national of Country X, which is
on the list maintained by the Secretary. G engages in an operation
with Company A. For example, if Company A were a bank, the
operation might involve a deposit by G, or, if Company A were
an automobile dealer, the operation might involve the purchase of
a car, or, if Company A were a stockbroker, the operation might
involve the purchase or sale of a security, or if Company A were a
hotel, the operation might involve the letting of a room. Irrespective of the specific nature of the operation, the agreement under
which the operation is consummated is the same agreement which
Company A requires of all other customers. Company A is aware
of G's nationality, but participation in or cooperation with an international boycott is neither contemplated nor required as a condition
of G's willingness to enter into the operation with Company A.
Under section 999, what are the reporting obligations of Company
A with respect to these operations?
A: Company A is not obligated to report these operations with G under section 999(a). In many business operations,
there will be incidental contacts between the nationals or business
enterprises of boycotting countries and U.S. persons or businesses
in which they have an interest. Such contacts need not be reported
under section 999 provided that they satisfy the following criteria:
1. The nationality of the individual or enterprise is
merely incidental to the operations,
2. the location of an operation contemplated by the
parties is outside any boycotting country,
3. any goods or services to be furnished or obtained
in the operation are not produced in a boycotting country
and are not intended to be used, consumed, disposed of or
performed in a boycotting country,
4. the operation does not contemplate any agreement
which would constitute participation in or cooperation
with an international boycott,
5. no request for such an agreement is actually made or
received by any party to the operation, and
6. there is no such agreement in connection with the operation.
The types of operations described above satisfy these criteria
and accordingly need not be reported under section 999. The answer
to the question would be the same if Company A were an individual,
or if G were a corporation.
-7B. Definition of "Operations"
B-2. Q: Individual G is a U.S. citizen living in Country X.
G is retired. G receives social security payments and a pension,
but has no business activities. Does G have "operations" in, or
related to, Country X ?
A. No. G is not engaged in any business or commercial
activities.
B-3. Q: Individual H is a U.S. citizen living in Country X
and working there as an employee. H earns a salary and has
passive investment income, but has no business income. Does H
have "operations" in, or related to, Country X ?
A: No. The performance of personal services as an
employee does not constitute an "operation."
E. Effective Date Provisions
E-9. Q: Company A entered into a binding contract prior
to September 2, 1976 to manufacture and deliver equipment to a
customer located in Country X. The contract requires Company
A to use no components which are manufactured by blacklisted
United States companies. The contract also requires that the
vessel on which the equipment is shipped not be blacklisted. On
January 15, 1977, Company A is able to have the contract amended
to eliminate the requirement regarding components, but is unable
to secure any change regarding vessels. Will the amendment
regarding components remove the binding contract protection
otherwise afforded until December 31, 1977 that Company A has
regarding vessels?
A: No. Since Company A could have waited to abrogate or renegotiate its contract until the end of 1977 and since it
is in accord with the legislative purpose for Company A to accelerate elimination of the provision regarding components, it will
remain protected until December 31, 1977 from the consequences
of its continuing to refrain from shipping the goods on blacklisted
vessels.
E-10. Q: If before December 31, 1977 a person carries out
several different operations in boycotting countries and the only
operation of that person that constitutes participation in or cooperation with an international boycott is carried out in accordance with
the terms of a binding contract entered into before September 2, 1976,
will the existence of that one boycotting operation trigger the section
999(b)(1) presumption that the other operations of that person
in boycotting countries are also operations in connection with
which boycott participation or cooperation occurred?
-8A: No. Operations carried out before December
31, 1977, in accordance with the terms of a binding contract
entered into before September 2, 1976, will not trigger the
section 999(b)(1) presumption.
E-ll. Q: Are operations of a person that constitute participation in or cooperation with an international boycott reflected
in the numerator of the person's international boycott factor before
December 31, 1977 if those operations are carried out in accordance with the terms of a binding contract entered into before
September 2, 1976?
A: No. Boycotting operations carried out before
December 31, 1977 in accordance with the terms of a binding contract entered into before September 2, 1976 are not reflected in
the numerator of the international boycott factor. They are
reflected in the denominator, however.
F. International Boycott Factor and Specifically Attributable Taxes
and Income.
F-5. Q: In the case of a controlled group (within the meaning
of section 993(a)(3)), m a y one m e m b e r use the international boycott
factor under section 999(c)(1) and another m e m b e r identify specifically attributable taxes and income under section 999(c)(2)?
A: Yes. Each member may independently choose either
to apply the international boycott factor under section 999(c)(1) or
to identify specifically attributable taxes and income under section
999(c)(2). The method chosen by each m e m b e r for determining the
loss of tax benefits must be applied consistently to determine all
loss of tax benefits of that m e m b e r . For example, if a m e m b e r
chooses to use the international boycott factor, then it must apply
the international boycott factor to determine its loss of the section
902 indirect foreign tax credit in respect of a dividend paid to it
by another m e m b e r of the controlled group, even if that other m e m ber determines its loss of tax benefits by identifying specifically
attributable taxes and income. In addition, if an affiliated group
of corporations files a consolidated return, then the affiliated
group must determine its loss of tax benefits either by applying
the international boycott factor to the consolidated return, or by
having each m e m b e r determine its loss of tax benefits by identifying
specifically attributable taxes and income.
F-6. Q: If Company A chooses to determine its loss of tax
benefits by applying the specifically attributable taxes and income
method set forth in section 999(c)(2), m a y it demonstrate the amount
of foreign taxes paid and income earned attributable to the specific
operations by applying an overall effective rate of foreign taxes
and an overall profit margin to each operation?
-9A: No. Company A must clearly demonstrate foreign
taxes paid and income earned attributable to specific operations by
performing an in-depth analysis of the profit and loss data of each
separate and identifiable operation.
F-7. Q: A United States partnership has operations in a
boycotting country. Is the international boycott factor computed at
the partnership level?
A: No. The international boycott factor is computed
separately by each partner based on information submitted by the
partnership and on other activities of that partner. Of course,
if the partner can meet the conditions of section 999(c)(2) of the
Code, he need not use the international boycott factor.
F-8. Q: Company A desires to determine its loss of tax
benefits by applying the specifically attributable taxes and income
method set forth in section 999(c)(2). However, Company A is able
to identify specifically attributable taxes and income only with respect
to a portion of its operations. Because Company A is unable to
determine specifically attributable taxes and income with respect to
all its operations, will Company A be required to determine its
loss of tax benefits by applying the international boycott factor?
A: No. Company A may compute its loss of tax benefits
by applying the specifically attributable taxes and income method if,
in addition to the tax benefits that Company A determines are to be
lost with respect to the portion of its operations for which it can
determine specifically attributable taxes and income, Company A
forfeits all the benefits of deferral, DISC, and the foreign tax credit
with respect to the remaining portion of its operations for which
it cannot identify specifically attributable taxes and income.
N. Reduction of Foreign Tax Credit
N-l. Q: How is the reduction of the foreign tax credit for
participation in or cooperation with an international boycott computed
under section 908?
A: The method of computation of the reduction of the
foreign tax credit under section 908 differs depending on whether the
person applying section 908 applies the international boycott factor
or identifies specifically attributable taxes and income under section
999(c)(2).
If the person chooses to identify specifically attributable taxes
and income, the person reduces the amount of foreign taxes paid
before the determination of the section 904 limitation, by the sum
-10of the foreign taxes paid that the person has not clearly demonstrated
are attributable to specific operations in which there has been no
participation in or cooperation with an international boycott.
If the person applies the international boycott factor, the
reduction of the foreign tax credit under section 908 is computed
by first determining the foreign tax credit that would be allowed
under section 901 for the taxable year if section 908 had not been
enacted. The amount of credit allowed under 901 would, of course,
reflect the credits allowable under sections 902 and 960, and would
also reflect the limitations of both sections 904 and 907. The credit
allowed under section 901 would then be reduced by the product of
the section 901 credit (before the application of the section 908
reduction) multiplied by the international boycott factor.
N-2. Q: After the reduction of credit has been determined
in accordance with the process described in the answer to Question
N-l, the taxes denied creditability m a y be deductible. If the taxes
are deducted, is a new section 904 limitation, a new section 901
amount and a new section 908 reduction of credit computed based
on the income reduced by the taxes deducted?
A: No. The process described in the answer to
Question N-l is applied only once and the reduction of credit is
determined as a result of that single application. If the taxes
denied creditability are deducted, no further adjustment is made
under sections 904, 901 or 908 as a result of the deduction.
N-3. Q: Company A owns 20 percent of the stock of Company
C, a corporation organized under the laws of Country X. Company
C participates in an international boycott in connection with all its
operations. Company C pays a dividend to Company A and Country
X withholds income tax on the dividend paid to Company A. Company
A computes its loss of tax benefits by identifying specifically attributable
taxes and income under section 999(c)(2). Will Company A be denied
its section 901 direct foreign tax credit in respect of the income tax
withheld by Country X on the dividend paid by Company C ?
A: If Company A can demonstrate that its investment
in Company C is a clearly separate and identifiable operation in
which Company A did not participate in or cooperate with an international boycott, Company A will not be denied its section 901 direct
foreign tax credit in respect of the withholding tax on the dividend
paid by Company C. On the other hand, even if Company C does
not participate in an international boycott, if Company A agreed to
participate in or cooperate with an international boycott in connection with its investment in Company C, Company A will lose its
-11foreign tax credit in respect of the withholding tax on the dividend.
Thus, whether Company C participates in an international boycott
is not relevant to the determination of Company A's loss of foreign
tax credit under the facts of this question. (To determine the denial
of the section 902 indirect foreign tax credit for foreign income taxes
paid by Company C, see the answer to Question A-19. )
oOo
e Department of theJR[/[$llliy
HINGTON.D.C. 20220
TELEPHONE 964-2041
January 3, 1977
FOR IMMEDIATE RELEASE
RESULTS OF TREASURY'S WEEKLY BILL AUCTIONS
Tenders for $2,501 million of 13-week Treasury bills and for $3,500 million
of 26-week Treasury bills, both series to be issued on January 6, 1977,
were accepted at the Federal Reserve Banks and Treasury today. The details are
as follows:
RANGE OF ACCEPTED
COMPETITIVE BIDS:
13-week bills
maturing April 7, 1977
Price
High'
Low
Average
Discount
Rate
98.896 a/
98.881
98.886
4.367%
4.427%
4.407%
26-week bills
maturing July 7, 1977
Investment
Rate 1/
Price
Discount
Rate
4.48%
4.54%
4.52%
97.711
97.691
97.697
4.528%
4.567%
4.555%
Investment
Rate 1/
4.70%
4.74%
4.73%
a/ Excepting 2 tenders totaling $410,000
Tenders at the low price for the 13-week bills were allotted 24%
Tenders at the low price for the 26-week bills were allotted 15%
. TOTAL TENDERS RECEIVED AND ACCEPTED
BY FEDERAL RESERVE DISTRICTSAND TREASURY:
Location
Received
Accepted
Received
Accepted
$
25,985,000
Boston
3,531,850,000
New York
22,690,000
Philadelphia
22,820,000
Cleveland
12,645,000
Richmond
23,405,000
Atlanta
239,925,000
Chicago
49,830,000
St. Louis
24,750,000
Minneapolis
24,325,000
Kansas City
22,215,000
Dallas
214,310,000
San Francisco
$
24,985,000
2,075,850,000
22,690,000
22,820,000
12,645,000
23,405,000
148,525,000
41,830,000
24,750,000
24,325,000
22,215,000
56,710,000
$
41,655,000
4,452,865,000
10,070,000
9,290,000
16,720,000
13,855,000
416,640,000
32,160,000
38,900,000
15,165,000
28,085,000
330,745,000
$
39,655,000
3,104,865,000
10,070,000
9,290,000
6,295,000
13,855,000
128,840,000
17,160,000
33,900,000
14,665,000
24,385,000
97,245,000
35,000
35,000
30,000
30,000
$2,500,785,000 b{ $5,406,180,000
$3,500,255,000
Treasury
TOTALS
$4,214,785,000
b/Includes $284,620,000 noncompetitive tenders from the public.
c/lncludes $118,800,000 noncompetitive tenders from the public.
^/Equivalent coupon-issue yield.
WS-1240
FOR IMMEDIATE RELEASE
FRIDAY, JANUARY 7, 197 7
CONTACT: PRISCILLA CRANE (202) 634-5248
REVENUE SHARING PAYMENT MADE
The final payment of general revenue sharing funds
authorized when revenue sharing law first was passed in
1972 is being made today to 37,405 States and units of
local general government. The amount being distributed
today by the Department of the Treasury's Office of
Revenue Sharing is $1,644,877,971.
"Today's payment brings to $30 billion the total
which has been returned to States and local governments
through general revenue sharing since the program began,"
Jeanna D. Tully, Director of the Office of Revenue
Sharing, announced today.
The first quarterly payment of funds authorized by
the 1976 Amendments to revenue sharing law which extended
the program for an additional three and three-quarters
years will be made in April 1977.
Of the more than 37,000 governments being paid today,
24,384 will receive their money using electronic funds
transfer procedures. "This new procedure will save time
and administrative expense," according to Miss Tully.
Approximately 600 units of local government which
WS-1241
2
had been entitled to participate in the revenue sharing
program for the July 1, 1976-December 31, 1976 period
did not receive their funds.
These units of government
failed to file one or both of two short
report forms,
required by revenue sharing law, which were due to be
returned to the Office of Revenue Sharing before
September 1, 1976.
The more than $2 million which would have been paid
to these governments, will be paid, instead, to the next
higher level of government within each affected State.
On October 13, 1976, President Ford signed into law
a measure which will extend the General Revenue Sharing
Program through September 30, 1980.
A total of $25.6
billion is authorized to be returned to approximately
38,000 State and local government recipients under the
renewal legislation.
-- 30 --
Gall:
Brian M. Freeman
376-0321
FOR IMMEDIATE RELEASE January 4, 1977
EMERGENCY LOAN GUARANTEE BOARD
SENDS ANNUAL REPORT TO CONGRESS
On December 30, 1976, the Emergency Loan Guarantee Board delivered its Fifth Annual Report to Congress describing its operations
from August 1, 1975, to September 30, 1976. In the Board's opinion,
Lockheed Aircraft Corporation's financial position has improved and
certain uncertainties have been eliminated. Although risks exist,
the Company's latest forecast is reasonable. The major hazard to
Lockheed's continued viability is the future of the L-1011 program;
but further disclosures of improper foreign-payments practices could
prove troublesome, and new capital remains necessary. If Lockheed
meets its projections, the Government will not be called upon to make
payment on the private bank debt which it guarantees. If, however, it
should be thus called upon, its position is adaquately protected by its
first lien on the collateral which secures the guaranteed debt. There
is a "reasonable probability" that the guarantee commitment will terminate as scheduled in December 1977 and a "strong possibility" of its
earlier termination if certain uncertainties are favorably resolved in
a timely manner. However, the parties can also request that the Board
exercise its discretion to grant a final one-year extension through 1978.
Lockeed repaid $55 million of guaranteed debt through the third
quarter of 1976, which reduced the amount outstanding to $140 million.
Repayments through December 30 reduced it to $100 million. Peak borrowings were $245 million in September 1974.
The ELGB program's net earnings for the period were $S_=million,
bringing the cumulative amount to $25 million since 1971.
The report emphasizes Lockheed's October 1976 financial restructuring by which $50 million of nonguaranteed bank debt was converted to
preferred stock and the remaining $350 million of such debt to a term
loan, and by which the lending banks were issued an additional 1.75 million of warrants for Lockheed common stock. Lockheed remains obligated
to seek additional long-term capital.
The Emergency Loan Guarantee Board looked into Lockheed's
payments to foreign officials and the subsequent investigation
by governmental agencies. The report emphasizes the Board's
monitoring activities; the requirements it imposed upon
Lockheed; its innut on Lockheed's international marketing
nolicy; and amendments to the underlying agreements which make
certain payments and violations of corporate policy events of
default. It also discusses the Board's assessment that, based
upon the information in its possession, Lockheed could survive
the effects of disclosure of past foreign-pavment practices ana
WS-1242 its repayment obligations for the guaranteed debt.
satisfy
-2Part II of the report focuses on Lockheed's operations. It describes the Company's management changes and the continued profitabilitj
of its noncommercial operations and unprofitability of the L-1011 com>-N
mercial program. The Company's foreign export sales have continued to
improve despite disruptions from disclosures of foreign-payment practices.
Lockheed's year-end 1975 cash lagged behind projections due to
undelivered aircraft and unanticipated buildups in inventories and accounts receivable. However, the inventoried aircraft were delivered in
1976, permitting repayments of guaranteed debt beginning in the second
quarter of 1976. The report emphasizes that 1976 paydowns exceeded
forecasts and that all guaranteed borrowings are forecast to be repaid
at the end of the guarantee period in 1978.
The L-1011 program is considered in depth, including marketing conditions, deliveries, performance of the aircraft, and manufacturing. Improved air traffic and profits have not been translated into significanl
new orders for wide-bodied aircraft. Customers resold used L-1011's
in effective competition with Lockheed's efforts to market new aircraft,
but there are no longer used L-1011's on the market. Lockheed eliminated its risks on certain undelivered aircraft and on its obligations
to dispose of others. Potential production scheduling problems may result from the Japanese airline's delay in exercising its purchase options, but these should be manageable. Customer response has continued
to be favorable. Expenses remained within forecast, despite production
rate reductions. A seperate section considers new versions of the L-10L
and the launch order for the Dash 500 model.
Lockheed began to report profits on an actual unit basis rather
than the 300-aircraft program. In recognition of sales and cost uncertainties, it also began to write off initial program costs and costs
associated with excess capacity.
The report considers Lockheed's non-L-1011 programs emphasizing
that these comprise the bulk of its business and continued to be largel
profitable.
For 1975, Lockheed's auditors continued to qualify their opinion o
its financial statements on grounds related to the foreign-payments dis
closures, the future of the L-1011 program, and certain unresolved
claims. Overall net operating income was $45.3 million on sales of $3.
million, nearly double the 1974 income. Although L-1011 losses nearly
doubled to $94 million due to reduced sales and increased charges, its
profits on other programs increased 36% to $263. Lockheed's balance
sheet continued to reflect the Company's high leverage. Although total
assets and cash liquidity fell and accounts receivable increased, net
worth improved substantially in 1975 but below forecast due to the
delayed implementation of the financial restructuring plan.
Lockheed's operations through the third quarter of 1976 are also
considered. Due to continued L-1011 losses, net income declined 16%
from
the
comparable
1975
period;
but, dueand
to the
continued
profitable
heed's
of
other
financial
programs,
pondition.
it
exceeded
forecasts
further
strengthened
Lock-
le Department of theJR[/[$Uf(Y
SHINGTON.D.C. 20220
TELEPHONE 964-2041
Dec. 31, 1976
MEMORANDUM TO THE PRESS
United States Under Secretary of the Treasury for
Monetary Affairs Edwin H. Yeo visited Portugal at the
invitation of Finance Minister Medina Carreira
Mr. Yeo
was also received by President Ramalho Eanes and Prime
Minister Mario Soares.
. . _ . _ .
The visit was part of continuing discussions between
the United States and Portugal regarding economic and financial cooperation.
.
J,.-.-;---.
As the first phase of a program of assistance design
ed to achieve financial stability and recovery of the
Portugese economy, the delegations of the two countries
agreed on the essential principles,for a $300 million
line of credit for Portugal from the United States
Treasury Exchange Stabilization Fund.
#
WS-1243
202/634-5377
January 4, 197 7
FOR IMMEDIATE RELEASE
TREASURY SECRETARY SIMON NAMES RICHARD B. SELLARS TO KEY
VOLUNTEER POST FOR SAVINGS BONDS
Richard B. Sellars, Chairman of the Finance Committee of
the Board of Directors, Johnson § Johnson, New Brunswick, New
Jersey, has been named National Chairman of the Savings Bonds
Volunteer State Chairmen's Council, one of the government's
most important volunteer posts.
Mr. Sellars began a two year stint on January 1, 1977,
as chairman of the Volunteer Council, which is composed of
top volunteers from each state for the Bond Program in that
state. An estimated 670,000 people annually do volunteer work
of some kind for Savings Bonds.
The Volunteer Council meets once a year in Washington with
the Secretary of the Treasury and other officials. In naming
Mr. Sellars Treasury Secretary William Simon said I am
delighted that Dick has agreed to serve in this post. The
Treasury is very appreciative of the Volunteer State Chairmen
who, individually and collectively as the Council, lead our
- more WS-1244
- 2-
country's efforts in the sale and promotion of Savings Bonds."
Mr. Sellars, a native of Worcester, Mass., joined Johnson
§ Johnson's Ortho Pharmaceutical Division in 1940. In succeeding years he became Vice President and Director of Ortho, and
President of Ethicon, Inc., another Johnson § Johnson subsidiar)
In 1950 he was elected to the Board of Directors of Johnson §
Johnson.
In April, 1973, Mr. Sellars became Chairman of the Board
and Chief Executive Officer of Johnson § Johnson, which manufactures medical and health care products in 40 nations.
In November, 1976, he assumed his present position and continues as a member of the Executive Committee of the Board.
On accepting his volunteer Savings Bonds position Mr.
Sellars said "I am pleased to be working with such a distinguished group of businessmen and professionals who believe in
the Bond Program as strongly as I do. Together we will work
to sell the Savings Bonds philosophy to more and more Americans
in 1977."
Mr. Sellars has been active in many business, civic and
professional activities. He is also Volunteer State Chairman
for the Savings Bonds Program in New Jersey and has been a
member of the U.S. Industrial Payroll Savings Committee.
FOR RELEASE AT 4:00 P.M.
January 4, 1977
TREASURY'S WEEKLY BILL OFFERING
The Department of the Treasury, by this public notice, invites tenders for
two series of Treasury bills to the aggregate amount of $5,900 million, or
thereabouts, to be issued January 13, 1977,
as follows:
91-day bills (to maturity date) in the amount of $2,400 million, or
thereabouts, representing an additional amount of bills dated October 14, 1976,
and to mature April 14, 1977
(CUSIP No. 912793 F6 8), originally issued in
the amount of $3,508 million, the additional and original bills to be freely
interchangeable.
182-day bills, for $ 3,500 million, or thereabouts, to be dated January 13, 1977,
and to mature July 14, 1977
(CUSIP No. 912793 H9 0 ) .
The bills will be issued for cash and in exchange for Treasury bills maturing
January 13, 1977,
outstanding in the amount of $5,911 million, of which
Government accounts and Federal Reserve Banks, for themselves and as agents of
foreign and international monetary authorities, presently hold $2,682 million.
These accounts may exchange bills they hold for the bills now being offered at
the average prices of accepted tenders.
The bills will be issued on a discount basis under competitive and noncompetitive bidding, and at maturity their face amount will be payable without
interest.
They will be issued in bearer form in denominations of $10,000,
$15,000, $50,000, $100,000, $500,000 and $1,000,000 (maturity value), and in
book-entry form to designated bidders.
Tenders will be received at Federal Reserve Banks and Branches and from
individuals at the Bureau of the Public Debt, Washington, D. C. 20226, up to
1:30 p.m., Eastern Standard time, Monday, January 10, 1977.
Each tender must be for a minimum of $10,000.
in multiples of $5,000.
Tenders over $10,000 must be
In the case of competitive tenders the price offered
must be expressed on the basis of 100, with not more than three decimals, e.g.,
99.925.
Fractions may not be used.
Banking institutions and dealers who make primary markets in Government
WS-1245
(OVER)
-2securities and report daily to the Federal Reserve Bank of New York their positions
with respect to Government securities and borrowings thereon may submit tenders
for account of customers provided the names of the customers are set forth in
such tenders.
Others will not be permitted to submit tenders except for their
own account.
Tenders will be received without deposit from incorporated banks
and trust companies and from responsible and recognized dealers in investment
securities.
Tenders from others must be accompanied by payment of 2 percent of
the face amount of bills applied for, unless the tenders are accompanied by an
express guaranty of payment by an incorporated bank or trust company.
Public announcement will be made by the Department of the Treasury of the
amount and price range of accepted bids.
Those submitting competitive tenders
will be advised of the acceptance or rejection thereof.
The Secretary of the
Treasury expressly reserves the right to accept or reject any or all tenders,
in whole or in part, and his action in any such respect shall be final.
Subject
to these reservations, noncompetitive tenders for each issue for $500,000 or less
without stated price from any one bidder will be accepted in full at the average
price (in three decimals) of accepted competitive bids for the respective issues.
Settlement for accepted tenders in accordance with the bids must be made or
completed at the Federal Reserve Bank or Branch or at the Bureau of the Public Debt
on January 13, 1977,
in cash or other immediately available funds or in a like
face amount of Treasury bills maturing January 13, 1977.
tenders will receive equal treatment.
Cash and exchange
Cash adjustments will be made for difference;
between the par value of maturing bills accepted in exchange and the issue price
of the new bills.
Under Sections 454(b) and 1221(5) of the Internal Revenue Code of 1954 the
amount of discount at which bills issued hereunder are sold is considered to accrue
when the bills are sold, redeemed or otherwise disposed of, and the bills are
excluded from consideration as capital assets.
Accordingly, the owner of bills
(other than life insurance companies) issued hereunder must include in his Federal
income tax return, as ordinary gain or loss, the difference between the price paid
for the bills, whether on original issue or on subsequent purchase, and the amount
actually received either upon sale or redemption at maturity during the taxable
year for which the return is made.
Department of the Treasury Circular No. 418 (current revision) and this notice
prescribe the terms of the Treasury bills and govern the conditions of their issue.
Copies of the circular may be obtained from any Federal Reserve Bank or Branch, or
from the Bureau of the Public Debt.
if Department of the TREASURY
IHINGTON, D.C. 20220
TELEPHONE 964-2041
Memorandum for the Press:
January 5, 1977
Attached are letters of transmittal from Treasury Secretary
William E. Simon to the President of the Senate and the Speaker
of the House of Representatives transmitting a Treasury Department report on "The State of the United States Coinage."
Queries should be directed to Frank H. MacDonald, Deputy
Director of the Bureau of the Mint, (202) 376-0560.
oOo
WS-1246
THE SECRETARY OF THE TREASURY
WASHINGTON
DEC 31 1975
Dear Mr. President:
With President Ford's approval, I am transmitting a
report prepared by the Department of the Treasury on "The
State of the United States Coinage."
The report identifies two major problem areas which
should receive the attention of the Congress without
delay. First, the report notes that the diminishing
utility of the one-cent piece in the Nation's commerce
and its increased production costs suggest giving serious
consideration to eliminating the one-cent piece from our
coinage- system. In addition, the report recommends the
replacement of the existing dollar coin with a smaller,
conveniently-sized dollar, as well as the elimination of
the half-dollar from the Nation's circulating denominations.
I respectfully urge consideration of the report and
its recommendations by the Senate at the earliest feasible
date.
Sincere
The Honorable
Nelson A. Rockefeller
President of the Senate
Washington, DC 20510
Enclosure
THE SECRETARY OF THE TREASURY
WASHINGTON
DEC 3 1 1978
Dear Mr. Speaker:
With President Ford's approval, I am transmitting a
report prepared by the Department of the Treasury on "The
State of the United States Coinage."
The report identifies two major problem areas which
should receive the attention of the Congress without
delay. First, the report notes that the diminishing
utility of the one-cent piece in the Nation's commerce
and its increased production costs suggest giving serious
consideration to eliminating the one-cent piece from our
coinage system. In addition, the report recommends the
replacement of the existing dollar coin with a smaller,
conveniently-sized dollar, as well as the elimination of
the half-dollar from the Nation's circulating denominations.
I respectfully urge consideration of the report and
its recommendations by the House of Representatives at
the earliest feasible date.
Sincerely yours
William E.<:Slmd
The Honorable
Carl Albert
Speaker of the House
of Representatives
Washington, DC 20515
Enclosure
T H E STATE O F T H E U N I T E D STATES C O I N A G E
I.
INTRODUCTION
After completion of a comprehensive review of United
States coinage system requirements to 1990, the Treasury
Department has identified substantial deficiencies in the
existing system which require resolution in the near future.
There are two major problem areas:
(1) the diminishing utility of the one-cent
denomination in commerce, and
(2) the failure of the present half-dollar and
dollar coins to circulate readily.
ONE-CENT GOIN
The United States Government is rapidly approaching
a decision point concerning continuance of the one-cent
coin. The decision is prompted by the diminishing utility
of the one-cent coin in commerce, causing ever -increasing
production to compensate for high attrition of coins from
the circulating supply. Inflation has a double impact because it increases the cost per transaction of keeping a
one-cent coin in circulation while simultaneously decreasing
-2-
the purchasing power of each cent
transacted.
The
dimin-
ishing utility of the one-cent denomination in commerce
is clearly evidenced by its high (1*%) annual attrition
from the circulating pool compared to the nickel (7%) and
the dime and quarter (both essentially 0%). The attrition,
which represents permanent voluntary withdrawal from
circulation by the public, is directly related to the lack
of purchasing power of the one-cent alone and, to a lesser
extent, even to that of two, three, or four cents combined.
Future increases in inflation are expected to create further
corresponding increases in attrition rates which in turn
place demand on the Mint for replacements, in a never-ending
spiral.
Compounding the situation, estimated cost increases for
coinage metal and manufacturing and distribution costs will
cause the cost of producing the cent to exceed its face value
by about 1980. In addition, the price of copper is projected
to rise to such a level by 1990 that the cent coins may provide an economical source of copper for limited industrial
consumption, adding to the rate of withdrawal of these coins
f rom c i rcu1 at i on.
-3-
If coin demand and economic market conditions meet
current projections, and if the current coinage system
remains unaltered, the present coin manufacturing capacity
of the Bureau of the Mint must be increased about 20% by
1980, and must be almost tripled by 1990. This projected
build-up of mint capacities will be solely for cent manufacturing. Presently cent manufacturing accounts for 75%
of all coin production. By 1990, over 90% of capacity
would be dedicated to manufacturing cents, which would cost
about 2 cents for each coin produced.
Elimination of the cent coin at some later date would
be a much more drastic action than elimination now, since
in the future more production plant and equipment and more
Mint employees would be affected by the precipitous reduction
in production requirements.
Alternative one-cent coins which are less costly to
produce have been examined. These alternatives would, of
course, lower the production and distribution costs for a
period of time but, in the best case, only to 1990, when
cost would again exceed face value. Changeover confusion
would also be considerable. Importantly, however, an alternate coin does not solve the basic phenomenon of decreasing
utility in corrmerce and the increasing day-to-day transaction
hand 1ing costs.
-4-
HALF-DOLLAR AND DOLLAR COINS
Presently, utilization is very low for the half-dollar
and practically nonexistent for the dollar coin, due to the
cumbersome size of these coins and the ready availability
of convenient substitutes (2 quarters for the half-dollar
and 4 quarters, or the dollar note, for the dollar coin).
The alternatives are to continue manufacturing the present
coins, to reduce the sizes, or to eliminate the dollar and
half-dollar coin from the system.
EARLY CONSIDERATION
The problems with the present coinage system, as
discussed above, are considered by the Treasury Department
to be of such magnitude and widespread impact as to justify
early consideration by Congress of whether changes in the
Nation's coinage system are appropriate. In particular,
a thorough public airing of the complex consumer issues is
required. Decisions are needed to provide a proper basis for
planning, budgeting and implementing actions by the Bureau
of the Mint, the Federal Reserve System, commercial banks and
bus inesses.
-5-
I I. THE CURRENT COINAGE SYSTEM
The Secretary of the Treasury is responsible for the
production of coins in such quantities as he determines
necessary to meet the Nation's needs. The Secretary's
statutory responsibility for the production of coins is
carried out by the Bureau of the Mint, whose two major field
facilities, the Philadelphia and Denver Mints, manufacture
most of the country's coinage for circulation. Once produced, the coins are shipped by the Mint to the Federal
Reserve Banks and branches, which, in turn, distribute the
coins to commercial banks.
As specified by law, the Nation's coinage system
currently consists of the following denominations: dollar,
half-dollar, quarter, dime, nickel and the cent. All
physical characteristics of the coins, including their alloy,
size and weight, are specified by law. Since the late 1960fs
all denominations from the dime through the dollar have been
made from a clad (sandwich) material which has thin outer
layers of cupro-nickel (7 5% copper and 25% nickel) and an
inner core of pure copper. The five-cent piece is made from
an alloy consisting of 7 5% copper and 25% nickel; the one-cent
piece is composed of 35% copper and 5% zinc.
-6-
The quantity of coins produced annually by the Mint
depends essentially on public demand. The Federal Reserve
System and the Mint jointly forecast the anticipated coinage requirements, and on the basis of the projections, the
Bureau of the Mint prepares its operational and financial
plans so that it can provide coins to meet the Nation's needs.
The financial plans include all of the costs of making coins
which, in addition to manufacturing expenses, cover the costs
of coinage metal and the costs of distributing the coins to
the Federal Reserve Banks. Thus, in Fiscal Year 1977 the
Mint's estimated coin production of 12 billion pieces will
cost the American taxpayer about $130 million.
Historically, the Nation's coinage demand has increased
annually at a rate of approximately 10%. In more recent years,
however, there have been abrupt deviations from this pattern.
These deviations have been caused primarily by sharply varied
demand for cents, the production of which accounts for
approximately 7 5% of the Mint's total coinage output. By
way of illustration, in Fiscal Year 1974 the coinage production of the Mint totaled 10.4 billion pieces, 8.4 billion
of which were cents. During the next fiscal year, total coin
production increased to 13.4 billion pieces with cents
accounting for 10 billion. In Fiscal Year 1976, excluding
the 3-month transition period, the Mint produced 12.6
billion coins, over 9 billion of which were one-cent pieces.
-7III. CONSEQUENCES OF RETAINING THE PRESENT
C O I N A G E SYSTEM
The consequences of retaining the present coinage
system can be derived from the experienced and projected
growth in the demand for circulating coins. Production
by the Bureau of the Mint increased from 2.7 billion coins
in Fiscal Year 1961 to 12.6 billion in Fiscal Year 1976.
With the present set of denominations, annual coin requirements are forecast to increase to 18 billion by 1980 and to
41 billion by 1990. To provide a basis for planning and
implementing action by the Bureau of the Mint, several different methods and mathematical models have been developed
for estimating future coinage requirements. The 18 billion
figure for 1980 and the 41 billion figure for 1990 are in t
intermediate portion of the range of forecasts which are
provided by using the various methods and models.
The factors or relationships underlying the demand for
cents are different from those affecting the demand for all
other coin denominations. A stable relationship exists between the demand for nickels, dimes and quarters and the
growth in retail sales, or similar measures of economic
activity. Cent demand is less predictable due to the uniqu
functions of this denomination in commercial transactions
and the evident declining utility.
-8-
Normally, there is an expected correlation between
the disappearance of cents from circulation (the attrition
rate) and the estimated coin life of about \5 years. In
recent years, however, there has been practically no
correlation. On the other hand, the attrition rate, and in
particular the growth in the attrition rate, appears to be
more closely associated with the declining purchasing power
of this coin. For example, two previous studies of samples
of coins in circulation indicate attrition rates for cents
of 4.8% in 1962 and 13.0% in 1973. Conservative projections
indicate "that this attrition rate will grow to about 21.0%
by 1990. In effect, the public, by not bothering to keep
these coins in circulation, has been "voting" over a protracted period of time for elimination of the one-cent piece
from the United States coinage system.
The result of the experienced growth in cent attrition
rates is that approximately two-thirds of the cents produced by the Mint in Fiscal Year 1975 were necessary to
replace coins withdrawn from circulation. This proportion
is projected to increase, as the utility of the cent declines, to the extent that by 1990 about 31 billion (82%) of
the estimated production requirements of 37 billion cents
-9-
would be solely to provide replacements for coins removed
from the circulating pool. As the 1990 projected production of 37 billion cents would be about 90% of the
expected total requirement for all denominations, cent
projections are clearly the most significant impact on
required production capacity and on total coinage system
cos t s .
Current forecasts show that total coinage demand will
exceed present Mint production capacity by about 1980, and
will exceed present capacity by as much as two or three
times by"1990. In addition, valuable resources and substantial costs would be involved in producing the tremendous
number of one-cent coins, which would not circulate and
which would be of limited value commercially.
The cost to the public of maintaining a coinage system
includes all costs of the Mint in producing, handling and
shipping its product. In addition, costs of handling,
storing and distributing the coins by the Federal Reserve
System, commercial banks and merchants are all passed to
the consumer in one form or another. By this definition,
the aggregate costs to our society of maintaining an adequate
supply of cents have Deen estimated. The estimates were
based on reasonable assumptions regarding increases in costs
-10to the Mint of manufacturing and shipping coins. For
example, the trend in copper prices was estimated to increase from the present figure of $.60 per pound to $1 per
pound in 1980 and $1.50 per pound by 1990. Similarly, the
costs of fabricating coinage metal, coining, and shipping
were assumed to increase at an annual rate of 4%. Also,
the 1975 estimated cost figure of $.03 per 100 coins for
Federal Reserve and commercial banks to process cents was
assumed to increase at an annual rate of 5%. On the basis
of these types of assumptions, the total annual costs for
maintaining the one-cent piece in the coinage system are
expected to increase from the $81 million figure in 1975
to $189 million in 1980, and to about $693 million in 1990.
These costs do not include the capital investment required
to expand the Mint's production capacity.
As mentioned earlier, the current Mint production capacity will be exhausted by 1980. Development of additional
capacity within existing facilities is not a total solution,
nor in some cases is it a reasonable alternative, since
these facilities already are overcrowded and have serious
environmental and engineering deficiencies. Future capacity
requirements will have to be met by constructing and equipping
new mints, with the first major production increment needed
by 1980. A new Denver Mint has been planned for this purpose.
-11-
This facility, when fully equipped, would have a capacity
of 16 billion coins per year, at an estimated full capital
investment cost of $86 million. To fulfill the 1990
projected requirement of 41.5 billion coins, additional
capacity from the present base in the amount of 25 billion
coins per year would be required. Extrapolating from the
cost estimate for the planned new Denver Mint, by 1990
capital investment in the order of $200 million would be
required to meet reasonable demand projections. Without
the one-cent piece in the coinage system, additional capacity
would not be required and, in fact, present Mint capacity
should be sufficient until at least the year 2000.
IV. ALTERNATIVES TO THE PRESENT COINAGE SYSTEM
A. Elimination of the One-cent Coin
The one-cent piece would have to be eliminated soon
in order to forestall the excessive costs to the public of
maintaining in circulation a coin of so little value for
commerce.
The cent has been the minimum U.S. coinage denomination
since 1857, when Congress eliminated the half-cent. The
purchasing power of a cent in 1917 was equivalent to that
of a nickel in 1975, and (assuming a 5% inflation rate) to
the projected value of a dime in 1990.
-12-
The costs associated with maintaining cents in
circulation are rising. The present manufacturing cost,
.7<: per coin, is projected to increase to 1.5c; per coin by
1990. However, the manufacturing cost is only a portion of
the total cost to the public. In addition to these and other
Governmental costs, commercial businesses incur costs for
handling the large volume of cents. Considering the frequency
with which the coin is handled, counted, packaged, stored
and transported; the labor, materials, and capital equipment
involved in the process; and the losses due to attrition, one
can easily conclude that it costs our society more than a penny
to transact a penny's worth of business.
Reduction of Production and Distribution Costs
Eliminating the cent would avoid an increasing annual
cost to the public via a reduction in total coin production and distribution. As mentioned previously, the total
annual costs to the American taxpayers of maintaining the
cent in the coinage system are estimated to be $189 million
in 1980, with a growth to about $690 million by 1990. Removing the cent from the system would not eliminate all of
these costs, since there would be some increases in requirements for nickels and dimes due to the absence of the
one-cent piece. Thus, reduction in costs is estimated to be
-13-
about $150 million annually in 1980, and about $600 million
by 1990. Also, expenditures of nearly $200 million for
establishment of additional mint capacity to 1990 would be
avoided if the cent were eliminated.
In addition to the reduced costs, removing the cent
from the coinage system also would eliminate the consumption
of valuable and increasingly scarce metal resources. With
the present configuration and alloy of the cent, this "waste"
of metal is in the order of 39,000 tons of copper in Fiscal
Year 1977, with a projected growth to 129,000 tons by 1990.
These are significant uses of a resource which has important
military applications as well as wide commercial applications
in the electrical, construction and transportation industries
Discontinuing cent production would reduce the manufacturing requirements of the Bureau of the Mint by more than
60%. Excluding this denomination, total production requirements to 1990 are not expected to exceed 7 billion coins
annually, and present coin production capacity would be
more than adequate to the 21st century.
Preferences of Affected Institutions and Individuals
While the Treasury Department has surveyed various
affected institutions concerning the possible elimination of
the one-cent piece, no attempt has been made to poll the
-14-
general
public.
H o w e v e r , the D e p a r t m e n t
has recently
several public statements which have generated limited
response. As of the middle of November 1976, 146 letters
had been received by the Department expressing an opinion
on the subject. A tally of the letters indicates that
89% of the respondents are opposed to, and 11% in favor of,
elimination of the one-cent piece. Most of those opposing
elimination do so because of perceived inflationary effects
and anticipated inconveniences in conducting cash transactions. The letters reflect the assumptions that individual
items will have to be priced in five-cent increments, and
that prices will always be rounded up. Some writers feel
that elimination of the cent would be demoralizing, since it
would be an open admission of continuing inflation and the
worthlessness of our currency. Others fear the creation
of a national or world impression that our monetary system
is shaky. A sentimental attachment to the cent is reflected in a few letters which mention "children's piggy
banks," and the "oldest coin," as reasons for not eliminating the cent. The small percentage of letters which
welcome the elimination of the cent express the belief that
the result would be increased consumer convenience and
made
-15-
savings to the Government and to business, that would
no longer have to deal with the coin. However, since a
significant sampling of public opinion has not been conducted, the real attitudes and desires of the American
people on this subject are not known at this time.
Retail firms and commercial banks recently surveyed
by the Department have also expressed opposition to the
elimination of the cent because of assumed inflationary
impacts, as well as anticipated inconveniences which the
absence of the cent would cause in cash transactions.
Further, the overwhelming majority of state revenue departments opposed the discontinuance of cents, because of
problems associated with the adjustment of existing state
sales tax schedules and collection of tax revenues at the
retai1 leve1.
The Perception of Inflation
There is a prevalent notion that eliminating the cent
would generate an automatic increase in consumer prices.
Although the inflationary impact has not been systematically
studied, it does not necessarily follow that prices will
rise. For example, absence of the cent in cash transactions does not mean that prices would have to be stated in
five-cent increments. Many prices, particularly for items
that typically sell in multiples or as part of a basket of
-16-
different items (e.g., groceries), could continue to
be quoted in one-cent increments. Rounding would occur
only on the sum of purchases if payment was by cash,
and not at all if payment was by check or credit card.
Furthermore, for those item prices that were changed
to a five-cent increment basis, competitive pressures
undoubtedly would lead to some rounding down as well as up.
Over time, leads and lags in changing prices in five-cent
increments should tend to average out. And pricing adjustments could be made in many cases through changes in
packaging, or similar devices. Finally, the cost of keeping
the cent in circulation is built into the current price
structure; removing this cost should have a favorable price
effect in the long run.
Transitional Considerations
If a decision to eliminate the penny were announced
well in advance, commercial interests and state revenue
departments would have adequate lead time to make the
necessary accommodations. Although such an announcement
would stimulate cent hoarding, the present stock of cents in
circulation (45 billion), current Mint and Federal Reserve
inventory (3.5 billion), and Mint cent production capacity
(13 billion annually) should be adequate to avert a crisis
during the transition period.
-17Sunrmary
The primary advantage of eliminating the cent soon
is that immediate resolution of the dilemma eliminates the
cost of maintaining circulation and increasing mint capacity
to meet an artificially-high demand, which is nearly all due
to attrition caused by the coin's declining purchasing power.
Terminating cent production in the near future will
permit the Mint to reduce its operating costs, as well as to
avoid the expense of constructing new capacity. Deferring
the decision to halt cent production will necessitate a
costly expansion of manufacturing capacity, to be followed-when the decision is finally made--by a large-scale and more
disruptive cutback than would occur now.
Retaining the cent indefinitely would require a large
capital investment commitment by the Government. In 15
years the annual U.S. production of cents alone would exceed
the quantity of all coins produced world-wide during 1974,
and at a cost of nearly 2£ per piece. Clearly, before that
point is reached, cents will no longer be commercially useful
and elimination of the denomination will be warranted.
-18-
B. The Dollar and Half-Doliar Coins
The existing dollar and half-dollar coins have no
future roles in our coinage system because of their cumbersome size and the availability of acceptable substitutes.
In recent years, the Mint has produced approximately 60
million dollars and 180 million half-dollars annually.
These two denominations account for only 2% of the Mint's
total production. According to projections of demand, there
will be no significant increase in requirements for these
denominations in the foreseeable future. In essence, production satisfies a numi smatic-type demand, with coins
produced being immediately withdrawn from circulation.
Potential Circulation
The basic rationale for a small dollar coin is to increase the flexibility for consumer transactions. The
increased use of vending machines to save labor costs, and
the higher prices for items which consumers are already
accustomed to purchasing from machines, are expected to
pursuade the public that the convenience of using vending
machines outweighs any inconvenience of carrying an additional coin denomination. Moreover, the experience of other
countries, notably West Germany, with its 2 Deutsche Mark
coins (U.S. $.80), demonstrates that large denomination coins
in the same range as the new dollar coin can circulate and
-19A recent survey of commercial banks and merchants
conducted by the Bureau of the Mint, disclosed a desire by
both groups that the present dollar and half-dollar coins
be eliminated. Of all the groups surveyed, only the vending and coin equipment manufacturers gave a favorable response to the introduction of a new dollar coin. At the
present time, with the exception of a limited supply of very
expensive bill changers, there are no dollar vending machines
Initial circulation would be very much dependent upon
the production of dollar coin vending devices. At the presen
time, approximately 30% of vending machine sales are 60 cents
or more. Despite industry survey results to the contrary,
one must question whether dollar vending machines will be
developed and installed on the speculation that consumers
would obtain the coins and use them. However, a commitment
on the part of the vending industry probably would be
forthcoming if legislation were enacted to replace the
existing dollar coin with a smaller, conveniently-sized coin.
Large scale production of automated machines which
would accept dollar coins could be accomplished in 18 to
24 months after legislation is enacted. Considering
the time required for production of new automated machines
-20-
and the likely
initial
r e l u c t a n c e on the part of
the
banks, retailers and consumers to use the new coin, it
would probably take 3 to 4 years after the passage of
legislation to achieve wide-spread circulation.
Although the above discussion has focused on the
replacement of the existing dollar coin with a smaller
conveniently-sized dollar coin, the elimination of the
half-dollar coin should be considered simultaneously. It,
too, does not circulate and the introduction of a viable
one dollar coin would seem to obviate its future usefulness.
Size and Material
o
The proposed new dollar coin would be sized b e t w e e n
existing quarter and half-dollar. Compared to the quarter,
the diameter would be 10% greater and the weight 40% greater
(the present half-dollar has twice the weight of the quarter).
The weight of the proposed new dollar coin would be only onethird the weight of 4 quarters. The material recommended
for the proposed smaller dollar would be cupro-nickel clad
on copper (currently used for the dime, quarter, half-dollar
and dollar coin), which has excellent wear and corrosion
resistance and provides a greater degree of protection against
"slugging" than a "non-sandwich" material.
the
-21-
Because of its value relative to other coins, the new
dollar might be expected to be susceptible to slugging or
counterfeiting. Vending machine and production technology,
however, have reduced this risk to minimal proportions. In
fact, dollar coin changers would be considerably less expensive and offer greater security than dollar bill changers.
Cost
The cost of producing the new dollar coin would be
approximately 3 cents, compared to 6 cents for the present
dollar coin and 1.5 cents for the $1 bill. Initial annual
production requirements of 300 million dollar coins would
cost the same ($9 million) as producing the current average
of 60 million dollar coins and 180 million half-dollars.
After the first few years the quantity produced is likely to
increase. This may be offset by decreased requirements for
the quarter dollar as new vending machines become available.
The new one dollar coin offers potential cost savings
by supplanting some of the demand for one dollar bills. The
coin would have an average life of 15 years, while the bill,
costing 1.5 cents, lasts approximately 15 months. Thus it
would take 12 bills, costing 18 cents, to provide the medium
of exchange service life of one dollar coin, costing 3 cents.
-22-
It would be highly speculative, however, to attempt to
project savings in $1 bill production in view of the
number of uncertain inter-related variables--e.g., if
initially the dollar coin became merely a numismatic item
and did not circulate, production of $1 bills would remain
high and there would be little or no savings; at the other
extreme, if production of $1 bills were arbitrarily stopped
there would be a savings of about $25 million. This savings
would oe partially offset by the increased demand for, and
therefore cost of, $2 bills.
Summary'
The present half-dollar and dollar coins have minimal
utility due to their cumbersome sizes and the ready availability of convenient substitutes. Their manufacture
should, therefore, be discontinued. Legislation should
be proposed to permit the Treasury Department to manufacture a conveniently-sized dollar coin which would be
slightly larger than the quarter. Strong interest by the
automated coin handling manufacturers indicates that vending
machines and dollar coin changers will be manufactured after
such legislation is enacted. This should provide increased
consumer flexibility and facilitate transactions for automatically vended products such as cigarettes and sandwiches
-23and services such as mass transit usage. At the same time,
consideration should be given to discontinuing half-dollar
production since the introduction of a smaller dollar coin
would further diminish the usefulness of a coin which is not
presently used to any significant degree for commercial
transact ions .
V. PROPOSED ACTIONS
In view of the foregoing, the Department believes that
the Congress should give serious consideration to the question of whether the cent is needed in our coinage system.
The analyses conducted by this Department show conclusively
that elimination of the cent after a suitable preparatory
period, but no later than 1980, would eliminate substantial
production and distribution costs.
However, no decision should be made without full scale
public hearings and a thorough understanding of the impact
on the consumer and the various institutions involved. The
consumer issue is complex and will need to be thoroughly
reviewed before determining the final course of action. The
Department feels that the potential cost reductions and the
diminishing utility of the cent warrant such a review at
this time and will be pleased to cooperate in every way
poss ible.
-24-
In a d d i t i o n , the C o n g r e s s should a u t h o r i z e
placement of the existing dollar coin with a smaller,
conveniently-sized dollar, as well as the elimination
of the half-dollar from the Nation's circulating denominations. Congressional review and analysis of the
recommendations at the earliest feasible date are urge
by the Department.
the re
Contact: J.C. Davenport
Extension: 2951
January 5, 1977
FOR IMMEDIATE RELEASE
TREASURY ANNOUNCES FINAL DETERMINATION
OF SALES AT NOT LESS THAN FAIR VALUE
WITH RESPECT TO FULLY AUTOMATIC DIGITAL SCALES
FROM JAPAN
Acting Assistant Secretary of the Treasury Peter O. Suchman
announced today that fully automatic digital scales from Japan
are not being, nor are likely to be, sold at less than fair
value within the meaning of the Antidumping Act, 1921, as amended.
Notice of this determination will be published in the Federal
Register of January 6, 1977.
A "Tentative Negative Determination", published in the
Federal Register of October 4, 1976, stated that there was
reasonable grounds to believe that the purchase price of fully
automatic digital scales from Japan, is not less, nor is likely
to be less, than the fair value of such or similar merchandise.
Pursuant to that notice interested persons were afforded the
opportunity to present oral and written views prior to the final
determination in this case.
For purposes of this investigation, the term "fully automatic digital scales" means fully automatic digital scales
that display weight, unit price and total price and have a
weight measuring capacity of 25 lbs. or less. Customs made
price comparisons on approximately 95 percent of the subject
merchandise from Japan sold to the United States during the
period May 1, 1975 through February 29, 1976 and found no
margins.
Imports of the subject merchandise during the period
investigated amounted to approximately 2300 units, valued at
roughly $1.7 million f.o.b. Japan.
*
WS 1247
*
*
DATE:
TREASURY BILL RATES
52-WEEK BILLS
LAST MONTH V. 7° 0 f°
TODAY
HIGHEST SINCE :
LOWEST SINCE:
///l(o
i-f-n
p Department of iheJREASURY
HINGTQN, D.C. 20220
TELEPHONE 964-2041
FOR IMMEDIATE RELEASE
January 5, 1977
RESULTS OF TREASURY'S 52-WEEK BILL AUCTION
Tenders for $3,071 million of 52-week Treasury bills to be dated
January 11, 1977, and to mature January 10, 1978, were accepted at the
Federal Reserve Banks and Treasury today. The details are as follows:
RANGE OF ACCEPTED COMPETITIVE BIDS: (Excepting 2 tenders totaling $12,740,000)
Price
High
Low
Average -
95.231
95.210
95.219
Discount Rate
Investment Rate
(Equivalent Coupon-Issue Yield)
4.96%
4.98%
4.97%
4.717%
4.737%
4.728%
Tenders at the low price were allotted 30%.
TOTAL TENDERS RECEIVED AND ACCEPTED
BY FEDERAL RESERVE DISTRICTS AND TREASURY:
Location
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
Kansas City
Dallas
San Francisco
Accepted
Received
$
61,855,000
5,876,750,000
16,055,000
182,045,000
22,495,000
12,340,000
222,615,000
54,320,000
68,535,000
39,445,000
30,130,000
466,600,000
$
17,855,000
2,627,250,000
1,055,000
57,045,000
3,995,000
6,340,000
87,515,000
18,320,000
19,935,000
14,945,000
11,630,000
204,800,000
$7,053,185,000
$3,070,685,000
Treasury
TOTAL
The $ 3,071 million of accepted tenders includes $ 74 million of
noncompetitive tenders from the public and $ 1,204 million of tenders from
Federal Reserve Banks for themselves and as agents of foreign and
international monetary authorities accepted at the average price.
oOo
WS-1248
FOR RELEASE UPON DELIVERY
STATEMENT BY THE HONORABLE GERALD L. PARSKY
ASSISTANT SECRETARY OF THE TREASURY
BEFORE THE
SENATE COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS
THURSDAY, JANUARY 6, 1977, AT 10:00 A.M.
Implications of Oil Price Decisions
Mr. Chairman and Members of the Committee:
I am pleased to be here this morning to discuss the impact
on the international economy and the international financial
system of the decisions of the Organization of Oil Producing
Exporting Countries (OPEC) with respect to the price of oil.
The effects of OPEC's oil price decision in late 1973 are
still being felt today. They will continue to be felt for
years. The recent price increases only reinforce and
intensify those effects. In my testimony today I would like
to describe what policy actions we believe are called for.
In order to do so, it is important to review in some detail
(a) the economic and financial effects of the oil price
increases, including those recently announced, (b) the world
economic situation and outlook, and (c) the actions now under
way to address the effects of the oil price increase.
WS-1249
- 2Despite substantial recent progress, the world faces
an overall economic situation which concerns us in many
respects.
It is true that the world has weathered the worst
recession since the 1930s.
Nevertheless even after a year
of above average growth in the industrial world, unemployment
rates remain extremely high and inflation is at levels that
even five years ago would have been thought to be completely
unacceptable.
Moreover, a number of countries are becoming
increasingly worried about how long they can continue
borrowing externally to finance their payments deficits.
The uncertainties have affected confidence which, in turn,
has affected investment and future growth.
Obviously, the OPEC actions increasing the oil price
have not been the sole cause of these economic difficulties.
Failure to adopt sound domestic economic and energy policies
in many countries has certainly contributed.
However, the
quadrupling of the oil price has been the largest single
shock the international economy has experienced since
World War II.
The immediate impact was a permanent loss in output --in
technical terms, a downward displacement of the growth path -in the oil-importing countries.
As a result it will be many
years before we regain the levels of output and consumption
we might have expected to attain in the absence of the oil
price increase.
- 3The costs of the adjustment which the price increase
requires are substantial, so substantial that they have put
severe strain on the prevailing social and economic structure
of some nations.
The result is that it has been very difficult
for oil importing countries to develop and implement policies
to facilitate the economic adjustments required.
Where
policy changes have been accepted, they have often been late
or fallen short of the need.
Continued unsatisfactory performance in many economies,
continued accumulation of external indebtedness, and concern over
further OPEC price increases, have caused some to fear
that the open trade and payments system may break down in
a welter of restrictions on trade and defaults on debt. I
do not believe that will happen because the governments of the
world realize that in their own long-term interest, they
must not allow it to happen.
What is needed now is for
these governments to convert this realization into action.
The approach that we believe is necessary involves four main
aspects:
1.
Development and implementation of national energy
policies to encourage cost-effective energy conservation
measures and the development of alternate energy sources.
2.
International cooperation on energy among oil
consuming nations and with oil producing nations.
- 4 3.
Adjustment and restructuring, through an appropriate
combination of domestic economic policies and
market-responsive exchange rate changes, of the
pattern of external balances of the oil importing
countries so that deficits on current account more
nearly match a sustainable flow of capital to
finance them.
4. Use of official sources of credit to encourage the
adoption of appropriate adjustment policies and to
augment available private financing during the period
of adjustment.
To understand what is needed in each of these areas,
let us look at some of the effects of the oil price
decisions in more detail.
-5The Economic and Financial Effects of the Oil Price Increases
The external, largely financial effects of higher oil
prices have captured the headlines, and I will discuss them
shortly.
However, I first want to point out that the financial
effects are symptoms -- the basic effects are on the real
economies of the oil importing countries.
It is the magnitude,
pervasiveness and severity of these real effects which
has made adjustment to higher oil prices so costly, and in
turn has intensified the disequilibria in international
payments and associated strains in exchange and financial
markets.
In order to give some idea as to the severity of these
effects, we have attempted to estimate possible orders of
magnitude for several of the major ones -- on real output,
unemployment, and the price level -- for the U.S. economy.
To do this, we simulated what might have happened to the U.S.
economy between 1974 and 1980 in the absence of higher oil
prices.
While the results can only be taken as indicative
of orders of magnitude, they indicate that the impact was of
major proportions.
In summary, the oil embargo plus the 400
percent OPEC price increases probably will cost the U.S. economy
a cumulative loss in real output of about $500 billion over
the period 1974-1980.
In other words, we believe that
over the remainder of the decade real GNP could have averaged
approximately 5 percent higher each and every year in the
absence of the OPEC actions of 1973-1974.
- 6At the same time, prices (measured by the GNP deflator) could
have averaged nearly 4 percent lower and unemployment rate
perhaps 1-1/2 points lower over the 1974-1980 period.
It is important to note that several factors mitigated
the economic and financial impact on the U.S. compared to other
countries:
-- we are relatively less dependent on OPEC oil than
many other nations;
-- U.S. firms have been very successful in increasing
exports to OPEC markets; and
-- the sheer size and scope of the U.S. capital market
has attracted capital inflows, both direct and
indirect, in substantial volume.
Looking at the effects on the financial system, OPEC
receipts from sales of their oil went from $23 billion in
1973 to $96 billion in 1974.
The collective OPEC surplus --
the receipts from all international transactions not used
to pay goods and services purchased from abroad -- went from
$5 billion in 1973 to approximately $70 billion in 1974,
$40 billion in 1975, and about $43 billion in 1976.
Table 1 provides estimates of the world payments pattern
for 1974-1976.
Given higher prices and increased demand
for oil, we currently estimate that the 1977 surplus will
be higher than the 1976 figure. However,
it is important to keep in mind that most people
have underestimated OPEC import growth in the past; and
recent evidence suggests that several countries have
- 7increased their spending. If this trend continues it could
effect the 1977 OPEC surplus substantially.
In turn, the non-OPEC world experienced an increase in
its net deficit of nearly the same magnitude, reduced only
by the $1-1/2 to $2 billion annually of grant aid extended
by OPEC countries to other nations. Obviously the deficit had
to be financed -- thus OPEC asset increases have their
counterpart in increased indebtedness of the oil importing
nations to OPEC --an increase of approximately $150 billion
in the last three years.
This aggregate figure understates the actual problem
somewhat since it nets out surpluses of a number of industrial
countries. If we consider only deficit countries the total
industrial country deficits aggregated roughly $110 billion
during this period. Total non-oil LDC deficits were about
$70 billion while the rest of the oil importing world ran
aggregate deficits of some $35 billion. In other words, the
total current account deficits in the oil importing world
that had to be financed between 1974-1976 totalled up more
than $200 billion. The deficits -- together with amortization
payments on outstanding debt -- have had to be financed by
some combination of reserve run-downs and borrowing, largely
the latter. Roughly three quarters of this borrowing,
has been prov.idec! by the private capital markets
of the world. As an indication of the magnitudes involved,
the medium-term Euro-currency credit and Euro-bond markets
- 8extended an estimated $65 billion (gross) in international
credits during 1976 alone -- compared with $25 billion
in 1973, the year before the oil price hike.
The recent OPEC price decisions involves much smaller
percentage increases than the January 1, 1974 change.
However, even an increase of 5 percent of $11.51, or $0.57
per barrel would have been 21 percent against the base of
the mid-1973 price. Even more importantly, its effects
have to be assessed within the context of current realities -the unemployment, the inflation, the debt accumulation of
January 1977. In this setting, even an increase of 5 percent
takes on major significance.
-- a 5 percent increase adds over $6 billion directly
to the worldTs oil import bill, including some
$1 billion to that of the LDCs. Each 1 percent
adds about $1-1/4 billion to the world's oil bill.
-- a 5 percent increase would further raise prices and
reduce growth in the industrial countries, with
subsequent effects on the LDCs.
-- any price increase could have significant effects in
individual domestic economies which are vulnerable
to psychological as well as economic shocks.
The World Economic Situation and Outlook
Turning to the world economic situation, the industrial
countries, led by the U.S., Germany and Japan, began to
recover from the 1973-1974 recession in early to mid-1975.
-9As has been the case in earlier cyclical upswings
consumption and inventory restocking provided the
major source of domestic stimulus with export growth also
being of importance. The recovery proceeded in the Mbig
three" countries and spread throughout the world economy until
mid-1976, when a pause in the expansion appeared and began to
spread. By the fall of 1976 a considerable slowing down in
growth rates was being experienced in many of the OECD member
countries, although the year-on-year average growth rates
will still register solid expansion, with average OECD growth
rates of about 5 percent. More recently, there have been signs o
revival in the "leaders11 -- U.S., Germany and Japan --
as indicated by such indicators as industrial production growth,
new orders, stock market upturns, and surveys of investment
intentions. This is particularly true of the United States.
However, the revival is not widespread at this point or general
within the industrial world, and the investment climate -crucial for continued sustained growth, and for restructuring
of domestic output and consumption patterns --is still uncertain
While average inflation rates for the OECD members as
a whole continued to decline during 1976, they remained
disturbingly high at 8 percent and only modest improvement
is expected in 1977 even if the oil price increase is "only"
5 percent.
-10More disturbing is the extreme disparity in inflation
rates (measured by consumer price indices) across countries
-- currently ranging from 25 percent in Portugal and 20 percent
in Italy to 1 to 4 percent in Switzerland and Germany respectively
Unless adjustment action -- including appropriate exchange rate
change and domestic policy measures --is taken, such
disparities will cause continued movement in exchange and
financial markets.
The OECD countries as a group are estimated to have had
a current account deficit of some $23 billion in 1976, up
sharply from the $6 billion of 1975. This reflects inventory
adjustments and other effects of higher domestic growth on
import demand; a substantial portion of this change is
reflected in a reduction in the collective deficit of the•;?
non-oil LDCs.
The non-oil exporting developing countries appear to have
reduced their current-account deficit in 1976 quite substantially. The 1976 improvement reflected an expansion of the LDC
export markets in the recovering OECD countries, as well as
slower growth rates in those LDCs which restrained their
imports through demand management or direct controls.
Although real rates of growth in non-oil LDCs were lower
in 1976 than the average of the past decade, the rates generally
-11remained positive.
This was possible -- in the face of costly
oil imports, restrained import volume, and somewhat tentative
export demand -- largely through heavy reliance on foreign
borrowing. Whether the borrowing will be helpful or burdensome in the long run depends on the employment of these funds.
Foreign borrowings have been used effectively by some LDCs
to facilitate adjustment to external economic conditions and
changes in relative prices. Debt servicing is not likely
to be a problem for these countries. In other LDCs, adjustment
has either proven to be a particularly difficult task, or
has not received adequate governmental attention. In some
cases, external borrowings have been used to maintain consumption
levels and living standards in the short run: for these
countries, debt servicing is more likely to be a problem.
The economic picture for 1977 remains disturbingly cloudy.
Developments in the external sector are likely to exert
pressures on a number of economies -- in terms of growth, inflatio
and resulting employment conditions -- to a far greater degree
than has been the case in any year since the 1960s except
in 1974, the year of the quadrupling of the price of oil. Major
adjustment policies recently enacted or in prospect will have
significant interactive effects in Western Europe as well
as effects on the LDCs -- in particular the African LDCs which
are heavily dependent on European markets.
-12The OECD estimates that real growth rates in the industrial countries (OECD members) wiU average less than 4 percent
in 1977, compared: to 5 percent in 1976. The lower aggregate
growth rate results partly from the fact that the "stronger"
countries -- Japan, Germany, and the U.S. -- are entering a
stage of the expansion when the growth rate usually begins to
slow. Partly, however, it results from the fact that several
countries which are implementing policies aimed at fostering
fundamental domestic adjustment in response to external constraint
partly by restraining growth of domestic demand -- will be
growing quite slowly. The smaller OECD countries are expected
to grow somewhat faster, while the non OPEC developing countries
as a group are expected to experience somewhat lower growth in
1977. The non-market economies of Eastern Europe, faced with
sizable reductions in the quantity -- and a considerable firming
in the terms --of external finance, may constrain domestic
growth.
In the 1974-1976 period current account deficits were
successfully financed -- to the surprise of many earlier
doomsday forecasters -- as the international financial system
proved to be flexible and resourceful. Lending through the
private markets expanded dramatically and their activities were
augmented by the IMF's Oil and Compensatory Finance Facilities
as well as its regular facilities, and the EC borrowing network.
Further, the non-OPEC developing countries have
built up large reserve positions during the 1973-1974 commodity
-13boom on which they were able to draw.
Prior to the
oil price increase, most industrial countries had made relatively
little use of international borrowing for balance of payments
reasons and had large untapped potential for obtaining external
capital.
The oil importing world, however, enters 1977 under
much less favorable conditions than existed in 1974. External
debts, for the non-OPEC world as a whole, are about $200
billion higher.
The bulk of the international borrowing
has been of short- to medium-term maturity and will, in many
cases, need to be rolled over or refinanced.
As debt grows
to finance the continuing deficits, private lenders are
becoming more selective in their lending, and countries which
have delayed adjustment will approach limits beyond which
they cannot afford to borrow.
Unused funds available to
official institutions for balance of payments lending have
also been reduced.
This is a serious matter and it cannot
be ignored by lenders or borrowers.
-14Management of the Impact of the Oil Price Increase
The world is beginning to take the steps necessary to
deal with these effects of the oil price decisions.
Some countries
have been slow in acting, others must do much more.
The
effort is a painful one, which will inevitably leave all
the oil-importing nations short of their aspirations but
which is infinitely better than the alternative of a
reversion to the beggar-thy-neighbor policies of the 1930s.
In terms of our four-fold strategy, here is where we stand.
1) Domestic Energy Policies
The free world has made little progress since 1973 in
reducing the vulnerability which stems from its over-reliance
on imported oil.
With economic recovery, demand has been
increasing and in 1977 it is expected to rise over 1976 levels.
For such trends to be reversed, the United States must assume
a leadership role.
opposite.
Unfortunately, we have done just the
Demand has been increasing, production declining,
and our imports have grown.
In 1973, we were importing
29 percent of our oil; in 1976, the figure is 41 percent.
Not only has U.S. reliance on imported oil increased, but the
proportion from OPEC has risen from 71 percent of oil imports
to 82 percent.
Most Americans would agree that our goal should be to
reduce our vulnerability to supply interruptions.
However,
it is not generally understood that to achieve that goal,
adequate incentives must exist to reduce domestic demand
and to develop alternative sources of supply.
We should not
-15be' seeking zero imports. We can reduce vulnerability through
reducing demand, diversifying supply and developing storage
and emergency measures. However, if prices for oil and gas
continue to be artificially controlled; if we continue to
threaten divestiture of oil companies; if an adequate return on
energy investment is not provided; the decisions necessary to
bring on additional supplies simply will not be made in a
timely fashion.
The development of a sound domestic energy policy was
one of the highest priority items of the Ford Administration
and I am sure it will continue to receive priority attention
under the new Administration. Unfortunately, there is no
single, easy solution to our energy problem. We need a series
of actions in a number of very diverse areas ranging from
measures to increase current fossil fuel production to basic
research and development of alternative energy sources.
Recently, Secretary Richardson and Administrator Zarb presented
to the Congress a comprehensive status report on the development
of our energy policy. I would like to focus today on only
a few aspects of our domestic energy policy. These include:
-- The need to realize that domestically
produced oil and natural gas must be priced
realistically.
-16-- The need to maintain an investment climate
which will ensure that private capital markets
will be able to finance the energy industry
without government financial assistance or
intervention.
-- The need to achieve regulatory reform so as to
simplify procedures, expedite approvals and
licensing and, in general, free the energy industry
from the governmental controls which hamper their
ability to meet our national energy objectives.
Continued disparities in the prices of domestically
produced oil and natural gas encourage a wide variety of
distortions in both the producing side of the industry as
well as in the consuming side. For example, the production
of intrastate gas is far more valuable to the producer than
the production of gas sold in interstate commerce. In addition,
continued price controls on oil and gas delay and handicap
the economic development of higher cost alternate resources
such as geothermal or solar energy. In many instances, these
sources are currently unable to compete with controlled prices
without some government sponsored financial incentives.
To the consumer, the current composite pricing system fails
to reflect either the true values of oil and gas or
their replacement costs. Moreover, the price disparities and
incentives inconsistencies have made it necessary for the
-17government to establish an elaborate system of entitlements
to equalize prices for refiners, adding further costs to both
the consumer and the taxpayer. Even more serious, when the
costs to the consumer are held to an artificially low level,
the customer further delays the necessary steps which must
ultimately be taken on conserving energy. As a recent study
by the International Energy Agency noted, U.S. energy price
controls keep U.S. energy costs artificially low when
compared with those of other industrialized countries. For
example, gasoline costs from 2-3 times as much in other
industrialized countries as it does in the United States.
Clearly, this cannot continue if we are to be serious in our
effort to conserve energy.
Furthermore, adequate profits are necessary to raise the
capital to replace the energy resources we are now consuming.
In the absence of adequate prospects for profits, private
investments in energy will lag and either (1) we will not
develop the necessary domestic energy resources, or (2) the
government, with its attendant bureaucracy and delays, will
have to replace private development of new resources.
Uncertainties in the investment area lead to caution and
hesitancy. Hesitancy in making investment commitments for
development of new domestic energy resources will further
delay reduction of imports to a manageable level. Besides the
current regulatory, geological and environmental uncertainties,
-18potential for both horizontal and vertical divestiture have
created new uncertainty for the industry which will
undoubtedly cause deferments in investment commitments,
just at the time when we want to encourage expanded efforts.
2) International Cooperation on Energy
At the same time that the United States must get its own
energy house in order, we must pursue further cooperation
among oil importers, through, among other fora, the International
Energy Agency. Through this body, commitments have been made
to share oil in an emergency. We should also formulate
group objectives for reducing oil imports; undertake joint
research and development projects; and more importantly,
remove barriers to investment in energy.
A third interrelated element in energy policy must involve
cooperation with the oil producing countries. In part, this
can be accomplished through an energy dialogue which, among
other things, should emphasize OPECTs responsibility
in the world economic system. This is not only with respect
to price but also to an increased role in the provision of officia
finance to support adjustment by those countries adversely
affected by the direct and indirect effects of higher oil prices.
It is important to emphasize that although producers and
consumers have different views on oil prices, there are many
other more specific interests which are complementary. We should
aim to develop such interest in various ways. For example, oil
-19producers want to diversify their economies. They need goods
and offer the faster growing market for oil-consuming country
goods. Also, to industrialize, OPEC desires consumer country
technical skill which producers are willing to pay for. The
focus of consumer relations with the producers should be to
strengthen these common bonds. We should not be pursuing
a deliberate policy confrontation. Instead, we should bring
producers and consumers closer together to foster greater
understanding of each others1 needs:
-- Consumers should understand the desires of the
producers for diversification of their economies and for
higher standards of living for their poeple.
-- Producers should understand that the rapid rise in oil
prices has placed a great burden on all economies of the world
economies which must remain viable and strong if producers
are to grow and prosper.
Our objective should be to create the objective
conditions which will bring about an expanding world supply
of energy market prices.
The price increase of this past month, should not alter
these basic policies. Rather, it should serve as a harsh
reminder of how far we still need to go in developing these
policies and that we must move with renewed haste.
-203) Adjustment.
While many oil importing countries have been able
to maintain growth rates by external borrowing, such loans
ultimately represent claims held by the creditor countries
against the future resources of the debtor.
In order for a
country to continue to borrow, it must be able to persuade
creditors that it will be able to repay those borrowings
sometime in the future.
Thus, while countries will adjust
at differing rates and under various policy choices, the
common thrust must be to build up a domestic capital base
which will be capable of producing goods in the future,
including a sufficient portion that will earn foreign
exchange.
It is imperative that this capital base take
into account the change in relative prices -- in particular
energy prices.
The future flow of production from larger
current investments will assure rising income levels as
well as permit the actual transfer of real resources to the
OPEC countries when their import requirements begin to
exceed their oil revenue.
Unless such a capital base is built
up, a country will have to reduce consumption substantially
in the future when it comes time to amortize accumulated
debts.
Progress is now being made on the adjustment of current
payments patterns.
A number of countries have taken or are
in the process of taking action to reduce their current account
- 21 deficits -- notably the U.K., Italy and Mexico. France has
instituted a comprehensive anti-inflationary program, which
should in time reduce both its domestic inflation a^d its
external deficit.
Though important progress is now under way, more needs
to be done. A continuing effort is needed, on the one hand
to encourage countries to place greater emphasis on measures
to adjust their payments imbalances and, on the other hand,
to ensure that transitional financing -- private and official
-- is available in adequate amounts while the adjustment takes
place.
This means not only that the weaker countries must improve
their positions; the non-OPEC countries in stronger positions
must be prepared to accommodate this adjustment in their own
trade and current account positions. The U.S., as one of those
countries able to attract substantial capital inflows as a
result of its relatively strong economic position, should be
prepared to accept substantial trade and current account
deficits in present circumstances. In an expanding economy
these adjustments can be more easily absorbed.
Protectionist measures by the U.S. -- aimed at curbing
imports or artifically stimulating exports -- would be
self-defeating and would severely damage the system. Countries
which are no longer able to borrow sufficient sums from private
or official sources must adjust.
If U.S. policies frustrate the efforts of other countries
to adjust through market-determined exchange rate changes and
domestic macro-economic policy measures, they will be forced
to adjust by resorting to direct controls on their trade and
payment flows.
-22This would lead to a recurring series of protectionist
reactions, as countries attempted to prevent further deficits.
The ultimate outcome of such a policy would be a breakdown of
world trade and worldwide economic stagnation. The adverse
effects on the economic growth and welfare of the United States
would also be substantial. And while the U.S. deficit might
be reduced, it would not be eliminated.
4) Financing to Support Adjustment
Even with the adoption of appropriate adjustment measures
by countries in deficit and those in surplus, transitional
official financing has an important role to play in cushioning
the pace and abruptness of the adjustments sought --in
permitting adequate time for rational, cooperative and deliberate
policies to take force and have their effects. The provision
of official financing, by supporting effective and responsible
moves toward adjustment, can also play an important indirect
role in assuring that private financing is available, because
its promotion of adjustment measures will help provide the
assurances needed by the private markets to enable them to play
their necessary role.
Several measures to expand countries' access to sources
of multilateral financing have been taken or proposed in the
past year or so, many in response to U.S. initiatives. The IMF
has significantly expanded access to its Compensatory Finance
Facility, and this facility has provided nearly twice as much
credit in the past year as it did in total during the preceeding
dozen years of its existence. The IMF has created a Trust Fund
-23for the benefit of its poorest developing country members,
which will provide them with urgently needed balance of payments
credit from the profits on sales of IMF gold. The IMF has
expanded access to its regular credit facilities for all countrie
by 45 percent, pending implementation of proposed amendments to
its Articles of Agreement. These amendments have been approved
by the Congress and will, we hope, take effect by mid-1977.
The IMF has acted to expand the list of currencies that are
effectively usable in its balance of payments financing operation
a measure that can add significantly to its holdings of usable
resources. And the IMF has available -- and is beginning to
utilize, after a long period of inactivity -- the resources of
the General Arrangements to Borrow, under which the U.S. and
other major countries are prepared to lend supplemental resources
to the IMF.
Looking somewhat farther ahead, a significant increase
in IMF resources -- a 33.6 percent, SDR 10 billion increase
in quotas -- has been agreed upon and is in the process of
ratification by member countries. The increase in the U.S.
quota has already been approved by the Congress, and we hope
that others will follow suit shortly. Also, in recognition
of the uncertainties in the present situation, IMF members have
agreed to review quotas again in the near future -- in advance
of the required quinquennial review. That review will begin
in the next few months.
-24The IMF is in a unique position to provide the needed
combination of economic expertise and financial resources
to assist in the development of effective national
stabilization and adjustment programs and lend the conditional
credit needed to bridge the time from implementation to fruition
of such programs.
The IMF deserves and has received the strong
support of the United States in its efforts as a major force for
stability and cooperation in international economic affairs.
The list of measures to expand official sources of financing
in the past few years is an impressive one.
It is evidence of
a general willingness on the part of countries to act cooperatively and constructively to meet rapidly changing and
unprecedented world financial requirements.
The need for sub-
stantial official balance of payments financing --on a
multilateral, conditional, and transitional basis -- will be with
us for some time.
The measures taken to date, however, should not lead us
to conclude that we have done all that may be necessary.
While
I remain optimistic that the world economy will survive the next
year without financial disruptions, there are risks.
Although
private sector flows, supplemented by official flows through
existing official facilities, should be adequate, there could
develop a time when the stresses and strains become too great.
Thus, we need to be prepared with a supplemental and temporary
source of official financing.
-25The United States more than two years ago proposed
such a facility -- the OECD Financial Support Fund -- but
unfortunately it has failed to gain the support of the
Congress to date and consequently has not yet been established.
The Support Fund is designed to meet extraordinary needs for
financing --on the basis of firm policy conditions -- in a
truly extraordinary situation.
Most other OECD countries have
ratified the Support Fund agreement, and U.S. action would bring
the Support Fund into being.
Legislation to authorize U.S.
participation in the Support Fund has been resubmitted to this
Congress, and I hope it will gain early passage.
Summary and Conclusion
Events of the past several years -- highlighted by the
successive OPEC price actions -- have placed severe strains
on the international economic and financial system.
The
problems posed by these strains -- which I have outlined for
you -- can be dealt with only if we attack the real causes -the economic, not just the purely financial.
I have set out
the strategy we believe is necessary to deal with out economic
problems.
The world is beginning to carry out this strategy.
The
United States has an opportunity -- indeed, a responsibility
to lead in this endeavor, by:
(1)
moving ahead promptly to implement a sound national
energy policy that will encourage cost-effective energy conservation and development of cost-effective alternative sources
of energy;
-26
(2) continuing cooperative efforts in international
energy between both other oil consuming nations and the
oil producers;
(3) keeping its markets open to foreign goods and
services and pursuing the further reduction of trade barrie
through the Multilateral Trade Negotiations;
(4) allowing its exchange rate to respond to market
pressures; and
(5) supporting through multilateral channels, the
provision of financial support where necessary, conditioned
on the adoption and implementation of adequate adjustment
policies.
oOo
TABLE 1
World Payments Patterns
Rough Estimates of Current Account Balances
(including official transfers)
($ billions, rounded)
1974
1975
Est.
1976
OPEC
+70
+40
+43
OECD
-33
- 6
-22*5
Non-Oil LDCs
1/
Others"
Unexplained Residual
-21
-29
-21
- 9
-15
-12*$
2/
- 7~~
+10
+14
y—Israel,
South Africa, Sino-Soviet area and Eastern
European countries.
2/ A large portion of the residual is accounted for by oil
settlements lags.
Source: 1974 and 1975 US. Treasury ^rt^^t^7^0°^nfona
Rfonnmic Outlook, December, 1976, adjusted
to area definitions.
FOR IMMEDIATE RELEASE
January 6, 1977
UNDER SECRETARY JERRY THOMAS
RESIGNS TO JOIN MARINE BANKS, INC.
Under Secretary of the Treasury, Jerry Thomas, announced
today that he has submitted his resignation to President
Ford effective January 20, 1977.
After leaving the Treasury post he has held since
April 26, 1976, Mr. Thomas will become Chairman of the Board
and Chief Executive Officer of First Marine Banks, Inc., a
Florida-based multi-bank holding company which he founded in
1964. He held the same position before he entered the government .
As Treasury Under Secretary, Mr. Thomas, 46, served as a
member of the Foreign-Trade Zones Board, as Chairman of the
Board of Directors of the Federal Law Enforcement Training
Center and as a member of the Board of Directors of the
Securities Investor Protection Corporation. He also served
on the Board of Directors of the United States Railway
Association.
Prior to his government service, Mr. Thomas also served
as Chairman of the Board of each of First Marine Banks* nine
commerical banks. So that he might devote his full time to
the holding company, he will not hold any position with the
various banks.
Mr. Thomas is past-President of the Florida Senate and the
former Director and Administrator of the Florida Securities
Commission. Prior to entering commerical banking, he held
membership on both the Midwest and the Philadelphia-Baltimore
Stock Exchanges and headed his own investment banking firm in
Palm Beach, Florida.
oOo
WS-1250
\e Department of theTREftSURY
OFFICE OF REVENUE SHARING
WASHINGTON, D.C. 20226
TELEPHONE 634-5246
FOR IMMEDIATE RELEASE
MONDAY, JANUARY 10, 197 7
CONTACT: PRISCILLA CRANE C202) 634-5248
PUBLIC HEARING SCHEDULED ON REVENUE SHARING REGULATIONS
A public hearing has been scheduled on interim regulations
relating to new public participation, public hearing, assurances and reports provisions of general revenue sharing law.
The interim regulations were published in today's Federal
Register by the Department of the Treasury's Office of
Revenue Sharing.
"A public hearing on the interim regulations will take
place on Friday, February 11, 1977, beginning at 10 a.m.
in Conference Room 4121 at the Treasury Department, 15th
Street and Pennsylvania Avenue, N.W., Washington, D. C , "
Jeanna D. Tully, Director of the Office of Revenue Sharing,
announced today.
A person who wishes to be heard on February 11, 1977
must submit to the Director of the Office of Revenue Sharing,
an outline of the topics he or she wishes to discuss and an
estimate of the length of time which will be required to
discuss each topic. Ordinarily, ten minutes will be allowed
to each participant. Requests to appear must be delivered
to the Director, Office of Revenue Sharing, 2401 E Street,
N.W. , Washington, D. C. 20226, on or before February 4, 1977.
The interim regulations, which amend Subpart B of title
31, Code of Federal Regulations, have been put forward pursuant to the State and Local Fiscal Assistance Act of 1972,
as amended by the State and Local Fiscal Assistance Amendments
of 1976 (31 U.S.C, 1221, et. seq.).
The text of the interim regulations may be found in the
Federal Register of January 10, 1977. Individual copies may
be requested of the Public Affairs Division of the Office
of Revenue Sharing at C2Q2J 634-5248.
30 WS-1251
if Department of the TREASURY
SHINGTON, D.C. 20220
>
TELEPHONE 964-2041
•J-A
TST
contact: Gabriel Rudney
(202) 566-5911
January 7, 1977
FOR IMMEDIATE RELEASE
TREASURY SECRETARY ANNOUNCES MEMBERSHIP OF COMMITTEE
TO ADVISE TREASURY ON TAX ASPECTS AND STANDARDS
FOR PRIVATE PHILANTHROPY
Secretary of the Treasury William E. Simon announced
today the appointment of a 25-member committee of private
citizens to advise the Treasury on tax aspects and standards
for private philanthropy.
C. Doublas Dillon, former Treasury Secretary and Chairman of the Metropolitan Museum of Art in New York, will be
Chairman of the committee, to be known formally as the Advisory
Committee on Private Philanthropy and Public Needs.
Secretary Simon, Mr. Dillon and a representative of
Secretary of the Treasury-designate W. Michael Blumenthal attended
the organizational luncheon of the advisory committee Thursday
(Jan. 6) at the Treasury.
Secretary Simon told the gr oup: "Establishment of this
Commit tee is a direct outgrowth of the work of the well-known
Filer Commission -- The Commissi on on Private Philanthropy and
In December, 19 75, that Commission, of which a
Public Needs.
number of you were members, or c onsultants, presented a report
to the Congress and the Administ ration. It summarized that
unique role of private giving in the history of the United States
abundant evidence t hat maintenance of a vigorous
and pr ovided
»t
charit able giving sector is vita 1 to the well being of the
More than 200 recommendations for membership on the
nation
advisory committee came in after its establishment was announced
in the Federal Register in November. Committee members will
serve two-year terms without pay. Committee Coordinator is
Gabriel Rudney of the Treasury Department.
Members of the advisory committee, in addition to Mr.
Dillon, include:
Alan Pifer, President, Carnegie Corporation of New York.
WS-1252
(over)
- 2George W. Romney, President, National Center for Voluntary
Action, Washington.
Walter McNerney, President, Blue Cross Association, Chicago.
Leonard Silverstein, Attorney, Washingon.
Marion R. Fremont-Smith, Attorney, Boston.
Kingman Brewster, President, Yale University.
Ernest Osborne, Director, Sachem Fund, New Haven, Conn.
David Cohen, President, Common Cause, Washington.
John S. Nolan, Attorney, Washington.
William Matson Roth, President, San Francisco Museum of Art.
Leonard Conway, President, Youth Project, Washington.
Bruce Dayton, Chairman, Executive Committee, Dayton Hudson
Corp., Minneapolis.
Thomas A. Troyer, Attorney, Washington.
Robert Blendon, Vice President, Robert Wood Johnson
Foundation, Princeton, N.J.
H.J. Zoffer, Dean, Graduate School of Business, University
of Pittsburgh.
Paul Ylvisaker, Dean, Graduate School of Education, Harvard.
Eleanor Sheldon, President, Social Science Research Council,
New York.
James Joseph, President, Cummins Engine Foundation, Columbus,
Ind.
Mary Gardiner Jones, President, National Consumers League,
Washington.
William Aramony, National Executive, United Way of America.
Pablo Eisenberg, President, Center for Community Change,
Washington.
John Filer, Chairman, Aetna Life and Casualty Company, Hartford
Vilma Martinez, President Mexican-American Legal Defense
and Education Fund, San Francisco.
Wes Uhlman, Mayor, City of Seattle.
0O0
DATE:
January 10, 1977
TREASURY BILL RATES
13-WEEK | 26-WEEK
LAST WEEK: ^ */t> 7 7* ^JY/lo
TODAY: . if. lpI'} *f* 4. $° 3 %
HIGHEST SINCE
LOWEST SINCE
he Deportment of
INGTON.D.C. 20220
^TREASURY
TELEPHONE 964-2041
FOR IMMEDIATE RELEASE
J a n u a r y 1Q>
19??
RESULTS OF TREASURY'S WEEKLY BILL AUCTIONS
Tenders for $2,404 million of 13-week Treasury bills and for $3,501 million
of 26-week Treasury bills, both series to be issued on January 13, 1977,
were accepted at the Federal Reserve Banks and Treasury today. The details are
as follows:
RANGE OF ACCEPTED
COMPETITIVE BIDS:
High
Low
Average
13-week bills
maturing April 14, 1977
Price
Discount
Rate
Investment
Rate 1/
98.839
98.833
98.834
4.593%
4.617%
4.613%
4.71%
4.74%
4.73%
26-week bills
maturing July 14, 1977
Discount Investment
Price
Rate
Rate 1/
97.579
97.568
97.572
4.789%
4.811%
4.803%
4.98%
5.00%
4.99%
Sri*
Tenders at the low price for the 13-week bills were allotted 98%
Tenders at the low price for the 26-week bills were allotted 84%
TOTAL TENDERS RECEIVED AND ACCEPTED
BY FEDERAL RESERVE DISTRICTS AND TREASURY:
Location
Received
Accepted
Received
$
20,575,000
Boston
3,808,040,000
New York
22,140,000
Philadelphia
38,370,000
Cleveland
22,535,000
Richmond
26,700,000
Atlanta
252,910,000
Chicago
44,685,000
St. Louis
20,980,000
Minneapolis
55,135,000
Kansas City
19,490,000
Dallas
298,890,000
San Francisco
$
16,575,000
2,053,615,000
18,490,000
37,770,000
22,535,000
26,670,000
61,410,000
21,180,000
12,980,000
47,690,000
19,490,000
65,100,000
Treasury
TOTALS
$2,403,505,000 a/ $6,377,495,000
$4,630,450,000
$
41,030,000
5,194,915,000
7,420,000
162,160,000
20,165,000
14,545,000
394,390,000
49,210,000
21,240,000
18,430,000
14,980,000
439,010,000
/Includes $357,680,000 noncompetitive tenders from the public.
Includes $150,215,000 noncompetitive tenders from the public.
'Equivalent coupon-issue yield.
VS-1253
Accepted
$
7,030,000
3,239,815,000
5,665,000
12,160,000
7,505,000
13,545,000
43,230,000
21,000,000
13,240,000
18,180,000
11,980,000
107,750,000
$3,501,100,000 b/
FOR IMMEDIATE RELEASE
January 10, 1977
TREASURY DEPARTMENT-FEDERAL RESERVE
PRESS STATEMENT
The Treasury Department and Federal Reserve today
announced that the United States will participate in the
arrangements agreed in principle at Basle for a medium-term
facility in the amount of $3 billion relating to official
sterling balances. The U.S. participation in this standby
facility will be in the amount of $1 billion. It will be provided through the Federal Reserve System and the U.S. Treasury
Exchange Stabilization Fund.
The purpose of these arrangements is to reinforce the
international monetary system by helping the United Kingdom
achieve an orderly reduction in the reserve currency role of
sterling and in this connection to facilitate the funding of
a portion of Britian's external liabilities. The Bank for
International Settlements will cooperate in the arrangements
and the Managing Director of the International Monetary Fund
is being asked to assist in their implementation. These sterling
balance arrangements will reinforce the economic program undertaken by the United Kingdom in connection with the $3.9 billion
standby agreed with the International Monetary Fund on January 3,
1977. A copy of the press announcement made by the central bank
group in Basle is attached.
oOo
Attachment
WS-1254
BIS Press Communique
Discussions have recently been taking place between the
United Kingdom and the other Group of Ten countries and Switzerland on the subject of sterling balances. These discussions
follow the successful conclusion of the United Kingdom1s
application to the International Monetary Fund and were prompted
by a shared determination to make a joint contribution to greater
international monetary stability.
Fluctuations in the official sterling balances have at
times in the past been disruptive to the United Kingdom's economic
policies and to the international monetary system. The aim in
the discussions has therefore been to prevent such instability
in the future. In these circumstances, there was general welcome
to the United Kingdom's declared policy to achieve an orderly
reduction in the reserve currency role of sterling.
To support these aims, agreement in principle has been reached
by governors of the central banks concerned, on a medium-term
financing facility in the amount of $3 billion related to the
official sterling balances, which at end-September were valued at
$3.8 billion. This stand-by facility will be provided to the Bank
of England by the BIS, backed up by the participating countries.
The Managing Director of the International Monetary Fund is being
requested to assist in the implementation of the agreement.
The participating countries are Belgium, Canada, Germany,
Japan, the Netherlands, Sweden, Switzerland and the United States
of America. Other countries may wish to participate later.
As part of the operation the United Kingdom intends to
offer securities in the form of foreign currency bonds1-10-77
to present
official sterling holders.
z&
Department of theTREASURY
WASHINGTON, D.C. 20220
TELEPHONE 566-2041
/789
FOR RELEASE AT 4:00 P.M.
January 11, 1977
TREASURY'S WEEKLY BILL OFFERING
The Department of the Treasury, by this public notice, invites tenders for
two series of Treasury bills to the aggregate amount of $5,900 million, or
thereabouts, to be issued January 20, 1977,
as follows:
91-day bills (to maturity date) in the amount of $2,400 million, or
thereabouts, representing an additional amount of bills dated October 21, 1976,
and to mature
April 21, 1977
(CUSIP No. 912793 F7 6), originally issued in
the amount of $3,402 million (an additional $2,006 million was issued on December 10,
1976), the additional and original bills to be freely interchangeable.
182-day bills, for $3,500 million, or thereabouts, to be dated January 20, 1977,
and to mature July 21,'1977
(CUSIP No. 912793 J2 3 ) .
The bills will be issued for cash and in exchange for Treasury bills maturing
January 20, 1977,
outstanding in the amount of $5,904 million, of which
Government accounts and Federal Reserve Banks, for themselves and as agents of
foreign and international monetary authorities, presently hold $2,613 million.
These accounts may exchange bills they hold for the bills now being offered at
the average prices of accepted tenders.
The bills will be issued on a discount basis under competitive and noncompetitive bidding, and at maturity their face amount will be payable without
interest.
They will be issued in bearer form in denominations of $10,000,
$15,000, $50,000, $100,000, $500,000 and $1,000,000 (maturity value), and in
book-entry form to designated bidders.
Tenders will be received at Federal Reserve Banks and Branches and from
individuals at the Bureau of the Public Debt, Washington, D. C
20226, up to
1:30 p.m., Eastern Standard time, Monday, January 17, 1977.
Each tender must be for a minimum of $10,000. Tenders over $10,000 must be
in multiples of $5,000.
In the case of competitive tenders the price offered
must be expressed on the basis of 100, with not more than three decimals, e.g.,
99.925.
Fractions may not be used.
Banking institutions and dealers who make primary markets in Government
WS-1255
\^
r\/
(OVER)
-2^c-ricies and report daily to the Federal Reserve Bank of New York their pos_tir.n'
v:i:h reject to Government securities and borrowings thereon may submit tenders
i.'.>'- accoar.t, of customers provided the naiaes of the customers are set forth Ln
r..«-c!'. tenders.
Others will not he permitted to submit tenders except for their
cr~-.i account.
Tenders will be received without deposit from incorporated b-_nks
a«"... trust companies and from responsible and recognized dealers in investment
t~ev.urit.ie_-,. Tenders from others must be accompanied by payment of 2 percent of
the face amount of bills applied for, unless the tenders are accompanied by an
express guaranty of payment by an incorporated bank or trust company.
Public announcement will be made by the Department of the Treasury of the
amount and price range of accepted bids.
Those submitting competitive tenders
will be advised of the acceptance or rejection thereof.
The Secretary of the
Treasury expressly reserves the right to accept or reject any or all tenders,
in whole or in part, and his action in any such respect shall be final. Subject
LLr these reservations, noncompetitive tenders for each issue for $500,000 or less
without stated price from any one bidder will be accepted in full at the average
price (in three decimals) of accepted competitive bids for the respective issues.
Settlement for accepted tenders in accordance with the bids must be made or
completed at the Federal Reserve Bank or Branch or at the Bureau of the Public Debt
on January 20, 1977,
in cash or other immediately available funds or in a like
face amounr of Treasury bills maturing January 20, 1977; provided, however, that se
ment for tenders submitted to the Bureau of the Public Debt must be completed on
January 21, 1977, and must include one day's accrued interest if settlement is made
other than Treasury bills maturing January 20, 1977. Cash and exchange tenderswil
receive equal treatment. Cash adjustments will be made for differences between the
value of maturing bills accepted in exchange and the issue price of the new bills.
Under Sections 454(b) and 1221(5) of the Internal Revenue Code of 1954 the
amount of discount at which bills issued hereunder are sold is considered to accrui
when the bills are sold, redeemed or otherwise disposed of, and the bills are
excluded from consideration as capital assets.
Accordingly, the owner of bills
(other than life insurance companies) issued hereunder must include in his Federal
income tax return, as ordinary gain or loss, the difference between the price paid
for the bills, whether on original issue or on subsequent purchase, and the amount
actually received either upon sale or redemption at maturity during the taxable
year for which the return is made.
Department of the Treasury Circular No. 418 (current revision) and this noti£
prescribe the terms of the Treasury bills and govern the conditions of their issu<
Copies of the circular may be obtained from any Federal Reserve Bank or Branch, ol
from the Bureau of the Public Debt.
oOo
January 11, 1977
MEMORANDUM FOR THE PRESS:
John M. Porges has resigned as U.S. Executive Director
of the Inter-American Development Bank and as Special Assistant to the Secretary of the Treasury, effective January 13,
1977. He has held the posts since June 1973.
Mr. Porges will join the Cavendes Investment Banking
Group in Caracas, Venezula, with responsibilities for their
international operations.
oOo
WS-1256
FOR IMMEDIATE RELEASE
REMARKS BY THE HONORABLE WILLIAM E. SIMON
SECRETARY OF THE TREASURY
AT THE
U.S. INDUSTRIAL PAYROLL SAVINGS COMMITTEE MEETING
DIPLOMATIC FUNCTIONS SUITE, STATE DEPARTMENT
WASHINGTON, D. C , JANUARY 12, 1977
Thank you for your report, George. You and your committee
should be very proud of the results. We at Treasury wish to
express our sincere thanks for your dedicated service.
And now, to acknowledge the efforts you have made on our
behalf, it is my pleasure and privilege to present a number
of awards.
First, to the outgoing 1976 committee. If all the 1976
members will please stand. In grateful appreciation of the
excellent service you have given to the payroll savings
program and to the nation, we would like to present each of
you with the Department of Treasury's silver medal of merit.
I would also like to read one of the letters that
accompanies this award. Each letter differs, of course,
depending upon your assignment. This letter is to Bill
Miller and I would like to ask him to step forward at
this time.
"Dear Bill:
"I am deeply
you and
payroll
savings
impressed with the contributions
the other members of the U.S. Industrial
Savings Committee made to the success of the
bonds campaign during our bicentennial.
"The enrollment of payroll savers exceeded the
challenging goal of 2,500,000. The sale of small
denomination E - Bonds was $4,900,000,000, the
greatest amount since 1945."
"You played a significant role in these remarkable
achievements as the chairman for the Electrical Equipment Industry. Your efforts benefited the nation and
the individual citizen. It is with special pleasure
that I present to you the attached medal of merit."
WS-1257
-2The letter carries my signature as Secretary of the
Treasury. I would now like the savings bonds people to
present the various chairmen with their individual silver
medals of merit.
The second group of awards I have goes to the distinguished past chairmen of this committee — all of whom,
as you know, continue to serve.
If Bill Gwinn will please come forward, I would
like to read the inscription on this liberty bell trophy.
WILLIAM P. GWINN
PRESENTED BY TREASURY SECRETARY WILLIAM E. SIMON
FOR PATRIOTIC SERVICE
JANUARY 12, 1977
Our other former chairmen present today — all of
whom will receive their liberty bell trophy by mail —
are Gabriel Hauge for 1975, John deButts for 1974, and
Don MacNaughton for 1972. My thanks to all of you.
Finally, I have two awards for our distinguished outgoing chairman, George Stinson. As you have heard, the
committee did a magnificent job under his leadership. They
exceeded the highest goal ever accepted by a committee —
2,500,000 new and increased savers. This goal was an
increase of 100,000 over last year. George's energy,
direction and dedication made this accomplishment possible,
and in turn, made possible the total of more than 7-1/2
billion dollars in Series E and H sales for 1976 — the best
since 1945 and over 500 million more than 1975. It has been
a great personal pleasure for me to work with George. His
stature in the Business community is one that can be matched
by very few.
George, if you will come up here, I would like to
present you with this framed parchment citation. It reads:
"George A. Stinson, Chairman, U.S. Industrial
Payroll Savings Committee. For exceptional achievement
in the 1976 payroll savings campaign, 'take stock in
America — 200 years at the same location.'
"Under his leadership, and inspired by his example,
American industry during our bicentennial year exceeded
its challenging goal of enrolling 2,500,000 savers and
raised the sale of Series E bonds through the payroll
savings plan to a new record. This contribution to the
security
oftribute
both individuals
and the nation is an
impressive
to his efforts.
-3"His generous service is in the finest tradition of the volunteer spirit that characterizes
the savings bonds program.
"Given under my hand and seal, this twelfth
day of January, Nineteen hundred and seventy-seven."
I also have for you this beautiful gold medal of merit.
The inscription on the case reads —
MEDAL OF MERIT
AWARDED
GEORGE A. STINSON
FOR
DISTINGUISHED LEADERSHIP
AS 1976 CHAIRMAN
U.S. INDUSTRIAL PAYROLL SAVINGS COMMITTEE
BY
WILLIAM E. SIMON
SECRETARY OF THE TREASURY
JANUARY 12, 1977
Although I have no formal awards for them, I would
like at this time to express my deepest thanks and appreciation
to Mrs. Francine I. Neff, National Director of the Savings
Bonds Division, Mr. Jesse Adams, Deputy Director, Chuck
Goodall, Executive Secretary of the Committee, and the entire
Savings Bonds division staff, for the splendid support they
have given this committee. I am sure you will agree that
without their help and guidance, the year's results would
not have been possible.
And now I would like to take just a few minutes to talk
about the state of our economy, the place of savings bonds
in it, and your role in the world of savings bonds.
While recovery from the recession is far from complete,
the U.S. economy is back on a path of economic expansion and is
making good progress. Since the current expansion began in
early 1975 the "real" output of goods and services has
increased at an annual rate of 6.4 percent — well above
this nation's underlying growth potential of about 3-1/2
percent each year. Personal consumption, business spending,
housing construction and government spending have all risen —
again in "real" terms with price changes removed — during
this expansion and the overwhelming consensus view both inside
and outside of government is that economic growth at aboveaverage rates will continue into 1977.
-4Nevertheless, we are justifiably concerned about the
slowdown of activity in recent months which has been sharper
and more prolonged than expected. There are specific reasons
for this slowdown — or "pause" as it sometimes is called —
including the unusual number of workers out on strike throughout the third quarter and the sluggishness of business spending
for plant, equipment and added inventories. But I believe that
the underlying cause is not to be found in any list of temporary
distortions. Instead, the real issue involves the weakened
confidence of the American people in their economic future.
By concentrating on the details of the latest economic
statistic, we have missed the broader message for economic
policy: a basic need for sustained economic growth in which
government fiscal and monetary policies are consistent with
the pace of private sector activity. The disappointing
economic distortions of the last decade will continue unless
three policy adjustments are made:
— First, the diversity of economic problems must be
better recognized to avoid concentrating on single issues.
Inflation, unemployment, sustained output, the availability
of productive resources, financial markets and the impact
of regulation must all be considered simultaneously to create
balanced growth.
— Second, when new policies are initiated they should
solve more problems than they create. During a period of
difficulty it is expedient to "do something" quickly to
demonstrate political leadership. This naive activist
approach often causes even more problems after the temporary
benefits disappear. The conventional wisdom that a few
billion dollars of additional government spending somehow
makes the difference between the success or failure of the
entire U.S. economy — which is rapidly approaching an annual
level of output at two-trillion dollars — is an unfortunate
economic myth. This approach to government spending resulted
in the Federal budget outlays rising from $135 billion in
fiscal year 1966 to $268 billion in FY 1974 and then jumping
to a level of at least $413 billion in the current fiscal
year 1977. It should come as no surprise to anyone that we
have reported a Federal budget deficit in 16 of the last 17
years — and 39 of the last 47 — climaxed by a combined
shortfall of Federal deficits and "net" borrowings for over
100 federal credit programs not even included in the budget
of almost one-half of a trillion dollars in the last 10
fiscal years (includes FY 1977). This dismal record and
businessmen.
the
"confidence-inspiring"
resulting impact onexperience
monetary policies
for American
is hardly
consumers
a
and
-5— Third, there is a fundamental need to adopt economic
policy goals for longer time horizons that stretch beyond
the next scheduled elections. The fine-tuning approach
keyed to political needs has led to many of the distortions
experienced over the years.
Such general recommendations may not attract much
immediate attention as most analysts concentrate on the
details of the preliminary monthly economic statistics
which are released each day. Nor is it easy to force the
consideration of specific spending and tax decisions into
a broader framework of long-term economic stability goals.
But unless we rapidly change our approach to deterrinining and coordinating national economic policies, I
anticipate that we will continue to experience the disappointing combination of inflation and unemployment, along
with the volatile shifts in the output of goods and services,
that has plagued the U.S. economy for more than a decade. If
this happens the improvement in confidence that is so badly
needed will not occur.
^ Now, where do savings bonds fit into all of this?
Well, the bond program has always had two goals — two roles
since it began over 35 years ago.
On the one hand, U.S. savings bonds give millions
of individual Americans greater financial security through
providing a method for saving that is totally safe and very
convenient.
On the other hand, the program helps America itself,
by providing the government with a dependable, long-term
foundation for its national debt structure.
The numbers are significant. As of December 31, 1976,
outstanding public debt of the Treasury, including matured
and non-interest bearing debt, stood at over $653.5 billion.
Some $241 billion of the total debt was held by the
Federal Reserve Banks and the government trust accounts,
such as social security and unemployment trust funds.
The problem area for us was the $413 billion of debt
in private hands. Of this, around $312 billion was m the
form of marketable securities, such as Treasury bills and
notes. An additional $29 billion was in non-marketable
securities other than savings bonds, leaving $72 billion
in series E and H bonds and remaining freedom shares, AS
-6quick calculation will show, slightly less than one fifth of
the privately-held portion of the public debt was in savings
bonds — a sizable amount. Although savings bonds holdings
have increased by over $4 billion in the past year, their
share of the privately-held public debt has declined because
of large increases in the debt. That the ratio of savings
bonds holdings to the privately-held public debt has not fallen
even further is largely due to your efforts.
But more important than percentages, savings bonds
holdings broaden and stabilize the government's debt base.
Millions of people buy these bonds, and they hold them twice
as long as marketable securities. Specifically, privatelyheld marketables are held an average of 2.9 years while *
savings bonds are held an average of 6 years.
The life of privately-held marketables has declined in
recent years and this causes considerable concern to economists.
Because we must then go into the market to refund more often
and each refunding raises serious issues of pricing and marketing strategies. Even eliminating the shortest term securities,
Treasury bills, about $1 out of every $6 of marketable debt
must be refunded and replaced within a year. Savings bonds,
however, based on past performance require only about $1 out
of every $9 refunded within a year — and that's a significant
difference.
These bonds, then, are critical to good debt management,
but their other role is even more important. This is to provide individual Americans with financial security through a
safe, convenient way to save.
Consider that the cornerstone of any personal financial
program is a block of highly liquid securities convertible
to a known amount of cash at almost any time. This is savings
bonds.
Safety is a key feature. In addition, payroll savings
is the most realistic way ever devised to save money. The
financial writer, Sylvia Porter, has written that, some years
ago, she and her husband started to save money by buying a
monthly savings bond. But they decided the then-interest
rate was too low so they stopped and told themselves they
would put the same amount into another account. Three or
four months went by and, said Mrs. Porter, they discovered
they hadn't put one penny into their account without the
incentive of an automatic bond-buying plan. Payroll savings
turns a good impulse into a regular habit — and six percent
of a good habit is better than any percent of a qood idea
that never takes off.
-7The interest rate for bonds is well placed in the
spectrum of available savings instruments, and there are
some very attractive tax benefits. Beyond this, savings
bonds is a personal thrift program that works in an era
which desperately needs to remember, and practice, the
values of thrift and individual responsibility.
I think people know this. They respond to efforts to
help them help themselves. Our 1976 bicentennial year bond
sales of $7.5 billion were the highest since 1945 and were
53 percent over a decade ago.
,ZJ
Thrift is an American tradition. And so is volunteerism.
You are all special volunteers and I'm pleased that 99
percent of all people who help Treasury to sell bonds are
volunteers. You, and they, make it possible to do the job
with only a small handful of government employees. Because
of your help we do not need to add another layer of
government bureaucracy.
If I might add just a word about another volunteer
group: The Advertising Council, through its professional
help and donated space, provides us with the equivalent of
J$75 million worth of advertising a year. They've helped us
^for many years — and you will find their contributions of
\immense benefit in your own work for savings bonds.
Another aspect of your volunteer service is that, unlike many federal programs, you and savings bonds build on
the strength of our citizens. You, and savings bonds, speak
to the good and the strong in people — to their care for
their families and their love of country instead of to their
fears or faults or failures. Through you millions of citizens
achieve a better and a fuller life and isn't that the real
purpose — the bottom line — of what we all want in
this country? I think so — and that's what makes us
the great nation that we are.
And now, if I may add a personal note:
My time as Treasury Secretary has been stimulating
and exciting, and I don't regret one day of it. But,
looking backward and forward, I know that one of my* lasting
satisfactions will be my association with the savings bonds
program. It is a good program — a people program —
one that unabashedly advocates personal responsibility for
a man and woman's own financial security. And it is a program built around volunteers.
-8I know that we ask a lot of our volunteers. We ask
for that precious commodity — your own time. We ask you
to become personally concerned and involved in selling an
idea — personal thrift — and a practical method whereby
the idea can be carried out. We can do this only because
we feel the idea and the product is so great.
I believe that, when your time for serving with this
program is over — and the results are in — you will
feel, as I do, a sense of great personal satisfaction. Each
one of you, as a member of the U.S. Industrial Payroll Savings
Committee, is a vital force in this program. It is important
to the government's debt management. It is important in
providing security to individual Americans. Your continuing
efforts mean a great deal to all of us. On behalf of the
government — and its citizens — thank you and good luck.
0O0
FOR RELEASE AT 4:00 P.M.
January 12, 1977
TREASURY TO AUCTION $2,500 MILLION OF 2-YEAR NOTES
The Department of the Treasury will auction $2,500
million of 2-year notes to raise new cash. Additional
amounts of the notes may be issued to Federal Reserve Banks
as agents of foreign and international monetary authorities
at the average price of accepted tenders.
Details about the new security are given in the attached
highlights of the offering and in the official offering
circular.
Attachment
WS-1258
HIGHLIGHTS OF TREASURY
OFFERING TO THE PUBLIC
OF 2-YEAR NOTES
TO BE ISSUED FEBRUARY 3, 1977
January 12. 1977
Amx^iarijt Offered:
To the public
$2,500 million
Description of Security:
Term and type of security
2-year notes
Series and CUSIP designation
Series L-1979
(CUSIP No. 912827 GJ 5)
Maturity date
January 31, 1979
Call date
No provision
Interest coupon rate
To be determined based on the
average of accepted bids
Investment yield
To be determined at auction
Premium or discount
To be determined after auction
Interest payment dates
July 31 and January 31
Minimum denomination available
$5,000
Terms of Sale:
Method of sale
Yield Auction
Accrued interest payable by investor
None
Preferred allotment
Noncompetitive bid for
$1,000,000 or less
Deposit requirement
5% of face amount
Deposit guarantee by designated
institutions
Acceptable
Key Dates:
Deadline for receipt of tenders
Wednesday, January 19, 1977,
by 1:30 p.m., EST
Settlement date (final payment due)
a) cash or Federal funds
b) check drawn on bank within
FRB district where submitted
c) check drawn on bank outside
FRB district where submitted
Delivery date for coupon securities
Thursday, February 3, 1977
Monday, January 31, 1977
Friday, January 28, 1977
Thursday, February 3, 1977
FOR IMMEDIATE RELEASE
Contact: James C. Davenport
Extension: 29 51
January 13, 19 77
TREASURY DEPARTMENT ANNOUNCES
PRELIMINARY COUNTERVAILING DUTY DETERMINATION
ON ITALIAN TOMATO PRODUCTS
Under Secretary of the Treasury Jerry Thomas announced
today the preliminary determination that imports of canned
tomatoes and canned tomato concentrates do not benefit from
the payment or bestowal of a bounty or grant within the
meaning of the U.S. Countervailing Duty Law (19 U.S.C. 1303).
Notice of this determination will appear in the Federal
Register of January 14, 19 77.
The Countervailing Duty Law requires the Treasury to
assess an additional (countervailing) duty that is equal
to the amount of a bounty or grant (subsidy) when one has
been found to be paid or bestowed. The program that is
the subject of this investigation was basically designed
by the Italian government as an emergency measure during
19 75 for the purpose of dealing with adverse economic
conditions in the industry during that year. Although
payments were made under the program, they were small
in relation to both total production and exports. More
important, all payments have been suspended by the Italian
government and are not expected to be made in the future.
Accordingly, a preliminary negative determination was
reached.
Interested parties will have 30 days from the date
of publication in the Federal Register in which to present
written views regarding this action. A final determination
must be issued by no later than July 2, 19 77.
Imports of canned tomatoes and canned tomato concentrates from Italy during 19 75 were valued at approximately
$7.3 million.
* * *
WS-1259
__/^
Apartment of
^TREASURY
WASHINGTON, D.C. 20220
TELEPHONE 566-2041
FOR IMMEDIATE RELEASE
January 19, 1977
RESULTS OF AUCTION OF 2-YEAR TREASURY NOTES
The Treasury has accepted $2,504 million of $5,523 million of
tenders received from the public for the 2-year notes, Series L-1979,
auc t ioned today.
The range of accepted competitive bids was as follows:
Lowest yield 5.94%
Highest yield
Average yield
5.99%
5.97%
The interest rate on the notes will be 5-7/8%
the above yields result in the following prices:
Low-yield price 99.880
High-yield price
Average-yield price
At the 5-7/8% rate,
99.787
99.824
The $2,504 million of accepted tenders includes $371 million of
noncompetitive tenders and $2,133 million of competitive tenders
(including 80% of the amount of notes bid for at the high yield)
from private investors.
In addition, $335 million of tenders were accepted at the average
price from Federal Reserve Banks as agents for foreign and international
monetary authorities for new cash.
WS-1260
FOR RELEASE UPON DELIVERY
STATEMENT BY THE HONORABLE GERALD L. PARSKY
ASSISTANT SECRETARY OF THE TREASURY
BEFORE THE
COMMISSION ON SECURITY AND COOPERATION IN EUROPE
FRIDAY, JANUARY 14, 1977, AT 10:00 A.M.
Mr. Chairman and Members of the Commission:
It is a pleasure to appear before this Commission
to discuss implementation of Basket II of the Final Act
of the Conference on Security and Cooperation in
Europe (CSCE). As Executive Secretary of the East-West
Foreign Trade Board and Chairman of its Working Group,
I welcome these hearings as an opportunity to clarify
the meaning and relevance of Basket II of the Final Act,
and the possibilities for East-West economic cooperation
which it offers. I hope that our discussions today can
provide guidance to the new Administration and the new
Congress to implement further the Final Act, and in so
doing facilitate future East-West economic cooperation.
I commend the Commission for its hard work in
monitoring implementation of the Helsinki Agreement,
and for its efforts to encourage private and governmental
WS-1261
- 2projects and programs which will take advantage of
provisions of the Act to expand East-West economic
cooperation and human contact.
I also applaud the
initiative demonstrated by the Commission in its
inquiries and studies in this area, which has been only
slightly understood.
In signing the CSCE Final Act, the United States,
Canada and 33 European States, including the Soviet Union
and the countries of Eastern Europe, undertook a
significant moral and political obligation to carry out
its provisions.
It is a broad document touching on a
wide range of issues grouped together in three Baskets.
Basket I contains a Declaration on a ten-point
listing of the principles agreed upon by the signatories
to guide relations between them; Basket II contains
provisions on cooperation in the fields of trade,
industrial cooperation, science and technology, environment and other areas of economic activity; and Basket III
includes provisions on humanitarian principles involving
the freer movement of people, ideas, and information.
In my remarks today I will focus on the progress and
prospects for resolving economic issues which hinder
the successful implementation of the Basket II provisions.
- 3Basket II, like the rest of the Final Act, contains
no legally binding commitments by its signatories to
adopt specific policies or programs which would facilitate
East-West economic cooperation.
But it does provide a
framework in which patterns of cooperation in this area
may emerge.
In Basket II, the Eastern and Western
signatories expressed their intention to work together
to develop their cooperation in the economic, scientific
and technical spheres of activity.
Basket II should be viewed as a basic economic
charter leading toward specific steps by governments
and nongovernmental institutions on a unilateral,
bilateral and multilateral basis.
U.S. Interests in Improved Economic Cooperation with the East
Basket II of the Final Act complements U.S. interests
in expanding East-West economic cooperation.
The central
theme running throughout this Basket is that economic
contacts are a natural outgrowth of improved political
relations -- and contribute, in turn, to the stability of
these relations.
In signing the Agreement the Participating
States endorsed the conviction that "their efforts to
develop cooperation in the fields of trade, industry,
science and technology, the environment and other areas
- 4 of economic activity contribute to the reinforcement of
peace and security in the world as a whole."
This i
s
precisely the concept that has underscored U.S. effort s
to develop economic cooperation with the East in these
fields over the past few years.
During the Cold War period, U.S. participation in
trade with the Communist countries was virtually nonexistent.
No cooperative efforts were undertaken either
in the economic and commercial fields or in science and
technology.
It was difficult to speak of bilateral
relationships with these countries in any meaningful
way.
As a result there was no inducement toward
cooperation and little incentive for restraint.
The Cold War policy of sharply restricted trade and
broad embargoes against the Communist countries came to
be seen as ineffective in either altering the nature of
their systems or materially improving their policies
toward the Western world.
It was also increasingly
recognized that this policy was counterproductive to
U.S. economic interests for several reasons:
-- East-West trade continued to expand more rapidly
than world trade despite the lack of significant U.S.
participation;
- 5-- Western Europe and Japan were vigorously gaining
access to Eastern markets with government backed credits
which the U.S. continued to withhold; and
-- The U.S. was suffering serious balance-of-payments
difficulties, and increased trade with the East could
generate healthy surpluses.
At the same time, the Soviet Union and the countries
of Eastern Europe came to realize that they could not
provide for increasing consumer demand or meet the
technological requirements of the more sophisticated
economies they were seeking solely from their own
economic resources.
As a result they moved toward
greater economic contact with the West.
Faced with these developments, the U.S. Government
has, in recent years, sought to implement a policy of
detente, in which the attempt to normalize U.S. economic
relations with the Soviet Union and Eastern Europe has
been an important element.
Stronger economic bonds between the U.S. and the
Communist countries have been a critical element of
this policy.
Economic and political relationships are
inevitably intertwined, and improving economic relations
can only develop in the context of a stable political
environment.
But closer economic ties can also help
- 6 create an environment for progress on political issues.
It has therefore been in our economic interest to work to
intensify our economic relationships with the Communist
world.
At the outset of this new approach, we achieved
some notable accomplishments.
In the Moscow Summit in May 19 72 former President
Nixon and Secretary Brezhnev signed the Basic Principles
concerning the development of U.S.-Soviet political
and economic relations.
Among these principles the two
leaders agreed that economic and commercial ties were
an "important and necessary element in the strengthening
of U.S.-Soviet relations."
Following this meeting, the United States began
negotiating a series of agreements designed to improve
our economic relations with the Soviet Union.
Their purpose
was to advance U.S. economic interests and to encourage
parallel improvement in our overall relations with that country.
In July of the same year an agreement providing for
the extension of $750 million in CCC credits to the
Soviet Union over a three-year period was concluded.
- 7 In October the Maritime Agreement was reached opening
40 ports in each country to the flagships of the other and
providing that U.S. and Soviet ships should share equally
and substantially in the carriage of cargoes between the
two countries.
Also in October, the Trade Agreement was concluded
providing for reciprocal extension of most-favored-nation
(MFN) tariff treatment, along with the Lend Lease
Settlement, providing for Soviet payments of $48 million
by July 1975 and of $674 million following U.S. extension
of MFN tariff treatment.
At the same time the President issued a national
interest determination authorizing the extension of
Eximbank facilities to the U.S.S.R.
In Eastern Europe, the Administration acted to
improve trade and economic relations with Romania and
Poland.
Eximbank facilities were restored to Romania
in November 1971 and to Poland a year later.
Following passage of the Equal Export Opportunity
«
Act in 1972, U.S. strategic export controls were reduced
to bring the list of controlled items into closer
conformity with the list of items controlled by our
COCOM allies.
- 8 These developments were generally successful in
advancing U.S. economic interests in East-West trade.
The flow of goods and an exchange of people between our
country and the East increased at an extraordinary rate.
Our commercial presence expanded in Moscow, Warsaw and
Bucharest as U.S. firms established permanent representations there.
The U.S. trade surplus with these countries
grew significantly, totalling more than $2.5 billion with
the U.S.S.R. alone during the 1971-76 period, and
$3 billion with Eastern Europe.
U.S. Impediments to Greater East-West Economic Cooperation
Following adoption of the Trade Act in January 19 75,
including those provisions which adversely affect our
trade with the U.S.S.R. and most of Eastern Europe,
further improvement in our commercial and economic ties
became harder to achieve.
The U.S.-Soviet Trade Agreement
was not entered into force, and the Lend Lease payments
were suspended.
The momentum slowed, costing our economy
•exports and jobs in our export industries.
These provisions of the Trade Act hinder the
development of United States economic activity with the
East by blocking the financing of American exports by
- 9 agencies of the United States Government, and by preventing
most-favored-nation treatment of imports from most of the
nonmarket economy countries.
President Ford and other members of this Administration
made clear our opposition to the discriminatory provisions
at the time the trade legislation was under consideration
in the Congress.
After the legislation was passed,
President Ford publicly and emphatically stated his
belief that remedial legislation was urgently needed.
Section 402 and related provisions of the Trade Act,
and the 1974 Eximbank Act Amendments, have adversely
affected the expansion of U.S. economic cooperation with
the East, and have served neither the political nor the
humanitarian interests of the United States.
A solution to the legislative problem would materially
enhance our business community's efforts to expand economic
relations with the East.
We have had many indications that
the lack of official credits from the U.S. has caused the
U.S.S.R. and some of the Eastern European countries to
direct their purchases elsewhere.
Lost U.S. exports has
meant lost jobs in our export industries, a negative impact
on our balance-of-trade and on our competitive position
in world markets.
- 10 The inability to extend MFN treatment to imports
from Eastern countries has also held back important
forms of economic cooperation, such as major joint
projects between our firms and the U.S.S.R. and
countries of Eastern Europe.
This is because these projects
often involve the eventual export of products to the U.S.
that are now affected by U.S. non-MFN tariffs.
Such
projects, especially with the Soviet Union, could eventually
supply the United States with products in limited supply
in our own market, such as energy sources and products
from energy consuming projects.
Losing these major joint
projects is, therefore, a net loss to the U.S.
On November 30, Secretary Simon and I visited Moscow
to attend the third annual session of the U.S.-U.S.S.R.
Trade and Economic Council with Foreign Trade Minister
Patolichev.
We experienced again, at first hand, the
American business community's strong belief that existing
U.S. law has strongly impaired the development of our
economic and commercial contacts with the Soviet Union.
Based on our discussions, we continue to believe
that intensified economic relationships build a
community of interest which can create an environment
for progress on political issues.
- 11 As the Soviet and American leadership have developed
the spirit of detente it has moved forward on a
diverse set of fronts -- political relationships,
military concerns, scientific developments, trade and
economic cooperation and many others.
parts is related.
Each of these
We should strive to move them
forward in a manner that is self-reinforcing.
Detente must not be seen as a short-term tactic but
rather as a sustained and growing commitment on both
sides.
While recognizing the differences between our
political and social systems, we must work at a broader
definition of detente, one which promotes increased
understanding and concern for the complex of issues -security, humanitarian and economic -- that form the
interface of our relationship.
Within this relationship
our economic interests have become a critical element,
a significant shift from the early 1960fs when they
were barely perceived in and of themselves, at all.
If we are to build a stronger foundation for economic
cooperation with the countries of the East that will
foster mutual benefits, the new Administration must
work with the new Congress in the months ahead to pass
remedial legislation that will remove existing impediments.
- 12 I believe that such a legislative effort should be of
the highest priority.
It is also important to under-
stand, however, that progress on the humanitarian
issues is of deep concern to the American people, and
that the way in which this concern is satisfied will
affect the success of any legislative proposal.
The Basket II text on trade stresses efforts by
states to promote trade and to remove obstacles to trade
development.
While this section provides no firm standard
of conduct because the provisions are couched in general
language, the Agreement nevertheless states that signatories
"will endeavor to reduce or progressively eliminate all
kinds of obstacles to the development of trade."
It is my belief that remedying the problem of the
discriminatory provisions in existing law will further the
economic and political interests of the United States, and
such action would also be consistent with the Helsinki
Final Act.
In addition we must encourage another change in U.S.
law that would remove an unnecessary barrier to the expansion
of U.S. commercial relations with the nonmarket economies of
the East.
The Johnson Debt Default Act of 1934 provides
- 13 criminal penalties for any individual who, within the
U.S., purchases or sells bonds or any other financial
obligations of any foreign government which is in default
in the payment of its obligations to the United States.
The Act has not served its initial purpose, which was to
protect American investors against the purchase of
obligations of countries likely to default.
Instead, it
has had the effect of deterring creative methods of
financing East-West economic activity by the private
market.
The repeal of the Act would, in my opinion,
facilitate the expansion of this trade on commercial
terms.
With regard to our antidumping and countervailing
duty legislation, some of our nonmarket trading partners
have expressed their concern that these may unfairly
hinder their ability to export to the United States.
In fact, the application of the antidumping and countervailing duty statutes to exports from nonmarket economy
countries may provide too much protection.
These
remedies are based on market-economy concepts, and
their application to goods produced in state-controlled
economies requires somewhat arbitrary and artificial
- 14 comparisons of prices and costs.
While I have no
specific recommendations at this time, consideration
should be given to substituting market-disruption
remedies for antidumping or countervailing duties.
Eastern Impediments to Greater East-West Economic Cooperation
While the United States must strive to remove obstacles
to implementation of the goals of Basket II of the Final
Act, the nonmarket economy countries must undertake
parallel efforts.
For instance, the Soviets and East Europeans can do
much to facilitate East-West economic cooperation by
improving the physical facilities available to Western
businessmen in these countries.
A basic limiting factor
in improving business facilities in these countries is
the shortage of adequate physical resources -- office
space, telephones, telex service, good secretarial help,
and living quarters.
Often there is not enough office
space for all who desire it.
Several countries, including
the Soviet Union, are taking steps to provide better
facilities, through construction of modern hotels and
office buildings dedicated to the service of foreign
businessmen.
But much remains to be done.
- 15 There are presently over ten U.S. firms awaiting
accreditation by Soviet authorities to establish permanent
offices in Moscow, in addition to the 24 U.S. firms
already established there.
The Soviets have stated that,
with regard to accredited offices, U.S. firms will receive
treatment no less favorable than that accorded to companies
of other countries.
We are hopeful that accreditations
will be forthcoming as the shortage of office and housing
space improves.
Another area in which significant improvement is
possible concerns the issuance of visas for American
businessmen to enter and leave the Communist countries.
The lack of multiple entry and exit visas for U.S.
businessmen permanently stationed in the U.S.S.R. and
other countries causes considerable hardship and
psychological stress when they have to enter or exit
quickly because of a personal emergency or commercial
necessity.
The Soviets have never accepted our long-
standing proposal that all resident U.S.-citizen
employees of accredited American companies receive
multiple entry and exit visas in exchange for the
issuance of multiple entry visas to all permanent Soviet
- 16 personnel of Amtorg, the Kama Purchasing Commission, Intourist,
and the Trade and Economic Council.
visa requirements.)
(The U.S. has no exit
We have also stressed the need for
such visas for third-country nationals assigned as heads
of accredited offices.
The Soviets have gone part way
to meet our proposals, by granting multiple entry and exit
visas to the two top-ranking U.S. representatives of U.S.
commercial establishments, and the three ranking U.S.
representatives on the Trade and Economic Council, but
they have refused to issue such visas to third-country
nationals representing U.S. firms in the U.S.S.R.
This
has caused considerable concern among some U.S. companies
who wish to assign third-country nationals as their Moscow
representatives.
The Soviets and East Europeans could also do much to
further the goals of the Final Act by making available
up-to-date economic and trade information on a regular
basis.
The Final Act provides that the Participating
States will promote the publication and dissemination of
economic and commercial information at regular intervals
and as quickly as possible, particularly statistics
concerning production, national income, budget, consumption
- 17 and productivity, foreign trade statistics, laws and
regulations concerning foreign trade, and information
allowing forecasts of the development of the economy.
The provision of economic and commercial information,
particularly of a nature that would be useful to Western
business firms and banks, has not, with a few exceptions,
improved greatly in the period since the Final Act was
signed.
With respect to the Soviet Union, there have been
no major changes since Helsinki in the quantity, quality,
and timeliness of statistics and other economic and
commercial information published within the Soviet Union.
There have, however, been some small improvements.
For
example the publication of quarterly trade statistics by
country and the provision to the United States bilaterally,
under the U.S.-U.S.S.R. Agricultural Agreement, of better,
agricultural data.
The U.S.-U.S.S.R. Commercial Commission's Working
Group of Experts, established under the Long-term Agreement
between the United States and the U.S.S.R. to facilitate
economic, industrial and technical cooperation, has also
served as a productive mechanism for obtaining better
statistics and other economic and commercial information
- 18 from the U.S.S.R.
This body is charged with exchanging
information and forecasts of basic economic, industrial
and commercial trends to facilitate economic cooperation between the U.S. and the U.S.S.R.
We have made
progress in obtaining more information through the
Working Group's information exchange program and in
special seminars on Market Research and on the organizational and legal aspects of U.S. and Soviet foreign
trade.
Provision of statistics concerning production,
national income, budget, consumption, and productivity
from most of the nonmarket economy countries continues
to be largely unsatisfactory, however, and no significant change has been evident in the manner of
reporting these statistics since Helsinki.
Balance-of-
payments statistics are especially meager.
Little
data on debt, debt service, or reserves are published.
Although the traditional Eastern European and Soviet
secrecy with regard to basic economic data is slowly
eroding, in many Communist countries, market research
information is simply not available of the kind Western
businessmen are used to having.
Such information is not
gathered, much less published.
In solving this problem,
the provisions of Basket II amount to a nudge in the
right direction, with a long way to go.
- 19 Another major area for improvement in East-West
economic cooperation is with respect to joint ventures
and other forms of industrial cooperation.
The Final
Act aims at cooperation in such fields as manufacturing,
exploitation of energy resources, and improvement of
transport.
The Participating States propose to
encourage this by means of intergovernmental agreements, both bilateral and multilateral, and through
contracts between enterprises and trade organizations.
These would include joint production and sale,
exchange of knowhow patents, and licenses, and joint
research, as well as cooperation on standardization
and arbitration.
Considerable progress had already been made in
these areas before Helsinki, and forward movement
has continued since then, including the recent
conclusion by the United States of a long-term
agreement with Romania on economic, industrial and
technical cooperation.
However, major impediments
remain which the Soviets and East Europeans could
help resolve.
- 20 American businessmen report that Soviet procedures
make it difficult, slow, and costly to do business with them,
requiring much patience and skill.
One of the most frequently
heard comments is that Soviet requests for proposals are not
specific enough; in effect they ask the vendors to tell them
what they need.
This forces the companies to do an
excessive amount of design work before preparing their
tenders.
American companies spend millions of dollars
repeatedly preparing bids, and most complain that the
whole concept and scope of work of the projects keep
changing, wasting time and money.
U.S. executives have also pointed out that the
unwillingness of the U.S.S.R. to allow foreign managers
a role in projects after completion is hurting the
prospects for joint business efforts.
Thus, U.S. hotel
firms will not allow their name on a hotel unless they
have a management role.
U.S. firms also wish to have a
role in quality control of a manufactured product if
their name is to be associated with it.
Some of the East European countries have opened the
possibility of equity participation and management
responsibility in joint enterprises, notably Romania, Hungary and
- 21 Poland.
While this development is very encouraging, the
exact terms of such participation are often unclear and
subject to interpretation.
We applaud what has been done,
but the clarification of such questions is an area in
which more progress can be made.
Existing Bodies Which Facilitate Economic Cooperation
As you are aware, non-government and governmental
bodies are now in existence whose purpose is to help
remove many of these obstacles to the expansion of EastWest economic cooperation.
I am speaking here of the
joint councils, whose membership consists of U.S.
businessmen and their counterparts in many of the
countries of Eastern Europe and in the Soviet Union,
and the government-to-government commercial commissions .
U.S.-U.S.S.R. Trade and Economic Council
In my contacts with the U.S.-U.S.S.R. Trade and
Economic Council, I have been impressed by the important
role this private organization has played in strengthening
economic ties between the United States and the Soviet
Union.
The Council's unique contribution in providing
continuing access for U.S. businessmen to Soviet foreign
trade policy makers at a time when American-Soviet
governmental relations in the economic sphere have been
- 22 strained by the legislative situation, and also by the
repercussions of recent political developments, is
important for the further development of U.S.-Soviet
economic cooperation.
In the three years since its creation in 1973, the
Council has worked to bring together businessmen, offering
a wide variety of services to facilitate their activities,
and organizing expositions, conferences, and seminars.
In
Moscow the Council has offered office facilities to its
hundreds of American members, and has helped them with
advice and information on doing business with Soviet
organizations.
It has explored new forms of international
business cooperation and provided a forum for resolution
of problems and the discussion of new ideas.
The Council has established several committees for
the specialized programs it hopes to implement.
Its
Science and Technology Committee is sponsoring a series
of seminars both in the U.S. and U.S.S.R., the most recent
one being on coal gasification in Moscow in early October.
The Finance Committee plans to inventory non-government
sources of export financing and recommend steps to increase
the amount of financing available from investment banks,
insurance companies, and regional banks.
The Ad Hoc Committee
- 23 on New Forms of Cooperation is exploring such matters as joint
ventures in third countries, marketing training for Soviets
in the U.S., establishment of a bonded warehouse in Moscow
for storage of spare parts and for servicing of equipment,
and Soviet leasing of plants for 15-20 years as a way of
maintaining Western management involvement within Soviet
legal restrictions.
The Tourism Committee is trying to
facilitate and increase tourism in both directions and is
working out a tourism agreement which it plans to present
to the two governments for them to negotiate.
The Legal
Committee is seeking to identify and publicize differences
in the American and Soviet commercial legal systems and to
reduce the extent to which these differences hamper the
development of trade.
All these committees met during the
recent Council meeting I attended.
U.S.-U.S.S.R. Joint Commercial Commission
I have also been directly involved in the activities
of the Joint U.S.-U.S.S.R. Commercial Commission, which
was established during the Moscow summit of May 1972.
The Commission's purpose is to promote the development
of mutually beneficial commercial relations between the
United States and the Soviet Union.
- 24 The accomplishments of the fifth and most recent
session of the Commercial Commission, held in Moscow in
April 1975, serve as an excellent example of the work being
done under its auspices.
The session covered the full
range of issues important to the expansion of bilateral
economic relations.
During the two-day session in Moscow, the members of
the Commercial Commission heard reports and exchanged views
on the status of discussions between Soviet foreign trade
organizations and U.S. companies on a number of cooperation
projects, including exploration for oil and gas, machinebuilding, and the manufacture of energy-consuming products.
The facilitation of visa issuance, including multiple entryexit visas to representatives of organizations, enterprises
and firms for business-oriented travel, was also discussed.
The Joint Commercial Commission has two Working Groups
which met during the Fifth Session.
The Working Group on
Business Facilitation met to discuss various topics, among
them the establishment of joint U.S.-U.S.S.R. stock companies,
visas and travel facilitation, marine cargo insurance, and
a bilateral air worthiness agreement.
-
- 25 The Working Group on Major Projects and Financing
discussed the status of several bilateral projects including
the Occidental Petroleum Chemical Complex and the Kama
Truck Plant.
The Commission also heard a report on the first
meeting of its Experts Working Group, held in February 1975,
in Moscow.
At that meeting, presentations were made by
both sides on the performance and prospects of their
respective economies, industries, agriculture, foreign
trade, and on the data sources used to measure and analyze
their trends and forecasts.
In addition, the Working
Group agreed to undertake a specific program of information
exchange for calendar year 1976, to include joint seminars
and periodic data exchanges which helped clarify and
facilitate solutions to many practical problems encountered
by our businessmen as they undertake economic cooperation
with the Soviet Union.
»
In short, Mr. Chairman, the Trade and Economic Council,
the Joint Commercial Commission and Experts Working Group
have been important vehicles for promoting greater East-West
economic cooperation and have thereby served U.S. policy
interests in East-West relations.
- 26 Because of their usefulness, I believe that the new
Administration should soon propose to the Soviets
a new date for meetings of the Experts Group and the Joint
Commission.
These invitations must be made by our
Government because it is our turn to serve as host for
the meetings.
I am confident that the Soviet Government
will welcome such initiatives.
Conclusion
Mr. Chairman, I have attempted to be as forthright
and as frank as possible in providing you the highlights
of those activities and efforts undertaken by this
Administration, and which should be taken by the new
Administration, to expand East-West economic cooperation
in keeping with the terms of Basket II of the Final Act.
I have also outlined those areas in which we should look
for positive movements by the nonmarket economy countries
which are signatories to the Helsinki Agreement.
It is an opportunity that I personally have welcomed.
Basket II of the Final Act provides countries in the East
and West with a foundation on which they can build
stronger ties through closer economic, scientific and
technical cooperation.
My experience as Assistant
Secretary of the Treasury has convinced me that these
ties are vital for the long-lasting peaceful relations
we all seek.
- 27 As this Commission works in the future for further
implementation of the provisions of Basket II of the
Helsinki Agreement, I urge you to continue to strive
for measures that will remove obstacles to the
expansion of East-West trade.
FOR IMMEDIATE RELEASE
Contact: L.F. Potts
Extension 2951
January 14, 1977
SIMULTANEOUS WITHHOLDING OF APPRAISEMENT
AND DETERMINATION OF SALES AT LESS THAN
FAIR VALUE WITH RESPECT TO
CLEAR SHEET GLASS FROM ROMANIA
Under Secretary of the Treasury Jerry Thomas announced
today a three-month withholding of appraisement and
simultaneous determination of sales at less than fair value
with respect to clear sheet glass from Romania. Notice of
both tnese actions will appear in the Federal Register_ of
January 17, 1977.
The case has been referred to the U.S. International
Trade Commission for a determination as to whether an
American industry is being, or is likely to bo, injured.
in the event of an affirmative injury determination,
dumping duties will be assessed on all entries of the subject merchandise on which such affirmative determination
is made and where dumping margins exist.
No request for a 6-month withholding of appraisement
having been received, known interested pernor- were
afforded the opportunity to present oral and written
views prior to these determinations.
Imports of the subject merchandise from Romania
during the period January through September 1?'76 were
valued at roughly $3.2 million.
* * *
WS-1262
FOR IMMEDIATE RELEASE
January 14, 1977
Contact: Jay Scheck
566-5561
CHANGE IN TAX REGULATIONS DEFINING PARTNERSHIPS NO
LONGER TO BE CONSIDERED
Secretary of the Treasury William E. Simon announced
today that the Department of the Treasury is no longer
considering a proposed amended regulation classifying
organizations, including the defining of partnerships, for
purposes of federal taxation.
In a statement on the subject, the Secretary said:
"On January 6, 1977, in order to permit consideration of
certain aspects of the proposed amended regulations classifying organizations for purposes of federal taxation, I
directed withdrawal of those proposed regulations. Having
now considered the matter further, I have concluded that
the amendment should not be reproposed.
"The existing regulations on the subject will remain
in force, and the Internal Revenue Service will be able to
continue its past practice of issuing rulings pursuant to
those regulations."
oOo
WS-1263
Department theTREASURY
WASHINGTON, D.C. 2
TELEPHONE 566*20*1
FOR IMMEDIATE RELEASE
J a n u a r y iy>
19??
RESULTS OF TREASURY'S WEEKLY BILL AUCTIONS
Tenders r;or $2,402 million of 13-week Treasury bills and for $3,510 million
of 26-week Treasury bills, both series to be issued on January 20, 1977,
^ereaccepted at the Federal Reserve Banks and Treasury today. The'details are
as follows:
RANGE OF ACCEPTED
* 13-week bills
COMPETITIVE BIDS: ^'maturing April 21, 1977
26-week bills
maturing July 21, 1977
Discount Investment
Price
Price
High
Low
Average
98.828 a/
98.818
98.820
Rate
4.636%
4.676%
4.668%
Rate 1/
4.76%
4.80%
4.79%
Discount
Rate
Investment
Rate 1/
97.545 b/ 4.856% 5.05%
97.537
4.872%
5.06%
97.539
4.868%
5.06%
excepting 1 tender of $750,000
Excepting 1 tender of $10,000,000
Tenders at the low price for the 13-week bills were allotted 22%.
Tenders at the low price for the 26-week bills were allotted 55%
TOTAL TENDERS RECEIVED AND ACCEPTED
BY FEDERAL RESERVE DISTRICTS AND TREASURY:
..ocation
Received
toston
$
39,370,000
3,873,840,000
lew York
19,185,000
'hiladelphia
32,305,000
Cleveland
Richmond
26,340,000
.tlanta
20,850,000
hicago
260,370,000
t. Louis
48,110,000
13,340,000
inneapolis
ansas City
40,595,000
alias
19,335,000
an Francisco
355,555,000
reasury
TOTALS
75,000
$4,749,270,000
Accepted
$
19,870,000
2,148,740,000
17,780,000
31,500,000
14,740,000
19,570,000
40,410,000
22,440,000
7,340,000
34,825,000
14,335,000
30,570,000
: Received
; $
50,215,000
: 6,491,705,000
:
105,190,000
138,275,000
::
95,835,000
;:
63,870,000
:
:
294,960,000
:
43,025,000
21,385,000
j
16,955,000
:
37,265,000
:
447,520,000
:
$
28,715,000
3,283,360,000
5,190,000
9,275,000
49,085,000
9,260,000
58,260,000
13,130,000
3,385,000
12,955,000
13,265,000
24,020,000
95,000
95,000
75,000 :
$2,402,195,000 cy. $7,806,295,000
^eludes $ 313,625,000 noncompetitive tenders from the public.
^eludes $128,580,000 noncompetitive tenders from the public.
quivalent coupon-issue yield.
1264
Accepted
$3,509,995,000d/
REMARKS BY TREASURY SECRETARY-DESIGNATE W. MICHEAL BLUMENTHAL
DETROIT ECONOMIC CLUB
COBO HALL, JANUARY 17, 1977
When I accepted the invitation to speak today, I planned
to discuss the Michigan Economic Action Council. Since then,
circumstances have changed somewhat and so I have a few other
things to say as well.
I am not here to say good-bye. My family and I have roots
in Michigan, we're not really going ro pull them up — we're
just going to stretch them a bit. But going to Washington, as
challenging and exciting as the opportunity is, does mean
that we won't be seeing many of you quite as frequently as before,
I won't be working with you — at least not in the same way —
on MEAC and other projects, and I will be seperated from my
colleagues at Bendix.
I was pleased to be introduced by Bill Agee. I only hope
that some of my other new colleagues in Washington will leave
their old jobs in private life feeling even half as confident
about their successors as I feel about mine.
It is reassuring to know that Bendix will be in the
hands of a man like Bill Agee. And I say that not only for
what Bendix means to me, but for what it and other healthy,
growing businesses in Michigan mean to the goal cf moving this
State in significant new directions.
When I accepted the chairmanship of MEAC, I did so for^
the same reasons so many distinguished and influential Michigan
leaders agreed to serve: we could see the compelling need -co
soften the roller coaster ride the Michigan economy suffers
because of our exaggerated sensitivity to national business
cycles.
Today I want to make a comment about the spirit of
MEAC. I mean the quality of responsiveness, cooperation and
common commitment which many organizations strive for and
few attain.
2
It began with the Governor, the Speaker and the Majority
Leader rising above their partisan differences to advance
the best interests of all the people of this State. That
spirit of unity spread — we had business leaders and labor
leaders, we had academicians, urbanites and farmers, media
people and money people, representatives from the tourist
and recreational industry, all moving together, working
together — in this case to improve our economy.
Working together we achieved unanimous agreement
on twenty-four recommendations as to things we can do to
provide stable long-term growth in our State economy. I
urge you to work for the implementation of those recommendation
to keep them going. I want to highlight two specific points
which I think are the most significant.
First is the Budget Stabilization Fund which we have
proposed as a leveling device to help counter fluctuations
in State revenues. As you know, Michigan's Constitution
obligates the State to maintain a balanced budget. Its
principal source of revenue is the State income tax, of
course, and when we have an economic downturn, our revenues
drop, and simultaneously the demand for human services
programs goes up.
The proposed Stabilization Fund would put aside a
portion of its revenues during years when personal incomes
are high and unemployment low and then to spend that money
during years of recession. This would require fairly
rigid formulas and controls over the process and these
are reflected in the bills being introduced now into the
legislature. Of all the recommendations of MEAC, I think
that this one represents the best hope for easing the
exaggerated swings in the Michigan business cycle and
their effects on State revenues.
The second recommendation I would highlight is that of
diversifying the economic base of the State. MEAC agreed
that there are two specific kinds of employers which should
be attracted to create new jobs: service industries not
dependent on a specific geographic location, and high-technology,
fast-growth industries. Michigan has been getting some hightechnology industry, but we haven't begun to realize our
potential. The Council specified a series of actions which
the State could take, both through its industrial expansion
programs and its other policies, such as business taxation,
3
that would make Michigan an even more attractive location to
such employers as, for instance, the regional offices of
insurance companies. These are the types of businesses we
or rather, you — must work to bring to Michigan.
The Council also recommended programs to help with the
financing and advising of small, entrepreneurial business,
in particular those with a high technological orientation.
Such industries often have a high mortality rate because of
lack of business experience. So the Council made a series
of recommendations on how to increase the efficiency and
size of the venture capital market for Michigan industries
and on how to create or improve existing programs of
assistance to small business.
I want to make it clear that I have not singled out
these two subjects because I think the other recommendations
of the Council are unimportant. To the contrary, I think
that they should all be vigorously pursued.
I had hoped and expected to take an active hand in the
effort to follow through on these ideas. My intention, in
fact, was not only to urge you and other people in the State
to work for their implementation, but also to spend as much
time as I could in Lansing myself on the Council's business.
Mow, of course, that is no longer possible, - you might say
because of a funny thing happened to me on the way to Lansing! In Washington, naturally, I find myself looking at Michigan's
economic problems, and indeed at the nation's economic problems,
from an entirely different perspective.
There is some irony in this situation, because we made a
great point, during our MEAC deliberations, of concentrating
on recommendations which could be implemented at the State
level and still have a real impact on the problems we were
trying to address. We were very much aware that there are
limits to local action and that the crucial decisions affecting
our economy would be made on the federal level, but we determined
to focus on what we could do on our own. We felt that this was
in the American tradition of self-help and we knew that one more
voice added to the chorus in Washington would have less chance
of being heard than if the message were delivered directly to
Lansing.
Now, however, I find myself in the unexpected position of
addressing precisely those problems which we deliberately ruled
4
out of our MEAC deliberations, — because they involved action
on the Federal level. To paraphrase Pogo, I can now say that
I have met the enemy - and it is I.
Such a change of perspective can be disconcerting, but I
must say that the spirit of our work in the Michigan Economic
Action Council is very happily alive in the team we have been
putting together in Washington. Governor Carter is deeply
committed to an open government, a government in which
decisions are made in an atmosphere of cooperation and
communication, not of secrecy. This is a philosophy and
an approach which I find personally congenial, — but it is
one which in the past, I fear, has only too rarely been
found among senior government officials. Whatever else we
achieve — and we are well aware of the difficulty of the
tasks before us — we now have an opportunity for a new
beginning, under a President who
believes that govern- lament must find its way back to the kind of participation and
cooperation we had in the Michigan Economic Action Council.
As an example, I should tell you that I will leave here
this afternoon and go to visit the local facilities of the
Treasury in Detroit. I want to meet the Treasury people
there, get to know them and give them access to me. I am
told that this is the first time a Secretary of the Treasury
has ever gone to visit these installations, and I think
it's time that we put an end to that kind of isolation.
It will be a hallmark of the Carter Administration to try
to break out of the sometimes artificial isolation of
Washington. I will begin the process in the Treasury
Department this afternoon, and my colleagues will continue
it along with me during the rest of this Administration.
At the same time, there will be greater stress on
increasing the efficiency and effectiveness of government,
goals which are a natural outgrowth of the closer communication
we are seeking. There is no law which says that government
must be slow moving and unresponsive — anymore than there
is a law which says that it must be inaccessible. Americans
in government are in no way inherently less efficient than
those who work in private industry. They are certainly no
less capable of doing a good job and being proud of their
work. We must ensure that the environment in which they
work allows them to find a reward, to develop a sense of
pride and to avoid burying their efforts in a bureaucratic
morass in which no one believes.
5
Along with these Carter Administration goals of openness
and efficiency, there is another: we intend to be practical.
We propose to take initiatives which are responsible, measured
and gradual in their impact. While they may be bold in concept,
they will be careful in execution. And they will not be oversold
We will not pretend to have a miracle cure in our quest
for a healthy diet leading to eventual full recovery. The
new Administration is acutely conscious of the need not to
raise false hopes, and not to indulge in hyperbolic
descriptions of what can be done in a brief period of
time. We will make changes and we will move forward,
but our country's problems are deep and long-standing
and — since openness also implies frankness and truth —
we will not pretend that they can be solved overnight or
that we will not have difficult choices to make.
So, I have no hesitation in defining the spirit in
which we begin our work. We want to be open. We want to
be efficient. We want to proceed pragmatically and with
care. And we want to be truthful about our failures, as
well as our successes. But what about our agenda? Since
Governor Carter has not yet become President Carter it is
perhaps a little early to attempt to answer that question
precisely, - but - if I may confine myself to the problems
of the economy — I think the President-elect's priorities,
and the outlines of his program, are clear.
To begin with, we need growth. "Growth with stability."
This is the formula we used in Michigan and it can be applied
just as aptly to the country as a whole. Our economy is
recovering from the very severe recession of 1974-1975,
but it is recovering too slowly. Output is rising again,
but not fast enough. We need more jobs for a constantly
expanding work force. We need more and better housing.
But, the essential point is that we cannot begin to meet
any of these needs adequately if our economy is not moving
ahead and growing in a healthy way.
By healthy growth, of course, I mean growth without
inflation. Nothing can be more damaging to our society
than the high level of inflation such as we experienced in
recent years, — especially in 1973 and 1974. Such a rise
in costs and prices distorts more than our business and
financial operations. It leads eventually to dislocations.
We believe that growth can take place without necessarily
triggering inflation.
It can and it must, — because the level of unemployment
we have experienced in this country in recent years is ^
intolerable. Nothing, it seems to me, can be more imp-M^a u,
6
nothing is more urgent, than to provide employment for all
those who are able and willing to work.
The problem with most discussions of unemployment is
that they deal with statistics, — statistics which often
hide as much as they reveal. We say, for example that
our goal is to lower the unemployment rate from the
presently unacceptable level of 7.9 percent to more
tolerable rates. As a measure, unemployment statistics are
meaningful. But behind these numbers, which represent
national averages, there is a social reality, — and this
is what we must grasp if we are to understand why the new
Administration has identified unemployment as the most
urgent problem on the national agenda.
>.
The social reality we must grasp can be illustrated by
other numbers which are very different — and much less
abstract — than the national average. We must realize,
for example, that unemployment rates are higher for females
than for males and also higher for non-whites than for whites
across all age groups. We note, too, that unemployment for
teenagers, both black and white, averages about 19 percent
and that for black teenagers in the poverty areas of our
cities, the unemployment rate is currently about 40 percent.
The situation we are dealing with, in other words, is
not only tragic and socially dangerous — it is also extremely
complex. And this complexity means that not one but a variety
of approaches is required.
So called macro-economics measures, for example, — the
kind which stimulate the economy generally across the board —
will be useful in reducing unemployment among trained, mature
working people who are standing, so to speak, at "the head of
the line" and are ready, willing and able to enter or re-enter
the labor force.
Such measures may, indeed, have the effect of expanding
total employment, — and this, of course, is important and
good. In our economy each percentage point of real growth
in the GNP will provide something in the order of 500,000
jobs and, since it is the private sector which accounts for
five out of six of these jobs, it is essential that we
encourage the capital investment which makes the private
sector grow.
7
So far so good, — but far from good enough! This growth,
unfortunately, will have little or no effect on those who are
not standing at the head of the employment line, — nor on
certain regions, certain categories, certain age-groups, in
short, on the so-called "hard-core." For these people a
different approach is needed, — one which aims not at the
overall economy and its rate of growth but rather, specifically,
at them — as people.
To talk about unemployment in these terms, of course,
inevitably invokes the plight of our cities. This is a larger
subject which transcends merely economic terms, yet, the
economic aspects of the so-called urban crisis — middle
class and blue collar flight from the city, tax base shrinking,
essential services cut back, industry moving out, — all add
up to one statistic: unemployment for those who are left
behind. It breeds despair, frustration and bitterness, —
and they in turn breed social decay and crime. These lead to
increased public expenditures which have to be paid from increased taxes which accelerate the flight of the middle
classes, so that we have the familiar downward spiral which
affects so many of our great cities and threatens the quality
of our civilization itself.
To begin to address these complex and interrelated issues,
the President-elect has already proposed an economic stimulus
package. It includes a variety of measures, such as a tax
rebate and a permanent individual tax cut, programs to encourage
corporate investment and others directly aimed at putting young
people and the so-called hard-core unemployed to work.
No one believes that these programs offer a panacea.
But they do represent a beginning, a carefully
beginning, in what must be seen as a long and difficult task.
In the spirit I attempted to define a few moments ago — the
spirit of initiatives and careful execution — we must be
prepared to monitor the various programs in our so-called
stimulus program, and adjust them to changing conditions if
necessary.
In the meantime, of course, we cannot forget that —
beyond the immediate need to accelerate our economic recovery
additional programs will have to be developed. The problem of
tax reform, in particular, is very high on our agenda. We,
for example, are determined to find practical, effective ways
to simplify the system. There is something very wrong, it
seems to me, in the fact that a middle-income wage earner
8
must hire an accountant in order to complete his tax return.
Tax reform also should address making the system more
equitable. Another goal would be to help it stimulate growth
by encouraging investment in the private sector, in a word,
we believe that the American people should not be working
for the tax system. The tax system should be working for
them.
The steps we are taking to move the economy and strengthen
the recovery will cost money, and we are keenly aware that the
deficit we are inheriting from the previous Administration is
excessively large. But the consensus over the broad spectrum
of economists and businessmen is that under present conditions,
with much under-utilized capacity in the economy, it is
entirely possible to apply this stimulus without rekindling
the flames of inflation. And we know that we cannot begin to
do the nation's business, to meet our responsibilities
domestically and internationally, — nor hope to move forward
balancing the federal budget in the foreseeable future —
unless our economy achieves and maintains a higher rate of
growth.
Before concluding, let me refer briefly to the relationship
of all this to the situation abroad. The slow recovery in the
United States has been matched by an even more sluggish
condition in Europe and Japan. This is a matter of concern
to us because we are, increasingly, in a global economy, and
economic weakness in one area inevitably affects all the
others. Payments imbalances, weak currencies, lagging
invesment programs, — all these interreact in a global
economic setting. They stifle trade and create unfavorable
atmosphere for growth and for the solidarity we need if we
are successfully to deal with' our common problems.
We have assigned the highest priority to our domestic
economic problems for a simple and obvious reason: our own
house must be put in order if we are to properly play our
role in the rest of the world.
Looking back over the past decade or so it seems to
me that somewhere, somehow, our country lost its way. we
have been too long off course, and historically, our recent
election will be seen as the beginning of a national effort
to recover our momentum and our sense of purpose. What
matters is not merely that we have a new Administration.
What matters is that we are turning to the future. We
are making a new start.
9
•
That, at least, is our intention, — and it is time
to recall that we are still the greatest and richest
country in the world and that we have the power to make
good on the promise we still represent — the promise of
peace and justice and a better life for the common man —
which we still represent in the eyes of the world
0O0
For Immediate Release
January 18, 1977
TREASURY PUBLISHES "BLUEPRINTS FOR
BASIC TAX REFORM"
Secretary of the Treasury William E. Simon today
released results of a year-long study of fundamental reform
of the Nation's tax system.
The report, "Blueprints for Basic Tax Reform," presents
two model plans for tax returns: a broadly based income
tax, called a "comprehensive income tax," and an alternative
plan for a tax based on consumption/ called a "cash flow
tax." Either plan would be much simpler, fairer, and more
efficient than the present system.
"Tinkering is no longer the answer," Simon said in the
foreword of the report. "We must design an entirely new tax
system, adopt it as an integrated whole, with a much broader
tax base but with much lower and simpler rates so that it
will be widely accepted and so that all can share its advantages. "
Both reform proposals would broaden the tax base,
reduce tax rates, and allow larger personal exemption. The
comprehensive income tax plan calls for integration of the
corporate and personal income taxes, taxation of capital
gains at full rates after allowing an adjustment for inflation, and taxing many other items that presently are not
taxed. In place of the existing complex rate structure,
with rates ranging from 14 to 70 percent, the model plan
has only three rate brackets, ranging from 8 percent to
30 percent.
The cash flow tax differs from an income tax in excluding
savings, although the withdrawal of savings for consumption
of goods and services would be taxed. This model also has
three tax brackets with rates from 10 to 40 percent. Because
the present income tax system has many important similarities
to the cash flow tax, the change to this model would not be
as great as it might seem.
°0°
WS-1266
blueprints for
Basic
January 17,1977
blueprints for Basic T a x R e f o
January 17,1977
Department of the Treasury
THE SECRETARY OF THE TREASURY
WASHINGTON 20220
FOREWORD
In December 1975, in a speech to the Tax Foundation, I
called for a fundamental overhaul of the U.S. tax system.
I felt that I was speaking for millions of Americans who
were fed up with the current tax system and wanted it
replaced with one they could understand and trust. I noted
that we need to return to the basic principles upon which
our income tax system was founded and the three cornerstones
of its structure — equity, efficiency and simplicity. I
said we need to wipe the slate clean of personal tax preferences,
special deductions and credits, exclusions from income and
the like, and impose a single, simple progressive tax on all
individuals. In the months that have passed since that
speech, I have received overwhelming evidence that this is
indeed the way the American people feel.
It is time to start over from scratch and develop a new
tax system in the United States. It must be a system that
is designed on purpose, based on a clear and consistent set
of principles, which everyone in the United States can
understand.
During the past year, at the same time my staff and I
were working with the Congress on the Tax Reform Act of
1976, we were also engaged in a major study, which we called
the "Basic Tax Reform" study. We began by examining the
concept of "income" and what it can and should mean as the
base for Federal taxation. We looked at all the transactions
and circumstances that produce what we commonly think of as
"income," and we also considered "income" from the standpoint
of its uses — its value to those receiving it.
We then tried to develop an ideal income base that took
into account all possible forms of income but that equally
considered practical realities and the overriding importance
of a simple tax system. Our "real-world" implementation
reflects many compromises and modifications that we have
discussed explicitly in the study so that everyone can
evaluate our judgments and our conclusions.
Our report — Blueprints for Basic Tax Reform —
presents the results of this year-long study. It gets down
to the fundamentals.
This report presents two specific model tax systems.
The first is a plan for broadening the base of the income
tax. It calls for integration of the corporate and personal
income taxes, taxation of capital gains at full rates after
allowing an adjustment for inflation, and taxing many other
items that presently are not taxed. In place of the existing
complex rate structure, with rates ranging from 14 to 70
percent, the model plan has only three rate brackets,
ranging from 8 percent to 38 percent.
The second model is based on consumption and is called
a cash flow tax. It differs from an income tax in excluding
savings, although the withdrawal of savings for consumption
of goods and services would be taxed. This model also has
three tax brackets with rates from 10 to 40 percent.
Because the present income tax system has many important
similarities to the cash flow tax, the change to this model
would not be as great as it might seem.
After years of seeking to reform the tax system, I am
convinced that tinkering is no longer the answer. We must
design an entirely new tax system , adopt it as an integrated whole, with a much broader tax base but with much
lower and simpler rates so that it will be widely accepted
and so that all can share its advantages. This report is a
start toward this objective. It demonstrates clearly that
we can construct a fair, efficient progressive tax system in
the United States.
Responsibility for preparation of this study was taken
by Assistant Secretary for Tax Policy Charles M. Walker.
Deputy Assistant Secretary William M. Goldstein provided
important counsel. Primary work on this project was undertaken
by Deputy Assistant Secretary David F. Bradford. Mr. Bradford
and the staff of the Office of Tax Analysis are due special
recognition for their professional expertise and special
thanks for their devotion to this task.
Washington, D.C.
January 1977
DEPARTMENT OF THE TREASURY
WASHINGTON, D.C. 20220
SSISTANT SECRETARY
ACKNOWLEDGMENTS
public fiance e c o n o m K t t h a n P J ? J e ^ - m 0 r e *BP«"-ng to a
staff of the UniSd States S n f r C t i n g t h e Professional
study of income 2 5 r 2 o ™ D e P a r t m e n t of the Treasury in a
Simon asked Assistant S e S e t a J v ^ f9° S e c r e t a r y William E.
Walker t0 p r e a r e
a Plan to simplify Ehe a x v l ^ " n
?
AS De utv
Secretary and Director «?.-£-!.«•
P
Assistant
f T a x Ana
asked to lead this e?L?f
S . S ^ °
lysis, I was
for Basic Tax Reform^- tL main o h S P u b l i c a t i ° n of "Blueprints
accomplished, and i? is £v Sf±" objective of the project is
superb efforts of tnose w h o ^ d ^
*°Z *S a c k n o w l edge the
pages of the report
S°
V ° m U C h ° f t h e w o r k ' The
effort, much l?±l a S £ ± 2 d u r ? n ^ ° f - a t r e m e n d °us cooperative
9 SVeninqs and
by many dedicated people
weekends,
y
B t r
e
caipeJ? L'^S DJSSS o f S. TtdlTAil 1STdirecSvlo^H ^ aCUmen 3S a tax°fnalys?fcontr^tedS1SS S c S j TorToIrtiTriZth/S
, SSnSe ° f h U m ° r -fenormous
^^iSiS'SS KrrKdS S^£/3°Sxwere
SeSSSvicCeh?rlSe^r S^SL^ £ C£~
throughout the report.
renected
Nelson McClung took principal responsibility for
Sco?t iurL?6 d^aDbaSS f°r th^ StUd^' -upportS g'j.
sSulat?onf' r l t h .°„ Jyscarver manning the computer
simulations. Gary Bobbins kept the project moving toward a
o?q^C%°f ^nmeetable dea<31ines. R?n Garbin S^the Office
of Computer Science, Office of the Secretary, provided
programming support.
_".uv_.u<_a
Th
Sarly
round
<-*_> ®
9
work for the study was developed with
SS1St n e
Se mour
S^l
^ Z ^
Y
Fiekowsky, Nelson McClung, Hudson
ptih i ^nd Ralph Bristol of the Office of Tax Analysis, and
Kicnard Koffey, now Deputy Tax Legislative Counsel.
Many others, inside and outside the Department of the
Treasury, contributed to the work. These include Peter
Cook, John Copeland, Daniel Feenberg, David Flynn, Geraldine
Gerardi, Gary Hufbauer, Michael Kaufman, Thomas King, Allen
Lerman, Howard Nester, Gabriel Rudney, Jay Scheck, Eugene
Steuerle, Walter Stromquist, and John Wilman, all members of
the Office of Tax Policy Staff. Joseph Foote of Washington,
D.C., Peter Mieszkowski of the University of Houston, Harvey
Rosen of Princeton University, Richard Barr of Southern
Methodist University, and Ann Bergsman of Hendrickson
Corporation brought their special knowledge to bear on the
problems we confronted. Others outside the Treasury who
assisted in various ways include William Andrews, Martin
Bailey, Edwin Cohen, Martin Feldstein, Frederic Hickman,
Daniel Halperin, Bernard Saffran, Emil Sunley, Nicholas
Tideman, and Alvin Warren.
Finally, for their unsurpassed skill, never ending
patience and cheerfulness, deepest thanks to Rosalind Carter
and Kathi Cambell who typed and typed and typed and ....
David F. Bradfiprd (
Deputy Assistant Secretary
for Tax Policy (Tax Analysis)
Washington, D.C.
January 1977
TABLE OF CONTENTS
Chapter 1:
INTRODUCTION AND SUMMARY OF THE REPORT
OVERVIEW 2
COMPREHENSIVE INCOME TAX. . . . _ ." . . . . [ [ [ ] ......
Integration of the Corporation and Individual
Income Taxes
Treatment of Capital Gains and Losses
Depreciation Rules
State and Local Bond Interest
Imputed Income from Consumer Durables
Itemized Deductions
Retirement Income and Unemployment Compensation...
Choice of a Filing Unit and Exemptions for
Family Size
CASH FLOW, CONSUMPTION BASE TAX
Advantages of a Consumption Base
How a Consumption Base Could Be Taxed
Similarities to the Present Tax Base
Treatment of Investments in the Model Plan
Other Features of the Cash Flow Tax
The Filing Unit and Tax Rates
TRANSITION PROBLEMS
HOW AN INDIVIDUAL WOULD CALCULATE TAX LIABILITY
UNDER THE REFORM PLANS
Elements Common to Both Plans
The Comprehensive Income Tax
The Cash Flow Tax
CHAPTER-BY-CHAPTER OUTLINE OF THE REMAINDER OF THE
REPORT
Chapter 2: WHAT IS TO BE THE TAX BASE?
INTRODUCTION 21
TWO PRELIMINARY MATTERS OF EQUITY
Equity Over What Time Period?
Is the Family or the Individual the Appropriate
Unit?
INCOME AND CONSUMPTION
Definitions of Income and Consumption
THE PRESENT TAX BASE
Is the Present Base Consumption or Income?
Is the Tax System Presently on an "Abilityto-Pay" or a "Standard-of-Living" Basis?
[ [ [ [ [ ]]
4
5
6
6
7
7
7
8
9
9
10
10
11
11
12
13
13
13
14
14
15
24
24
25
26
27
33
33
36
ALTERNATIVE BASES: EQUITY CONSIDERATIONS
Consumption or Income: Which is the Better
Base?
"Standard-of-Living" or "Ability-to-Pay":
Which Criterion?
Summing Up: The Equity Comparison of Consumption
and Income Bases
ALTERNATIVE TAX BASES: SIMPLICITY CONSIDERATIONS...
Consumption or Income Preferable on Grounds of
Simplicity?
Measurement Problems
"Standard-of-Living" or "Ability-to-Pay"
Preferable on Simplicity Grounds?
EFFICIENCY ISSUES IN A CHOICE BETWEEN AN INCOME
AND A CONSUMPTION BASE
SUMMING UP
Chapter 3: A MODEL COMPREHENSIVE INCOME TAX
OVERVIEW 53
Purpose of the Model Tax
Base-Broadening Objective
Organization of Chapter 3
EMPLOYEE COMPENSATION
Expenses of Employment
Employer-Provided Pensions
Social Security
Employer-Paid Health and Casualty Insurance
Disability Insurance
Life Insurance
Unemployment Compensation
PUBLIC TRANSFER PAYMENTS
Model Tax Treatment
Rationale for Taxing Transfer Payments
Valuing In-Kind Subsidies
BUSINESS INCOME ACCOUNTING
Basic Accounting for Capital Income
Capital Consumption Allowances
Self-Constructed Assets
Other Business Income Accounting Problems
INTEGRATION OF THE INDIVIDUAL AND CORPORATION
INCOME TAXES
The Corporation Income Tax
Inefficiency of the Corporation Income Tax
A Model Integration Plan
Administrative Problems of Model Tax
Integration
38
38
41
41
42
43
44
48
49
51
53
53
54
54
55
56
58
59
59
60
60
61
61
62
63
63
63
64
66
67
68
68
68
69
73
The 1975 Administration Proposal for Integration..
CAPITAL GAINS AND LOSSES
Accrual Versus Realization
!!!!!!!!!
Present Treatment of Capital Gains
//.......
Model Tax Treatment of Capital Gains
Capital Losses
Taxation of Accrual in the Model Tax
Accrual Taxation Alternative
Realization-With-Interest Alternative
The Income Averaging Problem
f. Inflation Adjustment
STATE AND LOCAL BOND INTEREST
Inefficiency of Interest Exclusion
Inequity of the Exclusion
Alternatives to Tax-Exempt Bonds
OWNER-OCCUPIED HOUSING
Imputed Rental Income
Deductibility of Homeowners1 Property Tax
Deductibility of Mortgage Interest
Consumer Durables
MEDICAL EXPENSES
'
Model Tax Treatment
"Tax Insurance" Under Present Law
Optional Catastrophe Insurance Provision
STATE AND LOCAL TAXES
Income Tax Deductibility
Property Tax Deductibility
Sales Tax Deductibility
Alternative Treatment of Sales and Income T a x e s —
Benefit Taxes
CONTRIBUTIONS TO CHARITIES
Charity as Income to Beneficiaries
Charities as Public Goods
A Practical Alternative to Taxing Charitable
Organizations
Alternative Tax Incentives for Philanthropy
CASUALTY LOSSES
Model Tax Treatment
Present Law Treatment
'.
INTERNATIONAL CONSIDERATIONS
The Residence Principle
Establishing the Residence Principle
Interim Rules
THE FILING UNIT
Model Tax Treatment
Problems of Taxation of the Filing Unit
Choice of the Filing Unit
75
75
75
76
77
79
79
81
81
82
83
84
84
84
85
85
85
86
88
89
89
90
90
91
92
93
93
93
94
94
95
95
96
96
97
97
97
98
98
98
99
10
°
101
102
102
103
The Problem of Secondary Workers
Tax Adjustments for Differences in Family Status..
ADJUSTING FOR FAMILY SIZE
Exemptions Versus Credits
SAMPLE COMPREHENSIVE INCOME TAX FORM
Chapter 4: A MODEL CASH FLOW TAX
INTRODUCTION
Cash Flow Accounting
ELEMENTS IN COMMON WITH THE COMPREHENSIVE INCOME
TAX
Family Size and Family Status
Deductions for Charitable Contributions, Medical
Expenses, and Taxes
Health, Disability, and Unemployment Insurance
Casualty Losses
DIFFERENCES BETWEEN THE CASH FLOW TAX AND THE
COMPREHENSIVE INCOME TAX
The Treatment of Assets Under a Cash Flow Tax
Equivalence of Qualified Account Treatment and
Tax Prepayment. Approach
Treatment of Borrowing and Lending
Advantages of Taxpayer Option Treatment of Asset
Purchases and Borrowing
Lifetime Perspective of the Cash Flow Tax
Uncertain Outcomes: A Problem with the TaxPrepayment Approach
No Optimal Treatment for Nonfinancial Business
Assets
DIFFERENCES BETWEEN CASH FLOW AND COMPREHENSIVE
INCOME TAXES : SPECIFIC PROVISIONS
Pension Plans and Social Security
Life Insurance
State and Local Bond Interest
Interest Paid
Corporate Income
Capital Gains and Losses
Business Income Accounting
SPECIAL PROBLEMS: PROGRESSIVITY, WEALTH
DISTRIBUTION, AND WEALTH TAXES
Progressivity of the Tax
INFORMATION ON SAMPLE TAX FORM FOR CASH FLOW TAX
Chapter 5: QUANTITATIVE ANALYSIS
THE DATA BASE 145
104
105
106
106
107
113
113
116
116
116
118
118
119
119
123
124
125
127
128
130
131
131
131
133
133
133
134
135
136
136
140
ESTIMATION OF THE INCOME CONCEPTS
Ecpnomic and Comprehensive Income
Present Law Tax
A Proportional Comprehensive Income Tax
THE MODEL COMPREHENSIVE INCOME TAX
THE CASH FLOW TAX
COMPARISONS OF TAX LIABILITIES UNDER THE DIFFERENT
PLANS
The Marriage Penalty
Lifetime Comparisons
Chapter 6: TRANSITION CONSIDERATIONS
INTRODUCTION 181
WEALTH CHANGES AND THEIR EQUITY ASPECTS
Carryover Problems
v
Price Changes
The Equity Issues
INSTRUMENTS FOR AMELIORATING TRANSITION PROBLEMS
Objectives
Alternatives
PROPOSED SOLUTIONS TO SELECTED PROBLEMS IN THE
TRANSITION TO THE COMPREHENSIVE INCOME TAX
Capital Gains
Corporate Integration
Business and Investment Income, Individual and
Corporate
Other Individual Income
TRANSITION TO A CASH FLOW TAX SYSTEM
Goals of Transition
Distribution Issues
A Preliminary Transition Proposal
Alternative Transition Plans
BIBLIOGRAPHY 217
147
154
156
159
159
167
172
172
176
181
182
183
185
188
188
189
191
192
194
200
201
204
205
206
209
211
BLUEPRINTS FOR BASIC TAX REFORM
Chapter 1
INTRODUCTION AND SUMMARY
OVERVIEW
There has been increasingly widespread dissatisfaction
in the United States with the Federal tax system. Numerous
special features of the current law, adopted over the years,
have led to extreme complexity and have raised questions
about the law's basic fairness. Many provisions of the code
are, in effect, subsidies to certain types of taxpayers, or
to particular interests, for some forms of investment and
consumption. These subsidies are rarely justified explicitly
and, in some cases, may even, be unintentional. In many
instances, they alter the pattern of economic activity in
ways that lower the value of total economic output. Further,
although the Federal tax system by and large relates tax
burdens to individual ability to pay, the tax code does not
reflect any consistent philosophy about the objectives of
the system.
Previous efforts at tax reform have not attempted a
thorough rethinking of the entire tax structure. As a
result, reform legislation over the past 25 years has
consisted of a series of patchwork palliatives, leading to a
tax system increasingly difficult to understand. Indeed,
the Tax Reform Act of 1969 has been referred to as the
"Lawyers and Accountants Relief Act," and the Tax Reform Act
of 1976 deserves this sobriquet no less. The confusion and
complexity in the tax code have led Secretary of the Treasury
William E. Simon to suggest that the Nation should "have a
tax system which looks like someone designed it on purpose."
The first part of this report is devoted to clarifying
the goals of the tax system, attempting to give specific
content to the universally recognized objectives of equity,
efficiency, and simplicity. Based on this analysis, two
alternative conceptions of an ideal tax system are adopted
to form the basis for practical reform plans. The report
presents two model plans, comprehending both the individual
and corporate income taxes, which demonstrate that the tax
system can be made more equitable, easier to understand and
justifyTTnd more conducive to the efficient operation or
the private economy.
- 2 -
Both plans have the general effect of broadening the
tax base — the measure of income to which personal exemptions
and tax rates are applied. This, is the result of including
in the base items excluded from tax under current law. This
permits a simpler code in that elaborate rules are no longer
required for defining items of tax preference or for protecting
against the abuse of such preferences. Under either plan,
the revenues currently collected from individual and corporate
taxpayers could be raised with a substantially lower rate
structure. In turn a lower rate structure would mitigate the
distorting effects of taxes on economic decisions.
The alternative proposals for tax reform are: (1) a
comprehensive income tax, and (2) a consumption base tax,
called a cash flow tax. Both proposals seek to treat
individual items in the tax code in ways that would achieve
consistency with an ideal base, departing from the ideal
only when necessary for administrative feasibility, simplicity, or compelling economic or other policy reasons.
When concessions are suggested, they are identified as such
and justification is provided.
The differences between the proposals derive from their
underlying concepts of the tax base. The comprehensive
income tax proposal is based on a broad concept of income
that is defined in terms of the uses of an individual's
receipts. According to this definition, an individual's
income can be allocated either to consumption or to increasing
his wealth (net worth). Because all increments to wealth
constitute income, this approach is sometimes called an
accretion concept. The cash flow tax assesses tax burdens
on the basis of consumption, excluding from the tax base all
positive and negative changes in net worth.
Both proposals deal with the major areas in which
changes from the current tax code merit consideration. In
all cases where there are ambiguities about defining consumption or change in net worth as components of income, or
where the benefits achieved by exclusions or deductions from
income under the current law appear to merit continued
consideration, specific policy judgments are made for the
purpose of presenting complete proposals. The report
identifies the features of each proposal that are essential
to the definition of the ideal tax base, distinguishing them
from elements that can be handled differently and still remain
consistent with a reasonable definition of either the
comprehensive income or consumption tax base. The table at
the end of this chapter compares the major features of the
model tax reform plans with the current tax system.
- 3-
This study shows that it is feasible to have a broadly
based tax that departs in major ways from the current tax
law. In providing specific alternative plans, the report
sets out a guide for future legislation aimed at sweeping
tax reform. It also points out some of the major policy
issues that remain to be resolved. In presenting a plan for
a tax system based on the consumption concept, the report
points toward a promising alternative approach to tax reform
that is not as different from our present system as it might
seem and that, if consistently implemented, should provide
major advantages in fairness, simplicity, and economic
efficiency.
COMPREHENSIVE INCOME TAX
Proposals to adopt a more comprehensive definition of
income in the tax base have received the most attention from
tax reform advocates.
As previously stated, income may be viewed as the sum
of consumption and change in net worth in a given time
period. Although income is thus defined conceptually in
terms of uses of resources, it is not practical to measure
an individual' s annual income by adding up all of his individual purchases of consumer goods and the change in value
of all the items on his balance sheet. Rather, the measurement of income is accomplished by using the accounting
notion that the sum of receipts from all sources within a
given time period must equal the sum of all uses. To
compute income, it is necessary simply to subtract from
sources expenditures that represent neither consumption nor
additions to net worth. These expenditures include the cost
of operating a business (payment of salaries, rent, interest,
etc.), or the direct cost of earning labor income (union
dues, work clothing, etc.). They may include other specified
expenditures, such as interest, charitable contributions,
State and local income and sales taxes, and large nondiscretionary medical expenditures.
Because of exclusions, deductions, and shortcomings in
income measurement rules, the tax base under current law
departs from this comprehensive concept of income. For
example, State and local bond interest and one-half of
realized capital gains are not included in the tax base. On
the other hand, corporate dividends are included in the tax
- 4 -
base twice, once at the corporate level and once at the
individual level. In some cases, rules for tax depreciation
allow deductions in excess of actual changes in asset
values. When this occurs, business income is understated,
and the taxpayer has increase in net worth that goes untaxed.
In setting out a practical plan to achieve equity,
simplicity, and efficiency in the tax system, the model
comprehensive income tax follows a broad concept of accretion
income as a guide. The major features of the model comprehensive income tax are summarized below.
Integration of the Corporation and Individual Income Taxes
A separate tax on corporations is not consistent with
an ideal comprehensive income tax base. Corporations do not
"consume" or have a standard of living in the sense that
individuals do; all corporate income ultimately can be
accounted for either as consumption by individuals or as an
increase in the value of claims of individuals who own
corporate shares. Thus, corporations do not pay taxes in the
sense of bearing the burden of taxation. People pay taxes,
and corporate tax payments are drawn from resources belonging
to people that would otherwise be available to them for
present or future consumption.
It is difficult, however, to determine which people
bear the burden of corporate tax payments. In a free
enterprise system goods are not produced unless their prices
will cover the costs of rewarding those who supply the
services of labor and capital required in their output as
well as any taxes imposed. The corporation income tax thus
results in some combination of higher relative prices of the
products of corporations and lower rewards to the providers
of productive services, and it is in this way that the
burden of the tax is determined. It spite of many attempts,
economists have not succeeded in making reliable estimates
of these effects, although a substantial body of opinion
holds that the corporation income tax is born by all capital
owners in the form of lower prices for the services of
capital.
The two major advantages of integrating the corporate
and personal taxes are that (1) it would eliminate the
incentive to accumulate income within corporations by ending
the double taxation of dividends, (2) it would enable the
effective tax rate on income earned within corporations to
be related to the circumstances of individual taxpayers.
- 5 -
Under the model comprehensive income tax, the integration of corporate income with the other income of shareholders
is accomplished by providing rules to allocate all corporate
income, whether distributed or not, to individual shareholders.
Corporate distributions to shareholders are regarded simply
as a change in the composition of investment portfolios —
that is, a portion of each shareholder's equity claims is
converted to cash — and have no tax consequences. Under
this "full integration" plan, corporation income is fully
taxed at the rates appropriate to each shareholder.
For this reason, the model plan eliminates the corporation
income tax. The possibility of having corporations withhold
taxes on behalf of shareholders, in order to alleviate
problems arising when tax liabilities exceeded corporate
cash distributions, is examined.
It is emphasized that
full integration is proposed in the context of a plan that
attempts to tax equally income from all sources. "Dividend"
integration such as that proposed by the Ford Administration
in 1975, which represents, in itself, a desirable change in
the absence of comprehensive reform, may also be considered
as a transition to the model treatment of corporate income.
Treatment of Capital Gains and Losses
Under the broadest concept of a comprehensive tax base,
capital gains that represent an increase in real wealth
would be taxed even though not realized by sale or exchange
of the asset. Similarly, capital losses, whether realized
or not, would be subtracted in full from all sources of
income in computing the tax base. The proposal moves in
that direction by adopting the integration concept. Full
integration provides a practical method for taxing increases
in asset values arising from corporate retained earnings, a
major source of capital gains in the current system. Capital
gains realized upon sale or exchange of assets are taxed
fully under the model plan after allowing a step-up in basis
for inflation. Because maximum tax rates would be considerably
lower if a comprehensive tax base were adopted, there is far
less reason for special treatment of capital gains to
achieve rough averaging effects in a progressive rate structure.
Realized capital losses are fully deductible against ordinary
income in the model system.
- 6 -
Thus, the proposal, while ending the current provision
for exclusion of one-half of capital gains from the base,
will also end the taxation of purely inflationary gains and
eliminate current limits on deductibility of realized
capital losses. Compared with present law, taxation of
capital gains would be lower during periods of rapid inflation and possibly somewhat higher during periods of relative
price stability. The proposal does not recommend taxation *
of gains as accrued (that is, prior to realization) because
the administrative cost of annual asset valuations is prohibitive
and because otherwise taxpayers might face problems in
making cash tax payments when no cash had been realized.
The corporate integration proposal would enable the largest
part of individual income previously reflected in realized
capital gains to be taxed as accrued by eliminating the
corporate tax and taxing corporate income directly to the
shareholders, whether or not it was distributed. This is a
fair and workable solution.
Depreciation Rules
The proposal defines some general principles for
measuring depreciation of assets for tax purposes. It is
recommended that a systematic approach to tax depreciation,
perhaps one modeled after the present Asset Depreciation
Range System, be made mandatory for machinery and equipment
and structures. A set of accounting procedures would be
prescribed that would provide certainty to .the taxpayer that
his depreciation allowances would be accepted by the tax
collector and would reasonably approximate actual declines
in the value of these depreciable assets. Cost depletion is
recommended in place of percentage depletion for mineral
deposits, as a better measure of the income arising from
these properties.
State and Local Bond Interest
The proposal suggests that interest from state and
local bonds be treated like all other interest receipts in
the computation of the tax base, on the grounds that those
receipts can be used for consumption or increases in net
worth. Transition problems relating to existing bond
holdings are recognized. The implicit tax burden in ownership of state and local bonds resulting from their lower
interest yield is identified and evaluated. The report
mentions alternative, less-costly ways of providing the same
subsidy to state and local governments as is presently
provided by the interest exemption.
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- 7 -
Imputed Income from Consumer Durables
Under the broadest form of comprehensive income base,
the imputed return in the form of the rental value of
consumption services from ownership of consumer durables
would be taxed. The exclusion of this form of income from
tax provides an important benefit to home owners. They have
invested part of their net worth in their home, rather than
investment assets, but the value of the use of their home
(the income it produces) is not taxed. This is particularly
true when, as under our present system, interest on home
mortgages is deductible from other income. This proposal
does not recommend taxation of the imputed value of the use
of homes and consumer durables because of difficulties of
measurement. However, it is recommended that the deductibility
of local taxes on noncommercial property, including owneroccupied homes, be reconsidered, on the grounds that this
amounts to exclusion of more than the income that would be
imputed to such assets.
Itemized Deductions
The report considers options for the treatment of major
deductions, including deductions for medical expenses
(which could be replaced with a catastrophic insurance
program), charitable contributions (which could be eliminated
or retained in the same form, without compromising the basic
integrity of either the comprehensive income or cash flow
tax), state and local income taxes (which would remain
deductible) and sales taxes (not deductible) and casualty
losses (not deductible). Decisions as to whether, and in
what form, major personal deductions should be maintained
depend on whether or not these expenditures should be viewed
as consumption and on whether or not particular types of
activities ought to continue to be encouraged through the
tax system. The report presents specific proposals for
treatment of major deductions but it is noted that other
rules are also consistent with the concept of a comprehensive income base. The deduction of interest is maintained,
as is, in modified form, the deduction of child care expenses.
The report recommends elimination of the standard deduction,
which will be replaced in part by more generous personal
exemptions.
Retirement Income and Unemployment Compensation
Under a comprehensive income tax, both contributions to
retirement pensions and the interest earned on such contri-
- 8 -
butions would be included in the base. However, a roughly
equivalent result is achieved by taxing earnings on pension
funds as they accrue and retirement benefits as received and
allowing employer and employee contributions to pensions to
be deducted from the tax base. This procedure is preferable
because it minimizes problems of income averaging. Rules
for making different types of pension accounts conform to
this principle are outlined in the report. It is proposed
that deduction of both employee and employer contributions
to Social Security be allowed and that all social security
retirement benefits be included in the tax base. The report
also recommends that unemployment compensation payments
be included in the tax base.
Liberal personal exemptions recommended will insure
that persons with very low incomes are not taxed on social
security benefits or unemployment compensation.
Choice of a Filing Unit and Exemptions for Family Size
The decision on the appropriate filing unit represents
a compromise between objectives that are mutually exclusive
under a progressive tax: a system in which families of
equal size and income pay equal taxes and a system in which
the total tax liability of two individuals is not altered
when they marry. The report recommends continuation of
family filing, with separate structures of exemptions and
rates for married couples, single individuals, and unmarried
heads of household. To reduce the work disincentive caused
by taxation of secondary earners at marginal rates determined
by the income of a spouse, the plan proposes that only 75
percent of the first $10,000 of earnings of secondary
workers be included in the tax base. Alternative treatments
of the filing unit consistent with the general principles of
a comprehensive income base are presented.
The report discusses the issues in the choice between
exemptions and tax credits as adjustments for family size,
and recommends a per-member exemption instead of a credit.
However, it is noted that various methods of adjusting for
family size, including use of credits, are fully consistent
with the comprehensive income base.
The report shows how adoption of the recommended
changes in the tax base would change tax rates. With an
exemption of $1,000 per taxpayer and an additional $1,600
per tax return, it is possible under the comprehensive
income tax to raise the same revenue with roughly the same
distribution of the tax burden by i : nco^class as undeFThe
present income tax, using only three rate brackets, ranging
- 9-
from 8 percent in the lowest bracket, to 25 percent for
middle income taxpayers, to 38 percent for upper income
taxpayers. The generous $1,000 personal exemption (instead
of $750 under present law) plus an additional $1,600 exemption
per return helps provide the same ability-to-pay distribution
of the tax burden as present law. Alternatively, it is
possible to raise the same revenue under the comprehensive
income tax with a flat rate of slightly over 14 percent on
all income if there are no exemptions and with a flat rate
of slightly under 20 percent with exemptions of $1,500 per
taxpayer.
In summary, the comprehensive income tax proposal is a
complete plan for a major rebuilding of the tax system that
eliminates many of the inconsistencies in the present tax
code. The plan clearly demonstrates the feasibility of
major improvements in the simplicity, efficiency, and fairness in the income tax.
CASH FLOW, CONSUMPTION BASE TAX
Consumption is less widely advocated than income in
discussions of tax reform but it deserves serious consideration as an alternative ideal for the tax base. A consumption
tax differs from an income tax in excluding savings from the
tax base. In practical terms, this means that net saving,
as well as gifts made, are subtracted from gross receipts to
compute the tax base. Withdrawals from savings, and gifts
and bequests received but not added to net savings, are
included in gross receipts to compute the tax base.
Advantages of a Consumption Base
The report shows that a version of a consumption base
tax, called the "cash flow tax," has a number of advantages
over a comprehensive income tax on simplicity grounds. The
cash flow tax avoids the most difficult problems of measurement under a comprehensive income tax — such as depreciation
rules, inflation adjustments, and allocation of undistributed
corporate income — because all forms of saving would be
excluded from the tax base.
In addition, the report demonstrates that the cash flow
tax is more equitable because it treats alike all individuals
who begin their working years with equal wealth and the same
present value of future labor earnings. They are treated
differently under an income tax, depending on the time
pattern of their earnings and the way they choose to allocate
consumption expenditures among time periods.
- 10 -
By eliminating disincentives to saving, the cash flow
tax would encourage capital formation, leading to higher
growth rates and more capital per worker and higher beforetax wages.
How a Consumption Base Could be Taxed
According to one method of designing a consumption tax
the taxpayer would include in his tax base all monetary
receipts in a given time period, including withdrawals from
past savings and gifts and bequests received, and exclude
from his tax base current savings, gifts made, and certain
itemized expenditures also allowed as deductions under the
comprehensive income tax. Thus, the full proceeds of asset
sales would be taxed if used for consumption rather than for
purchase of other assets (including such "purchases" as
deposits in savings accounts). Inclusion of asset sales and
deduction of asset purchases from the tax base, make it
possible for the tax base to measure an individual's annual
consumption without actually tallying up his purchases of
consumption goods and services.
A second method of computing the base for a tax based
on consumption is to exempt all capital income from tax.
Dividends, interest, capital gains, and profit from a personal
business would be excluded from an individual's tax base.
Interest receipts would be excluded from the base, and
interest payments on loans would not be deducted. Purchases
of productive assets would not be deductible, because the
returns from them would not be included in the base.
These alternative treatments of assets lead to a tax
base with the same present value. Deferral of tax in the
present leads to payment of the same tax plus interest when
the asset is sold for consumption. However, the payment of
taxes occurs later under the method which allows a savings
deduction than under the method which allows an interest
exemption.
Similarities to the Present Tax Base
The report points out that the current tax system is
closer to a cash flow tax than to a comprehensive income tax
in its treatment of many forms of income from capital. In
particular, two important sources of saving for many Amercans — homeownership and employer contributions to retirement annuities (or contributions of individuals to Keogh
Plans and IRA's) — are treated under the current law almost
- 11 exactly the same way they would be treated under a consumption
tax which allows a deduction for savings. Similarly, many
of the present system's uncoordinated exclusions of capital
income from tax approximate the second approach to a consumption
base tax. Thus, the model cash flow tax is not as complete
a change from the present tax system as it might seem.
Treatment of Investments in the Model Plan
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In the model cash flow tax individuals may choose
between the two essentially equivalent ways of treating
investments. Purchases of assets are eligible for deduction
only if made through "qualified accounts." The qualified
accounts would keep records of an individual's net investment balance so that annual saving and dissaving can be
measured. Each year, net contributions to qualified accounts
would be computed and subtracted from the tax base. If
withdrawals exceed contributions in any year, the difference
would be added to the tax base. Thus, the proceeds from an
investment made through a qualified account are subject to
tax only when withdrawn.
Savings not deposited in a qualified account are not
eligible for deduction, but the interest and capital gains
from investments financed by such saving are not included in
the tax base. There is no need to monitor the flow of
investments or the investment income earned outside of
qualified accounts because they have no place in the calculation
of tax.
The report spells out the consequences of allowing a
taxpayer to choose between alternative ways of being taxed
on income from assets, providing specific examples of how
the tax would work. It is shown how allowing two alternative
treatments for both assets and loans provides a simple
averaging device that would enable taxpayers to avoid the
inequities associated with applying a progressive rate
system to individuals with different annual variation in the
level of consumption.
The report also shows how allowing
alternative treatment of assets and loans simplifies the
measurement of the tax base.
Other Features of the Cash Flow Tax
Under the proposal, all consumer durables (such as
automobiles and homes) are treated as assets purchased
outside of a qualified account. No deductions are allowed
for the purchase of a consumer durable, and receipts from
the sale of a consumer durable are not included in the tax
base.
- 12 -
Gifts are treated differently under the cash flow tax
than under both the comprehensive income tax and the current
tax system. In the cash flow tax proposal, gifts and inheritances received are included in the tax base, while gifts
given are deducted. Under present income tax law and under
the model comprehensive income tax the treatment is reversed,
with gifts received excluded from the donee's tax base but
no deduction allowed for an individual who makes a gift. It
is assumed that in both systems there would continue to be a
separate tax on transfers of assets by gift or bequest, such
as the present estate and gift tax.
The proposal describes in detail how specific items of
capital income — dividends, interest, capital gains, income
from personal business, and accumulation of retirement
pensions -- are treated. The corporate income tax is
eliminated because there is no longer a need to tax undistributed corporate income. Purchases of corporate stocks
through qualified accounts are tax deductible, while all
withdrawals from qualified accounts are included in the tax
base. Sale proceeds of corporate stock, dividends, and
interest, if remaining in the qualified account, are not taxed.
The cash flow tax, like the comprehensive income tax,
would move towards neutrality in the tax treatment of
different kinds of investments. In doing so, both proposals
would have the effect of encouraging the best use of available
capital. In addition the cash flow tax would eliminate the
discouragement to capital formation inherent in the concept
of a tax on income.
The Filing Unit and Tax Rates
The cash flow tax proposal treats definition of the
filing unit, exemptions for family size, and deductions of
personal consumption items the same way as the comprehensive
income tax proposal. The differences between the two
proposals are in the treatment of items which represent a
change in net worth, or income from capital, and in the
treatment of gifts and inheritances.
Under the cash flow tax, an exemption of $800 per
person and $1,500 per return together with the three rate
brackets —
10 percent, 28 percent, and 40 percent — would
allow present tax revenues to be raised while maintaining
the same vertical distribution of tax burdens.
- 13 TRANSITION PROBLEMS
Reforming the existing tax system poses a different set
of problems than designing a new tax system from scratch.
Although the report concentrates on the design of approximations to ideal tax systems, the problems of transition
have also been examined and possible solutions embodied in
specific proposals.
Transition to a new set of tax rules poses two separate,
but related problems. First, changes in rules for taxing
income from capital will lead to changes in the relative
value of assets. Problems of fairness would exist if investors
who had purchased a particular type of asset in light of the
present tax system were subjected to losses by sudden major
changes in tax policy. Similarly, changes in tax policy may
provide some investors with windfall gains. Second, changes
in the tax law raise questions of what to do about income
earned before the effective date, but not yet subject to
tax. For example, the comprehensive income tax, which
proposes full inclusion of capital gains in the base (subject to an inflation adjustment), requires a transition rule
for taxing capital gains accumulated before, but realized
after, the effective date.
The report describes two methods for moderating the
wealth effects of tax reform—"grandfathering," or exempting
existing assets from the new tax provisions, and phasing-in
of the new rules. Specific proposals for use of these
instruments for projected changes in the tax code are
presented.
The report also outlines specific transition
proposals for handling income earned before the effective
date, but not yet taxed.
HOW AN INDIVIDUAL WOULD CALCULATE TAX LIABILITY UNDER
THE REFORM PLANS
Elements Common to Both Plans
The method of calculating tax liabilities under the
model tax systems would be similar to the method in use
today. Taxpayers would fill out a form like the Form 1040,
indicating family status and number of exemptions.
There
would not be a standard deduction under either plan. Taxpayers
who had eligible deductions would choose to itemize; to
reduce the number of itemizers, deductions would be subject
to floor amounts.
- 14 The tax base would be calculated on the form, and the
tax rate schedule appropriate to the filing unit (i.e.,
single, married, head of household) would be applied to
compute tax liability. Taxes owed and refunds due, would
depend on the difference between tax liability and taxes
withheld as reported on W-2 statements or estimated tax
paid.
The wages and salaries of the primary wage earner would
remain the biggest item in the tax base of most households
and would be entered into the calculation of income the same
way as under the current system.
The first $10,000 of
wages and salaries of secondary wage earners would be multiplied
by .75 before being added to the tax base. The rules for
calculating some deductions (e.g., child care) would be
changed, and other deductions (e.g., property and gasoline
taxes) would be eliminated.
The Comprehensive Income Tax
Under the comprehensive income tax, some additional
items would be added to the computation of tax. Corporations
would supply to all stockholders a statement of the amount
of profit attributed to that stockholder in the previous
year, and an adjustment to basis that would rise with earnings
and fall with distributions. Similar statements of attributed
earnings would be supplied to taxpayers by pension funds and
insurance companies. In addition to the income reported in
these statements, taxpayers would report income from interest
on State and local bonds, unemployment compensation, and
social security retirement benefits.
All capital gains (or losses) would be entered in full
in the computation of taxable income. The basis for corporate
shares would be increased by corporate income taxed but not
distributed to them. In computing gains from sale or exchange,
the taxpayer would be allowed to adjust the basis of assets
sold for inflation. A table of allowable percentage basis
adjustments would be provided in the tax form. The taxpayer
would use statements received from corporations to adjust
the basis of corporate shares upward for any past attributed
corporate profits and downward for dividends or other distributions
received.
The Cash Flow Tax
The major change under the cash flow tax is that the
taxpayer would receive yearly statements of net withdrawals
- 15 or deposits from all qualified accounts. If deposits exceeded
withdrawals, the difference between deposits and withdrawals
would be subtracted from the tax base.
If withdrawals
exceeded deposits, the difference would be added to the tax
base.
Interest, dividends, and capital gains realized on
investments made outside of qualified accounts would not be
reported on the tax form and would not be included in
taxable income. The rationale for this is that the tax
would have been pre-paid, because no deduction was allowed
at the time of purchase.
Gifts and inheritances received would be included in
the tax base (but if deposited in a qualified account would
have an offsetting deduction). A deduction would be allowed
for gifts and bequests given. The identity of the recipient
of deductible gifts would be reported on the donor's return.
CHAPTER-BY-CHAPTER OUTLINE OF THE REMAINDER OF THE REPORT
Chapter 2 — What is to be the Tax Base?
Chapter 2 reviews the main issues in choosing an
appropriate tax base (the sum to which the structure of
exemptions and rates is applied) and presents the case for
considering a cash flow tax based on consumption as an
alternative to a reformed comprehensive income tax. General
issues of equity in design of a tax system are discussed,
and the concepts of consumption and income are explained in
detail. It is shown that the current tax system contains
elements of both a consumption base and a comprehensive
income base. Thus, it is shown how the adoption of a consumption or cash flow tax would not be as great a change
from the present system as it might seem. The alternative
tax bases are compared on grounds of equity, simplicity, and
effects on economic efficiency.
Chapter 3 — A Model Comprehensive Income Tax
A model comprehensive income tax is presented in chapter
3. The major innovations in the plan relate to integration
of the corporation and individual income taxes, and to tax
treatment of capital gains, State and local bond interest,
income accumulated in pensions and life insurance funds,
retirement income, and unemployment compensation. Changes
in many personal deductions are suggested. Important recommendations for changes in the filing unit, adjustment for
- 16 -
family size, and taxation of secondary wage earners are set
forth. International considerations in income taxation are
discussed briefly.
The chapter concludes with a description
of a sample form for tax calculation under the comprehensive
income proposal.
Chapter 4 — A Model Cash Flow Tax
In chapter 4, a model cash flow tax based on consumption
is presented. The major innovation in the cash flow tax is
that savings may be deducted from the tax base. The use of
qualified accounts to measure the flow of saving and consumption is proposed. The equivalence between deductibility
of saving and exclusion of capital earnings from tax is
explained, and alternative treatments of assets reflecting
this equivalence are presented. Treatment of specific items
under the model cash flow tax is proposed in detail and
compared with treatment of corresponding items under the
comprehensive income tax. Arguments against the cash flow
tax on grounds of progressivity and effects on wealth distribution
are evaluated. The use of a supplementary wealth transfer
tax to provide greater progressivity is explored. The
chapter concludes with a description of a sample tax form
under the cash flow proposal.
Chapter 5 — Quantitative Analyses
Chapter 5 presents simulations of the effects of the
proposed reforms on the tax liabilities of different groups
of taxpayers. The chapter demonstrates that the vertical
structure of tax burdens under the present income tax system
may be broadly duplicated with a more generous set of exemptions
and a rate schedule which is more moderate and much simpler
so long as the tax base is greatly broadened as proposed
under either the comprehensive income tax (chapter 3) or the
cash flow consumption type tax (chapter 4 ) .
Chapter 6 — Transition Considerations
Chapter 6 proposes transition rules to accompany adoption
of the model tax plans. Problems which may arise in changing
tax laws are explained, and instruments to ameliorate
adjustment problems, including exempting existing assets
from changes and phasing in new rules, are described and
evaluated. Specific proposals are presented for transition
to both a comprehensive income base and a cash flow base
that cover the timing of the application of new rules to
specific proposed changes in the tax code.
Table 1
Summary Comparison of Model Tax Plans
Item
Current tax
Model comprehensive
income tax
Model cash flow tax
Corporate income
a. Retained earnings
b.
Dividends
Separately taxed to
corporations
Attributed to individuals
as income and included in
tax base
No tax until consumed
Separately taxed to
corporations, included
in individual tax base
with $100 exemption
Not taxed separately
No tax until consumed
I
50% of long-term gains
included when realized;
alternative tax available
Fully included in tax
base on realization;
no partial exclusion
No tax until consumed
Capital losses
50% of long-term losses
deductible against
included portion of
long-term gains and
$1,000 of ordinary
income; carryover of
losses allowed
Fully deductible from
tax base on realization
No tax offset unless
consumption is reduced
Depreciation
Complex set of depreciation rules for
different types of
equipment and structures
Reformed rules for
depreciation; depreciation to approximate
actual decline in
economic value on a
systematic basis by
industry classes
Permits expensing of all
business outlays, capital
or current
Capital gains
I
Table 1
Summary Comparison of Model Tax Plans
(continued)
Item
Current tax
Model comprehensive
income tax
Model cash flow tax
State and local bond interest
Excluded from tax base
Included in tax
base
Excluded from tax base
until consumed
Other interest received
Included in tax base
Included in tax base
Excluded from tax base
until consumed
Proceeds of loans
Excluded from tax base
Excluded from tax base
Inclusion in tax base
optional
Interest paid on loans
Deducted from tax base
Deducted from tax base
Deducted from tax base if
proceeds of loan included
in base
oo
I
Principal repayments on loans
Not deducted from tax
base
Not deducted from tax
base
Deducted from tax base if
proceeds of loan included
in base
Rental value of owner-occupied
homes
Excluded from tax base
Excluded from tax base
Implicitly included in tax
base because purchase treated
as consumption
State or local property, sales
and gasoline taxes (nonbusiness)
Deducted from tax base
Not deducted from tax
base
Not deducted from tax
base
Medical expenses 1/
Expenses over 3% of
adjusted gross income
deducted from tax base
No deduction; possible
credit for expenses
over 10% of income*
No deduction; possible credit
for expenses over 10% of
consumption*
Deducted from tax
Not deducted from base*
Not deducted from tax
base*
Charitable contributions 2/
Table 1
Summary Comparison of Model Tax Plans
(continued)
Item
Current tax
Model comprehensive
Income tax
Model cash flow tax
Casualty losses
Uninsured losses deducted Not deducted from tax
from tax base*
base*
Not deducted from tax
base
State and local income taxes
Deducted from tax base
Deducted from tax base*
Deducted from tax base*
Child care expenses 3/
Limited tax deduction
Revised tax deduction*
Revised tax deduction*
Contributions to retirement
pensions
Employer contributions
untaxed; employee
contributions taxed
All contributions
excluded from tax
All contributions excluded
from tax
Excluded from tax
Attributed to employer
or to individuals and
taxed in full as accrued
Excluded from tax
Retirement benefits from pension Included in tax base
funds
except for return of
employee contribution
Included in tax base
Included in tax base
unless saved
Social security contributions
Employer contributions
untaxed; employee
contributions taxed
All contributions
excluded from tax
All contributions
excluded from tax
Social security retirement
income and unemployment
compensation
Excluded from tax base
Included in tax base
Included in tax base
unless saved
Wage and salary income 4/
Included in tax base
Included in tax base
for primary earner;
for secondary earners,
75% of wages under
$10,000 and all wages
over $10,000 included*
Included in tax base for
primary earner; for secondary
earners, 75% of wages under
$10,000 and all wages over
$10,000 included*; savings
out of wages deductible
Interest earnings on
pension funds
I
VO
I
Table 1
Summary Comparison of Model Tax Plans
(continued)
Item
Current tax
Model comprehensive
income tax
Model 6ash flow tax
Deposits in qualified investment accounts
No tax consequences
No tax consequences
Deducted from tax base
Withdrawals from qualified
investment accounts
No tax consequences
No tax consequences
Included in tax base
Standard deduction
Available to nonNo standard deduction;
itemizers only; $1,600
$1,600 per return
or 1 6 % of adjusted gross exemption
income up to $2,400 for
single taxpayer,
$1,900 or 1 6 % of adjusted
gross income up to $2,800
for married couple filing
jointly
No standard deduction;
$1,500 per return
exemption
$750 per individual; extra $1,000 per indiexemptions for aged and
vidual
blind
$800 per individual
Personal exemptions
Office of the Secretary of the Treasury
Office of Tax Analysis
* Indicates alternative treatments possible.
1/ Medical deduction optional under model tax plans. Alternative ways of structuring deduction or
credit possible.
2/ Charitable deduction optional under model tax plans. Other alternatives possible, including
limited credit.
3/ Child care deduction and its form and limits optional under model tax plans.
4/
Treat-ent of secondary earners optional under model tax plans.
ro
o
- 21 Chapter 2
WHAT IS TO BE THE TAX BASE?
INTRODUCTION
The dominant complaint made about the present tax
system is that it does not tax all income alike. This
complaint reflects concern about equity: taxpayers with
the same level of income bear different tax burdens. It
reflects concern about efficiency: taxation at rates that
differ by industry or by type of financial arrangement leads
to misallocation of resources. Finally, it reflects concern
about simplicity: the enormously complex tangle of provisions the taxpayer confronts in ordering his affairs and
calculating his tax leads to differential rates of taxation.
The usual approach to the complaint that all income is
not taxed alike is to attempt to make income as defined by
tax law correspond more closely to the "real thing."
The problem with this approach is the difficulty of identifying
the "real thing." As with other abstractions, there are
numerous ways to look at the concept of "income," some of
which may be better or worse according to context.
Laymen find it hard to believe that there are major
problems in defining income. They are used to thinking in
terms of cash wages and salaries, which are easily identified and clearly income. In fact, wages and salaries
account for the great bulk of income — however defined —
in the U.S. economy; other items like interest and dividends
are also easily identified. So it may be fairly said that
most of the dollars identified as income in the total
economy will be the same under any definition of income.
But as one approaches the edges of the concept of
income, there is a substantial grey area. It is small
compared with the bulk of income, but this grey area (capital
gains, for example) is the focus of much controversy. There
is an extensive literature on the subject, beginning before
the turn of the century and continuing to the present, with
no consensus except that particular definitions may be more
practical in certain circumstances than in others.
- 22 Many of the major problems in defining income concern
expectations or rights with respect to the receipt of
payments in the future — does an individual have income
when the expectation or right arises, or only when the money
comes in? Is the promise to pay a pension to be counted as
income when made, although the amounts will be paid 20 years
hence? Is a contract to earn $60,000 a year for the next 5
years to be discounted and counted as income in the year the
contract is made? Is the appreciation in the market value
of an outstanding bond resulting from a decline in the
general market rate of interest to be counted as income now,
even though that appreciation will disappear if interest
rates rise in the future? Is the increase in the present
value of a share in a business attributable to favorable
prospects of the business earning more in future years to be
counted as income now or in the future years when the
earnings actually materialize?
Differences in view with respect to the definition of
income cut across political philosophies. Although many
"liberal" economists argue for an expansive definition of
income, the extreme view that income cannot be defined
adequately to constitute a satisfactory tax base has been
advanced by the eminent British Socialist economist, Nicholas
Kaldor, who argues for a consumption tax. At another
extreme, one of the most all-inclusive definitions of income
was formulated by Professor Henry Simons, a conservative
economist long affiliated with the University of Chicago.
Professor Simons1 definition — usually referred to as
the "Haig-Simons definition" or the "accretion" concept of
income — is perhaps most commonly used in discussions about
income taxes. Professor Simons himself was careful to say
that the definition was not suitable for all purposes and
would not, without modification, describe a satisfactory
tax base. Most analysts would agree. However, the definition is useful for analytical purposes. It represents a
kind of "outer limit" that helps identify items that are
potential candidates for inclusion or exclusion in any
income tax base. In the discussions that follow, it should
be understood that the Haig-Simons or "accretion" definition
is used and discussed in that way, and that no blanket
endorsement of that definition of income is intended.
Indeed, the accretion concept of income has many
shortcomings as a tax base. Several of them are serious,
and attempts to deal with them account for much complexity
- 23 -
in the present tax code. Among these shortcomings are
severe measurement problems. Many items that are required
for the calculation of net income must be imputed — either
guessed at or determined by applying relatively arbitrary
rules (as in the case of depreciation) . Because such rules
are never perfect, they are the subject of continual controversy. A particular problem with certain current rules
is their inability to measure income correctly in periods of
inflation.
An especially serious drawback of an accretion income
base is that it leads to what is sometimes called the
"double taxation" of savings: savings are accumulated after
payment of taxes and the yield earned on those savings is
then taxed again. This has been recognized as a problem in
the existing tax law, and many techniques have been introduced to make the tax system more neutral with respect to
savings. The investment tax credit, accelerated depreciation,
special tax rates for capital gains, and other provisions
are examples. Also, tax deferral on income from certain
investments for retirement purposes is an example of how
current law attempts to offset the adverse effects on savings of
using an accretion income base. Significantly, this last
example is also viewed as desirable for reasons of equity.
All these techniques have the same practical effect as
exempting from tax the income from the investment. To this
extent, this is equivalent to converting the base from
accretion income to consumption.
The present tax system thus may be regarded as having a
mixture of consumption and accretion income bases. In view
of this, a question that arises is whether the proper objective
of tax reform should be to move more explicitly toward
a consumption base rather than toward a purer accretion
base. The issue is considered in this chapter.
The analysis suggests that the consumption tax has many
important advantages as compared with an income tax and
accordingly should be seriously considered in designing a
reformed tax system. In some respects, a broad-based
consumption tax is more equitable than a broad-based income
tax. It is also easier to design and implement and has
fewer harmful disincentive effects on private economic
activity. In many important ways, a broad-based consumption
tax more closely approximates the current tax system than
does a broad-based income tax and would constitute less ot a
change.
- 24 -
The remainder of this chapter compares^consumption and
income taxes with respect to various criteria. The chapter
includes:
• A discussion of some general issues relating to
equity;
• An explanation of the concepts of consumption and
income, including a discussion of some definitional
problems;
• A comparison of the treatment of personal savings under
the current tax system with the treatment of savings
under a consumption tax and a broad-based income tax;
• A discussion of the merits of the alternative tax bases
on criteria of equity;
• A comparison of the alternative tax bases for simplicity?
and
• A discussion of the economic efficiency effects of tax
policies and a comparison of the efficiency losses
under a consumption tax and an income tax.
TWO PRELIMINARY MATTERS OF EQUITY
As has already been suggested, the specification of a
tax code has the effect of defining the conditions under
which two taxpayers are regarded as having the same circumstances, so that they should properly bear the same tax
burden. This section considers two aspects of such a
comparison that have important implications for tax design:
first, over what period of time are the circumstances of two
taxpayers to be compared; and, second, what are the units —
individuals or families — between which comparisons are to
be drawn.
Equity Over What Time Period?
Most tax systems make liabilities to remit payments
depend upon events during a relatively short accounting
period. In many cases, this is a matter of practical
necessity rather than principle. That is, tax liabilities
must be calculated periodically on the basis of current
information. Generally, there is nothing sacred about the
- 25 accounting period — be it a week, a month, or a year —
as far as defining the period over which taxpayer circumstances are to be compared. Indeed, it is usually regarded
as regrettable that practical procedures do not allow the
calculation of liabilities to take a much longer view.
Averaging and carryover provisions represent (inadequate)
attempts to resolve inequities that arise in this respect.
An example from another program will illustrate. Under
many welfare programs the accounting period is 1 month. A
family earning just at the eligibility level at an even rate
for the year will receive nothing. A family earning the
same amount during the year, but earning it all during
the first 3 months will appear to have no earnings during
the remaining 9 months. That family will then be eligible
for full benefits for 9 months, in spite of being no worse
off than the first family in the perspective of a year's
experience.
It is assumed in this study that the period over which
such comparisons are made should be as long as possible.
Ideally, two taxpayers should be compared on the basis of a
whole lifetime of circumstances, and this is taken here to
be a general goal of tax system design: lifetime tax burden
should depend upon lifetime circumstances.
It is important to note that lifetime tax burden
depends not only on the sum of all tax liabilities over a
taxpaying unit's lifetime, but also on their timing.
Deferral of a portion of tax liability is a form of reduction
in tax burden in an income tax framework because interest
can be earned on the deferred tax payments. For example, if
investors can expect a 10-percent annual rate of return on
riskless assets, a tax liability of $110 a year from now is
equivalent to a tax liability of $100 today because $100, if
untaxed and invested, will grow to $110 in value in one
year's time. A common way of expressing this is to say that
the present value of a tax liability of $110 one year in the
future is $100. When comparing the lifetime tax burdens of
two taxpayers, we are, in fact, comparing the present value
of the sum of current and future tax liabilities viewed from
the vantage of some point early in the life of the two
taxpayers (e.g., at birth, or at the beginning of working
years, or at age 18).
Is the Family or the Individual the Appropriate Unit?
What taxpaying unit is the subject of this comparison
of situations? When it is asked whether one taxpayer is in
- 26 -
the same situation as another, is the taxpayer an individual
or a family? The sharing of both consumption and wealth
within families supports continuation of present law in
regarding the family as the unit of comparison.
On the other hand, a family is not a simple institution, with a predictable lifetime, and a constant identity. Quite apart from the problem of distinguishing
varying degrees of formality in family structure (e.g., is
the second cousin living in the guest room part of the
family?), the family necessarily is a changing unit, with
births, deaths, marriages, and divorces continually altering
family composition.
In this study, differences in family association have
been regarded as relevant to that comparison of lifetime
situation by which relative tax burdens are to be assigned
to different individuals. The practical consequence of this
will be that the tax liability of a father, for example,
will depend in part upon consideration of the situation of
the whole family.
INCOME AND CONSUMPTION
A tax base is not a quantity like water in a closed
hydraulic system, wherein the total remains constant regardless of how it is directed by valves and pumps. Rather,
it is an aggregation of transactions — sometimes implicit
but usually voluntary. The transactions that take place
will depend in part upon how they are treated by the tax
system. The choice of a tax base is a choice about how to
tax certain transactions.
A tax base is necessarily defined by a set of accounting
rules that classifies actual and implicit transactions as
falling within or outside the "tax base," that is the total
to which a tax schedule is applied to determine the taxpayerfs
liability. The Internal Revenue Code prescribes an "income"
tax, with "income" defined by the elaborate body of statutory
and administrative tax law that has evolved. But this
definition is criticized by many observers, who believe that
tax burdens should be related to a broader tax base, i.e., to
a wider set of transactions.
As was pointed out above, the concept of income generally
used in discussion of tax reform has been called an "accretion"
concept. It is supposed to measure the command over resources
- 27 -
SSS'-KCtJrH^'^t^^-.t.j, P.rio_. that
he form of
sumption or held as potential 5 S * V
inU
SUn, ti0n i n t h e
form of an addition S the ?axpaJer's ^alS
S
h
Hence
apparently paradoxical practice _»? *!*" - » •
' the
"outlay" or "uses" concent - L
defining "income" by an
worth.
concept — consumption plus change in net
incomfS^e^sSrcL^drS?^;11' ***!
t0 aSSOCiate
speaks of income "from labor " s S h ^ C ° U n t S * T h ? s ' o n e
"from capital " or- »^Z
' • c h a s w a 9 e s / °r income
and proSts? 'BecausJ S u r S S " 6 J ° r S h i p S ' " S U c h a s interest
double entri aclountina s £ s ? L a n d u s e s ™ s t b e equal in a
same whichever siSe is tfKn ?A
* reSUlt
should be the
provided thlt a n uses are re a , S r P ° S e S ° f m e a s <^ment,
inclusion in thlTtax Jase r e g a r d e d a s ^ropriate for
Definitions of income and Consumption
transactSS ^T^^ * fudiment^ry classification of
make o? ^If1^1^ °aSf' ^6 Possible applications he can
S S
J
^ U n d S m a y b e d i v i d e d into the purchase of
S b t r a c ? f o n ! T C e \ f ° r h ± S i r e d i a t e U S e a n d Editions to or
subtractions from his accumulation of savings. Thus an
account of his situation for the year might be the followingS O U R C E S U S E S
Wages
Interest
Balance in
savings
account at
beginning of
period
Rent
Clothing
Food
Recreation
Balance in
savings account
at end of
period
The two sides of this account are, of course, required to
balance. Of the uses, the first four are generally lumped
- 28 -
under the concept of consumption, the last constituting the
net worth of the household. Thus, the accounts may be
schematically written as:
SOURCES
USES
Wages
Interest
Net worth at
beginning of
period
Consumption
Net worth at end
of period
The concept of income concerns the additions or accretions to source and the application of that accretion
during the accounting period. This can be found simply by
subtracting the accumulated savings (net worth) at the
beginning of the period from both sides, to give:
ADDITION TO
SOURCES
USES OF ADDITION
TO SOURCES
Wages
Interest
Consumption
Savings (equals
increase in net
worth over the
period)
Income is defined here as be the sum of consumption
and increase in net worth. Note carefully that a uses
definition is adopted as a measure of differences in individual circumstances. This approach to the concept of
income has substantial advantages as a device for organizing
thinking on particular policy issues, even though it will no
doubt be unfamiliar to many readers, who naturally think of
income as something that "flows in" rather than as something
that is used. With this uses definition of income, the
situation of the illustrative individual may be represented
by:
- 29 -
ADDITION TO
SOURCES
USES OF ADDITION
TO SOURCES
Wages
Interest
Income
The last version of the accounts makes clear the way in
which information about sources is used to determine the
individual's income. To calculate his income for the year,
this individual obviously would not add up his outlays for
rent, clothing, food, recreation, and increase in savings
account balance. Rather, he would simply add together his
wages and interest and take advantage of the accounting
identity between this sum and income.
This classification of uses into consumption and
increase in net worth is not sufficient, however, to accommodate distinctions commonly made by tax policy. It will
be helpful, therefore, to refine the accounts to the following:
ADDITION TO
SOURCES
USE OF ADDITION
TO SOURCES
Wages
Interest
Consumption
Cost of earnings
Certain other
outlays
Increase in net
worth
An individual's outlay for special work clothes needed
for his profession requires the category "cost of earnings."
These are netted out in defining income. Note that the
decision about which outlays to include in this category is
a social or political one. Thus, in present law, outlays
for specialized work clothes are deductible, but commuting
expenses are not. There is no independent standard to which
one can appeal to determine whether such outlays are consumption, and hence a part of income, or work expenses, and
hence out of income.
- 30 -
Similarly, a judgment may be made that some outlays,
while not costs of earning a living, are also not properly
classified as consumption. The category of "other outlays"
is introduced for want of a better label for such transactions.
For example, in everyday usage, State income taxes would not
be an application of funds appropriately labeled "personal
consumption," much less "increase in net worth." (They might
be allocated to the "cost of earnings" category.) Thus,
using the definition of income as the sum of consumption and
the increase in net worth, we now have:
ADDITION TO
USES OF ADDITION
SOURCES
TO SOURCES
Earnings
(Wages +
Interest)
•
—
—
—
-
-
_
.
.
-
,
_
-
.
—
.
-
_
-
.
Income (Consumption + Increase
in net worth)
Cost of earnings
Certain other
outlays
,
.
.
.
_
.
Again, to calculate income it is generally convenient
to work from the left-hand, sources side of the accounting
relationship described above. In this case,
Income = Earnings
minus
Cost of earnings
minus
Certain other outlays.
Similarly, and of great importance in understanding this
study, consumption may be calculated by starting with
sources data:
Consumption = Earnings
minus
Cost of earnings
minus
Certain other outlays
minus
Increase in net worth.
- 31 One further addition to the accounting scheme is needed
at this point: the item "gifts and bequests given." This is
a use of funds that some would regard as consumption, but in
this report the term consumption, without modifier, is
reserved for the narrower notion of goods and services of
direct benefit to the individual in question. The accounts
now have the following structure:
ADDITION TO
SOURCES
USES OF ADDITION
TO SOURCES
Consumption
Gifts and bequests
given
Cost of earnings
Certain other
outlays
Increase in net
worth
It must be decided whether gifts and bequests given are
to be regarded as income, that is, as a component of the
total by which taxpayers are to be compared for assigning
burdens. The term "ability-to-pay" is used to describe the
income concept that considers income to be the sum of
consumption plus gifts and bequests given plus increase in
net worth, because it is within the taxpayer's ability to
choose among these uses and, hence, all three measure
taxpaying potential equally. It should be emphasized that
the label "ability-to-pay" is intended to be suggestive
only. There is no agreed upon measure of the idea of a
taxpayer's ability to pay. Because of this, quotation marks
will be used when the term "ability-to-pay" is used in its
role as a label for an income or consumption concept.
"Ability-to-pay" income or consumption would also
generally be calculated by starting on the sources side:
Earnings
"Ability-to-pay" income
minus
Cost of earnings
minus
Certain other outlays
Wages
Interest
- 32 -
"Ability-to-pay" consumption
=
Earnings
minus
Cost of earnings
minus
Certain other outlays
minus
Increase in net worth.
The difference between consumption and income is the
savings or increase in net worth over the period. Thus,
equivalently:
"Ability-to-pay" consumption = "Ability-to-pay" income
minus
Increase in net worth.
Finally, there is the pair of income and consumption
concepts that excludes gifts and bequests given from the
category of uses by which tax burdens are to be apportioned.
These are given the label "standard-of-living" because they
are confined to outlays for the taxpayer's direct benefit.
As with the term "ability-to-pay," this label is intended to
be suggestive only. The "ability-to-pay" and "standard-ofliving" concepts are related as follows:
"Standard-of-living" income = "Ability-to-pay" income
minus
Gifts and bequests given,
"Standard-of-living" consumption = "Standard-of-living" incor^
minus
Increase in net worth.
This discussion leads to a four-way classification of
tax bases:
- 33 -
Gifts Given
Included
Increase
in
net
worth
Excluded
Included
Ability-to-pay
income
Standard-of-living
income
Excluded
Ability-to-pay
consumption
Standard-of-living
consumption
THE PRESENT TAX BASE
Is the Present Base Consumption or Income?
While the present income tax system does not reflect
any consistent definition of the tax base, it has surprisingly many features of a "standard-of-living" consumption
base.
The idea of consumption as a tax base sounds strange
and even radical to many people. Nonetheless there are many
similarities between a consumption base tax and the current
tax system. Adoption of a broad-based consumption tax might
actually result in less of a departure from current tax
treatment of savings than adoption of a broad-based income
tax.
The current tax system exempts many forms of savings
from tax. In particular, the two items that account for the
bulk of savings for most Americans, pensions and home
ownership, are treated by the present tax code in a way that
is more similar to the consumption model than to the comprehensive income model.
Retirement savings financed by emPloye^Tc°ntJ^^ions
to pension plans (or made via a "Keogh" or "Individual
Retirement Account" (IRA)) are currently treated as they
would be under a consumption tax. Under the current system,
savings in employer-funded pension plans are not ^eluded m
the tax base, but retirement benefits from those plans,
- 34 which are available for consumption in retirement years, are
included. Employee contributions to pension plans are
treated somewhat less liberally. The original contribution
is included in the tax base when made, but the portion of
retirement income representing interest earnings on the
original contributions is not taxed until these earnings are
received as retirement payments. If the tax on those
interest earnings were paid as the earnings accrued, treatment of employee contributions to pension plans would be the
same as that under a comprehensive income tax. However, the
tax on interest earnings in pension funds is lower than
under a comprehensive income base because the tax is deferred.
If no tax were paid on the interest earnings portion of
retirement pay, then the present value of tax liability
would be exactly the same as the present value of tax
liability under a consumption tax. Thus, the current
treatment of employee contributions incorporates elements of
both the comprehensive income model and the consumption
model but, because of the quantitative importance of tax
deferral on pension fund earnings, the treatment is closer
to the consumption model.
The current tax treatment of home ownership is very
similar to the tax treatment of home ownership under a
consumption tax. Under present law, a home is purchased out
of tax-paid income (is not deductible), and the value of the
use of the home is not taxed as current income. Under a
consumption tax, two alternative treatments are possible.
Either the initial purchase price of the house would be
included in the tax base (i.e., not deductible in calculating the tax base) and the flow of returns in the form of
housing services would be ignored for tax purposes, or the
initial purchase price would be deductible and an imputation
would be made for the value of the flow of returns, which
would be included in the tax base.
In equilibrium, the market value of any asset is equal
to the net present value of the flow of future returns,
either in the form of monetary profits or value of consumption services. For example, the market value of a
house should equal the present value of all future rental
services (the gross rent that would have to be paid to a
landlord for equivalent housing) minus the present value of
future operating costs (including depreciation, operating
costs, property taxes, repairs, etc.). Thus, in both cases,
the present
of the tax
base would
be thehouse,
same. the
For
example,
if value
an individual
purchased
a $40,000
- 35 -
present value of his future tax base for that item of
consumption would be $40,000 regardless of how he chose to
be taxed. Because the initial purchase price is easier to
observe than the imputed service flow, it would be most
practical, under a consumption tax, to include the purchase
of a house in the tax base and exclude net imputed returns.
In that case, capital gains from sale of a house would not
be taxable.
In the current tax system, as in the consumption tax
system, the down payment and principal payments for an
owner-occupied residence are included in the tax base, and
the imputed net rental income in the form of housing services
is excluded from tax. Capital gains from housing sales are
taxable at preferential capital gains rates upon realization
(which allows considerable tax deferral if the house is held
for a long period) , and no capital gains tax is levied if the
seller is over 65 or if the gain is used to purchase another
house.
In contrast, under a comprehensive income base, the
entire return on the investment in housing, received in the
form of net value of housing services, would be subject to
tax and, in addition, the purchase price would not be
deductible from the tax base.
Many special provisions of the tax law approximate a
consumption tax in the lifetime tax treatment of savings.
For example, allowing immediate deduction for tax purposes
of the purchase price of an item that will be used up over a
period of years (i.e., immediate expensing of capital investments) is equivalent to consumption tax treatment of investment income because it allows the full deduction of savings;
thus, accelerated depreciation approximates the consumption
tax approach. While depreciation provisions under the
present law are haphazard, a consumption base tax would
allow the immediate deduction of saving to all savers.
In conclusion, taxation of a significant portion of
savings under the current system more closely resembles the
consumption model than the comprehensive income model. For
owner-occupied housing, a large fraction of pension plans,
and some other investments, the tax base closely approximates
either the present value of imputed consumption benefits or
the present value of consumption financed by proceeds of the
investment.
- 36 -
Is the Tax System Presently on an "Ability-to-Pay" or a
"Standard-of-Living" Basis?
Three possibilities may be considered for the income
tax treatment of a gift from one taxpaying unit to another:
(1) the gift might be deducted from uses in calculating the
tax base of the donor and included in sources in calculating
the base of the donee; (2) it might be left in the base of
the donor and also included in the base of the donee; or (3)
it might be left in the base of the donor but excluded from
the base of the donee.
The first of these treatments is that implied by a
"standard-of-living" basis for determining relative tax
burdens. The second treatment expresses an "ability-to-pay"
view. The third treatment is that of the present income tax
(excluding the estate and gift tax) law, at least with
respect to property, with no unrealized appreciation at the
time the gift is made.
The first and third treatments are similar in that there
is no separate tax on the transfer of wealth from one
taxpaying unit to another. The tax burdens under those two
options may differ with a progressive tax structure, however.
Under the third treatment, aggregate tax liability is
unaffected by the gift, but under the first, it will rise
or fall depending on whether or not the marginal tax bracket
of the donee is higher than the marginal tax bracket of the
donor. Under the second treatment, with the gift or bequest
in the tax base of both the donor and the donee, the consumption or change in net worth financed by the gift is, in
effect, taxed twice. It is taxed as consumption by the
donor, and then taxed again as consumption or an increase in
net worth of the donee.
To illustrate the alternative treatments of wealth
transfers, consider the case of taxpayers A and B, who start
life with no wealth and who are alike except that A decides
to accumulate an estate. Their sons, A' and B', respectively, consume their available resources and die with zero
wealth. Thus, A has lower consumption than B; A' (who
consumed what his father saved) has higher consumption than
B'. Under a "standard-of-living" approach, the pair A-A1
should bear roughly the same tax burden as the pair B-B'.
This is so because the higher consumption of A' is simply
that which his father, A, did not consume. Under an
"ability-to-pay" approach, the combination A-A' should bear
more tax than B-B'. A and B have the same ability to pay,
- 37 -
but because A chooses to exercise his ability to pay by
making a gift to his son, A1 has a greater ability to pay
than B', by virtue of the gift received.
Neglecting the effect of progressivity, present income
tax law taxes the combination A-A' the same as it does the
combination B-B' (whether or not A and A' are related). In
this respect, present income tax law incorporates a "standardof-living" basis. The way this is accomplished, however, is
"backward." That is, instead of taxing A on his "standardof-living" income and then taxing A' on his "standard-ofliving" income, present law taxes A on his consumption plus
increase in net worth plus the gift given (i.e., the gift is
not deductible in calculating the income tax due from A) ,
while A' is taxed on the value of his consumption plus
increase in net worth minus the value of the gift received
(i.e., the receipt of the gift is not included in calculating the tax due from A').
This procedure clearly mismeasures the income of A. It
mismeasures the income of A', as well, if a "standard-ofliving" concept of income is used. The income of A1 is
understated (gift received is not included) and that of A is
overstated (gift given is not excluded). However (continuing to neglect the effect of progressivity), the impact
of the tax system on A and A' is the same as if the treatment were the other way around, at least as far as intentional
gifts are concerned. Suppose, for example, that A wants to
enable A1 to have an extra $750 worth of consumption. Under
present law, A simply gives A' $750 cash and A' consumes it.
Under a "standard-of-living" concept of income (assuming A
and A' are both in the 25-percent rate bracket), A would
give A' $1,000. After paying taxes of $250, A' would have
$750 to consume. At the same time, A would deduct $1,000
from his tax base, saving $250 and making the net cost of
his gift $750.
Although the effects of progressivity would alter this
somewhat, it is not clear that the differences in rates
between giver and receiver would be likely to be large if a
lifetime view were taken. Naturally, under present law, an
adult donor will tend to have a higher marginal rate of
income tax than a child donee. It is for this reason that
present income tax law treatment of gift and bequest transactions may come closer than the more intuitively obvious
one ~ excluding to donor, including to donee — to measuring
- 38 -
"standard-of-living" income correctly. Certain administrative
aspects also favor the present treatment of gifts and
bequests for income tax purposes.
In summary, whether by accident or design, present
income tax law incorporates a rough sort of "standard-ofliving" view of the concept of income because it does not
include an extra tax on wealth transfers as an integral part
of the income tax. Such treatment approximates a provision
where a gift given is included in the income of the donee
and excluded from the income of the donor, even though the
mechanics of calculating the tax are on the opposite basis.
It is, then, mainly the estate and gift tax that
introduces the "ability-to-pay" element into the tax system,
because it results in a gift or bequest being taxed twice to
the donor, once under the income tax and again under the
transfer tax. The value implicitly expressed is that taxes
should generally be assessed on a "standard-of-living"
basis, except in the case of individuals whose ability to
pay is very large, and whose standard of living is low
relative to ability to pay (i.e., those who refrain from
consuming in order to make gifts and bequests).
ALTERNATIVE BASES: EQUITY CONSIDERATIONS
The previous section considered what tax base is
implicit in present law. In a sense, the answer itself is
an equity judgment, because equity traditionally has played
an important role in the tax legislation process. This
section considers the relative equity claims of a "consumption" as compared with an "income" basis, of either
"ability-to-pay" or "standard-of-living" type, and the
"ability-to-pay" or "standard-of-living" version of either
consumption or income.
Consumption or Income: Which is the Better Base?
Involved in the choice between consumption and income
as the basis for assessing tax burdens is more than a simple
subjective judgment as to whether, of two individuals having
different incomes in a given period but who are identical in
all respects in all other periods, the one with the higher
income should pay the higher tax. Examples of tax burdens
considered within a life-cycle framework suggest that a
consumption base deserves careful attention if the primary
consideration is fairness, whether one takes an ability-topay or a standard-of-living view.
- 39 -
Many observers consider income and consumption to be
simply alternative reasonable ways to measure well-being;
often, income is regarded as somewhat superior because it is
a better measure of ability to pay. However, in a lifecycle context, income and consumption are not independent of
each other. Of two individuals with equal earning abilities
at the beginning of their lives, the one with higher consumption early in life is the one who will have a lower
lifetime income. This is true because saving is not only a
way of using wealth, but also a way of producing income.
Thus, the person who saves early in life will have a higher
lifetime income in present-value terms. Although his initial
endowment of financial wealth and of future earning power is
independent of the way he chooses to use it, his lifetime
income is not independent of his consumption/savings decisions
The examples presented below show that a consumption
base would be more likely to maintain the same relative
rankings of individuals ranked by endowment than an income
base, if "endowment" is defined as an individual's wealth,
in marketable and nonmarketable forms, at the beginning of
his working years. Wealth so defined consists of the total
monetary value of financial and physical assets on hand, the
present value of future labor earnings and transfers, less
the cost of earning income and less the present value of the
"certain other outlays" discussed in the accounting framework
above. If endowment is regarded as a good measure of
ability to pay over a lifetime, this implies that a consumption base is superior to an income base as a measure
of lifetime ablTity to pay.
If individuals consume all of their initial endowment
during their lifetime (that is, leave no bequest), a consumption tax is exactly equivalent to an initial endowment tax.
However, an income tax treats individuals with the same
endowment differently, if they have either a different
pattern of consumption over their lifetime or a different
pattern of earnings.
Consider first two individuals with no initial financial
or physical wealth, no bequest, the same pattern of labor
earnings, and different patterns of consumption. Intuition
suggests that, unless these individuals differ in s ?™ e
respect other than how they choose to use their available
resources (e.g., with respect to medical expenses or family
status), they should bear the same tax burden, « e f B u r ^ ^y
the present value of lifetime taxes. The tax system should
- 40 -
not bear more heavily on the individual who chooses to
purchase better food than on the one who chooses to buy
higher quality clothing. Nor should it bear more heavily on
the individual who chooses to apply his endowment of labor
abilities to purchase of consumption late in life (by saving
early in life) than it does on the one who consumes early in
life.
While an income tax does not discriminate between the
two taxpayers in the case where the two taxpayers consume
different commodities, it does in the case where they choose
to consume in different time periods in their lives. An
income tax imposes a heavier burden on the individual who
prefers to save for later consumption than on the one who
consumes early, and the amount of difference may be significant. The reason is the double taxation of savings under
an income tax. The "use" of funds for savings is taxed, and
then the yield from savings is taxed again. The result is
that the individual who chooses to save early for later
consumption is taxed more heavily than one who consumes
early.
The tax burden may be reduced most by borrowing for
early consumption, since the interest cost is deducted in
calculating income.
Now, suppose that the two individuals have different
time paths of labor earnings but that the two paths have the
same present discounted value. For example, individual A
may earn $10,000 per year in a given 2-year period, while
individual B works for twice as many hours and earns $19,524
in the first of the 2 years, but earns nothing in the
second. (The figure of $19,524 is the total of $10,000 plus
the amount that would have to be invested at a 5-percent
rate of return to make $10,000 available one year later.)
Each individual prefers to consume the same amount in both
periods, and in the absence of tax, each would consume the
same amount, $10,000 per year. Intuition suggests these two
individuals should bear the same tax burden. However, under
an income tax (even at a flat rate, i.e., not progressive),
they would pay different taxes, with B paying more than A.
The reason, again, is the double taxation of B's savings.
The differences may be very large if a long time period is
involved. An income tax imposes a higher burden on the
individual who receives labor income earlier even though
both have the same initial endowments in present-value terms
and the same consumption paths.
- 41 -
"Standard-of-Living" or "Ability-to-Pav"_ which Criterion?
Although for the vast majority of individuals bequests
and gifts of cash and valuable property constitute a negligible portion of sources and an equally neqliaible oortion
:llT^l\lZt^ tht taX treat^ °* tLKgirIisact?ons10n
will have significant consequences for a minority of wealthy
individuals and, therefore, for the perceived fairness of
the tax system.
The equity judgment embodied in present law is that
large transfers should be subject to a substantial progressive tax under the estate and gift tax laws and that relatively small transfers need not be taxed. For income tax
purposes, amounts given are taxed to the donor and are not
taxed to the donee. This has general appeal. The usual
reaction to the idea that gifts given should also be included in the tax base of the donee is that this would be an
unfair double taxation.
As has been pointed out, the circumstances under which
large transfers occur are relatively large wealth and low
consumption of donor. The imposition of a substantial
transfer tax (estate and gift tax) is consistent with a
common argument for this tax; namely, that it is desirable
to prevent extreme accumulations of wealth. If this is,
indeed, the equity objective, it suggests that the code's
present allowance of relatively large exemptions and imposition
of high rates on very large transfers is sensible.
Summing Up: The Equity Comparison of Consumption and Income
As
a general matter, the important conclusions to be
Bases
drawn from the foregoing discussion are:
• Either an income or a consumption tax may be designed
to fulfill "ability-to-pay" or "standard-of-living"
objectives. The difference is not between these two
types of tax, but rather between a tax in which gifts
given are considered part of the tax base of either
donor or donee or, instead, part of the tax bases of
both donor and donee. In the latter case, the tax
embodies an "ability-to-pay" approach; in the former,
the tax follows from a "standard-of-living" approach.
The present income tax system expresses a "standard-ofliving" basis of comparison, while the present estate
and gift tax system combines with income tax to give an
"ability-to-pay" approach in certain cases.
- 42 -
• The difference between a consumption base and an income
base of either the "standard-of-living" or the "abilityto-pay" type is between one that depends upon the
timing of consumption and earnings (and gifts, in the
case of an "ability-to-pay" tax) during an individual's
lifetime and one that does not. The income tax discriminates against people who earn early in life or
prefer to consume late in life. That is, if a tax must
raise a given amount of revenue, the income tax makes
early earners and late consumers worse off than late
earners and early consumers. A consumption tax is
neutral between these two patterns.
• A consumption tax amounts to a tax on lifetime endowment. It may be viewed as an ideal wealth tax, that
is, a tax that makes an assessment on lifetime wealth.
An income tax will tend to assess tax burdens in a way
presumably correlated with lifetime wealth, but because
it depends upon matters of timing, the correspondence
is nowhere near as close as would be the case under a
consumption base tax.
• As previously noted, present law introduces an "abilityto-pay" element into the tax system through the estate
and gift provisions. The same device is equally
compatible with either an income base or a consumption
base tax. As will be discussed in chapter 4, in some
respects an estate and gift tax system fits more
logically with a consumption base system, which allows
deduction of gifts by the donor and requires inclusion
by the donee.
ALTERNATIVE TAX BASES: SIMPLICITY CONSIDERATIONS
Of central importance in determining the complexity of
a tax system — to the taxpayer in complying and to the tax
collector in auditing compliance — is the ease with which
the required transaction information can be assembled and
the objective nature of the data. Three desirable characteristics are readily identifiable:
• Transactions should be objectively observable —
as in the case of the transaction of a wage payment.
Such transactions are called "cash" transactions in
this report. "Imputed" transactions, i.e., values
arrived at by guesses or rules of thumb — as in the
case of depreciation — should be kept to a minimum.
- 43 -
• The period over which records need to be kept should be
as short as practicable.
• The code should be understandable.
Consumption or Income Preferable on Grounds of Simplicity?
With respect to simplicity criteria, the consumption
base has many advantages, as can be seen on examination of
the accounting relationships. At this stage, both the
concept of consumption and the concept of increase in net
worth must be complicated by adding imputed elements to the
simple example.
The portion of consumption calculable from cash transactions includes cash outlays for goods and services and
transfers to others (optional, depending upon the choice
between "standard-of-living" and "ability-to-pay" versions).
In addition, an individual usually obtains directly the
equivalent of certain consumption services that he could
purchase in the marketplace. The most important of these
are the services from durable goods, such as owner-occupied
houses, and household-produced services, such as child care,
recreation, etc.
The change in net worth over a given time period, the
other component of income, is calculable in part by cash
transactions. These include such items as net deposits in
savings accounts. Imputed elements,however, are extensive
and lead to some of the most irksome aspects of income tax
law. Among these are the change in value of assets held
over the period, including the reduction in value due to
wear and tear, obsolescence, etc. (depreciation); increases
in value of assets due to retained earnings in corporate
shares held, changed expectations about the future, or
changed valuation of the future (accruing capital gains);
and accruing values of claims to the future (such as pension
rights, and life insurance).
Thus, both consumption and the change in net worth can
be expressed as the sum of items calculable from cash
transactions within the accounting period and items that
must be imputed. The cash items are easy to measure, but
imputed items are a source of difficulty. Because the
imputed consumption elements are needed for a comprehensive
income or consumption base, consider first some of the more
significant imputed elements of the change in net worth,
representing necessary additions to complexity if an income
base is used.
- 44 -
Four problems commonly encountered in measuring change
in net worth are depreciation, inflation adjustment, treatment of corporate retained earnings, and treatment of
unrealized capital gains on nonmarketed assets.
Measurement Problems
Depreciation. Depreciation rules are necessary under
an income base to account for the change in value of productive assets due to wear and tear, obsolescence, and
increases in maintenance and repair costs with age. Because
productive assets often are not exchanged for long periods
of time, imputations of their annual change in market value
must be made.
Inevitably, depreciation rules for tax accounting, as
in the present code, can only approximate the actual rate of
decline in the value of capital assets. Because changes in
depreciation rules can benefit identifiable taxpayers, such
rules become the object of political pressure groups and
are sometimes used as instruments of economic policy,
causing the tax base to depart even further from a true
accretion concept. Thus, accelerated depreciation, at rates
much faster than economic depreciation, has been allowed in
some industries as a deliberate subsidy (e.g., mineral
industries, real estate, and some farming). To the extent
that the relationship between tax depreciation and economic
depreciation varies among industries and types of capital,
returns to capital investment in different industries and on
different types of equipment are taxed at different effective
rates. Differences in the tax treatment of capital income
among industries create distortions in the allocation of
resources across products and services and in the use of
different types of capital in production.
Unrealized depreciation of an asset is neither added to
nor subtracted from the consumption base. Thus, the time
path of depreciation imputed to assets does not affect the
tax base of asset owners. Adoption of a consumption base
tax would automatically eliminate current tax shelters that
operate by allowing depreciation in excess of economic
depreciation in some industries. Alternative tax subsidies
to the same industries, if adopted, would have to be much
more explicit and would be easier to measure. The accidental
taxation of returns to capital in different industries at
different rates that arises under the current system because
would
of imperfect
not occur.
knowledge of true economic depreciation rates
- 45 -
Inflation Adjustment. During a period of rapid inflat ion7thecurrinFT_ncome tax includes inflationary gains
along with real gains in the tax base. For example, an
individual who buys an asset for $100 at the beginning of a
year and sells it for $110 one year later has not had any
increase in the purchasing power of his assets if the
inflation rate is also 10 percent. Yet, under the current
system he would include at least part of any gain on the
sale of the asset in the sources side of his tax calculation.
An ideal income base would have to adjust for losses on
existing assets, including deposits in savings banks and
checking accounts, resulting from inflation. Such adjustments would pose challenging administrative problems for
assets held for long periods of time. The current tax
system effects a rough compromise in its treatment of "longterm capital gains" by requiring that only half of such
gains be included in taxable income and by allowing no
inflation deduction. (However, this treatment has been
substantially modified by the minimum tax and by denial of
maximum tax benefits for "earned income" if the taxpayer
also has capital gains.) Dividends and interest income are
taxed at the same rate as labor income even though the
underlying assets may be losing real value.
A second type of inflationary problem under the current
tax system is that rising nominal incomes move taxpayers
into higher marginal tax brackets, and thus increase the
average tax rate even when real income is not growing.
Inflation will automatically raise the average tax rate in
any tax system with a graduated rate structure, whether
based on income, consumption, or the current partial-income
base. A possible solution is some type of indexing plan,
such as automatic upward adjustment of exemption levels.
Because this problem does not affect the relative distribution
of the tax base among individuals, it is not an issue in
choosing between a consumption and an income base.
Under a consumption tax, inflation would not lead to
difficulties in measuring the relative tax base among individuals because consumption in any year would be measured
automatically in current dollars. A decline in the value of
assets in any year because of inflation would be neither a
positive nor a negative entry in the consumption base.
- 46 -
Treatment of Corporate Income. Given the difficulty of
taxing gains in asset values as they accrue, the present
corporate income tax serves the practical function of
preventing individuals from reducing their taxes by accumulating income within corporations. Naturally, this is but
a rough approximation of the appropriate taxation of this
income and the difficulty of identifying incidence and
allocation effects of this tax is well known. Under a fully
consistent income tax concept, as outlined below in chapter
3, "corporation income" would be attributed to individual
stockholders. This integration of the corporation and
personal income taxes is desirable for a progressive income
tax system because the variation among individuals in
marginal tax rates makes it impossible for a uniform tax on
corporate income, combined with exclusion of dividends and
capital gains, to assess all individual owners at the
appropriate rate. Although feasible and desirable in an
income tax system, full corporate integration is sometimes
regarded as posing too many challenging administrative
problems. A partial integration plan that allowed corporations to deduct dividend payments and/or allowed shareholders to "gross up" dividends by an amount reflecting the
corporation income tax, taking a credit for the same amount
in their individual income tax calculation, would eliminate
the problem of "double taxation" of corporate dividends.
This could be done without introducing significant complexity
into the tax code, but the problem of how to treat corporate
retained earnings would remain unresolved.
Treatment of corporate income under a consistent
consumption tax is simpler than under a comprehensive
income tax. The corporation profits tax as such would be
eliminated. Individuals would normally include in their tax
base all dividends received and the value of all sales of
corporate shares, and they would deduct the value of all
shares purchased. There would be no need to treat receipts
from sales of shares differently than other sources or to
attribute undistributed corporate profits to individual
shareholders.
Treatment of Unrealized Asset Value Changes. The
increase in net worth due to any changes in value of assets,
whether realized or not, would be included in the accretion
concept of income. An individual who sells a stock at the
end
of the
year
for
than
the
price
attime
the
beginning
of
interval
land
that
both
of
the
increases
experience
year$100
and
inmore
the
value
an individual
same
by increase
$100purchase
who
during
in
holds
net
the
worth.
asame
parcel
•_____ta_______-_B_____________^_l__-___i____________B_--__^ll_-^^
*
«
^
- 47 However, unrealized asset value changes are often difficult
to determine, especially if an asset has unique characteristics
and has not been exchanged recently on an open market.
Further, there is a question as to what is meant by the
value of an asset for which the market is very thin and
whether changes in the value of such assets should be viewed
in the same way as an equal dollar flow of labor, interest,
or dividend income. For example, if the value of an individual's house rises, he is unlikely to find it convenient
to realize the gain by selling it immediately. Any tax
obligation, however, must ordinarily be paid in cash.
Similar questions arise with respect to the treatment
of increases in the present value of a person's potential
income from selling his human services in the labor market.
It is not practical to measure either the increase in an
individual' s wealth from a rise in the demand for his labor
or the depreciation of the present value of future labor
earnings with age. Present law makes no attempt to recognize
such value changes nor would they be captured in the comprehensive income tax proposal presented in chapter 3.
Under a consumption tax, unrealized changes in asset
value would not need to be measured because consumption from
such assets does not occur unless either cash flow is
generated by the asset or the asset is converted into a
monetary value by sale.
Finally, the problem of income averaging can be minimized with techniques of cash flow management. Averaging
is desirable under an income tax because, with a progressive
rate structure, an individual with an uneven income stream
will have a higher tax base than an individual with the same
average income in equal annual installments. Equity requires
that two individuals pay the same tax when they have the
same lifetime endowment, regardless of the regularity of the
pattern in which earnings are received (or expended).
The consumption tax may be viewed as a tax in the
initial time period on the present value of an individual's
lifetime consumption expenditures. Deferral of consumption
by saving at positive interest rates raises total lifetime
consumption but leaves unchanged the present value of both
lifetime consumption and the tax base.
Although the annual cash flow measure of the consumption
tax correctly measures the present value of lifetime consumption, averaging problems may arise if annual casn now
- 48 -
varies from year to year. The major averaging problem
results from large irregular expenditures, such as the
purchase of consumer durables. As described in chapter 4,
there are two alternative ways of dealing with loans and
investment assets in measuring the tax base. Both methods
yield the same expected present value of the tax base over
time but enable an individual to alter the timing of his
recorded consumption expenditures. The availability of an
alternative treatment of loans and assets enables individuals to even out their recorded pattern of consumption
for tax purposes and represents a simple and effective
averaging device under a consumption tax.
The same type of automatic averaging cannot be introduced under an income tax because an income tax is not a tax
on the present value of lifetime consumption. Under an
accretion income tax, the present value of the tax base
rises when consumption is deferred, if interest earnings are
positive, because the income used for saving is taxed in
the year it ij5 earned and then the interest is taxed again.
Thus, allowing deferral of tax liability under an income tax
permits a departure from the accretion concept, lowering the
present value of tax liability.
The discussion above suggests that, contrary to popular
belief, a consumption-based tax might be easier to implement, using annual accounting data in an appropriate and
consistent fashion, than an income-based tax.
"Standard-of-Living" or "Ability-to-Pay" Preferable on
Simplicity Grounds?
The choice between an "ability-to-pay" and a "standardof-living" approach under the consumption or income tax has
significant implications for simplicity of administration.
It is relatively easy to insure that the amount of a gift is
counted in the tax base of either the donor or the donee.
Under present law, gifts (other than charitable gifts) are
not deductible from the tax base of the donor. If gifts
were deductible, the donor could be required to identify
the donee. A requirement that both donor and donee be
taxed, as would be implied by an "ability-to-pay" approach,
would introduce a great temptation to evade. Taxing both
sides would require that the gift not be deductible by the
donor and that it be included in the tax base of the donee.
Particularly for relatively small gifts and gifts in-kind,
^_-a_-_-------w----------------------k---------->-----___----_-_____k
- 49 -
auditing compliance with this rule, where no evidence is
provided in another person's return of having made the aift
could be a formidable Drohl^m
i?^»- ™. u It y Hiaae c n e 9irt»
compliance with the existing aift LT^
^
fTr r e a s ° n '
somewhat haphazard? 8 X 1 S t i n g g l f t t a x 1«* " believed to be
The issue of gifts in-kind is important. It is difficult
(e a a S a n o f f h 6 r & g l f t h a S b e e n g i v e n i n these ctses
(e.g., loan of a car or a vacation home). Again, if the
Ltion faSiL ^^^ ^° °ne °f the partie* to ^ ^ransK e aiver and LtReport
a gift simply means it is taxed to
rne giver ana not the recipient.
Gifts in-kind are significant in another sense. Gifts
and bequests can be considered a minor matter to most
people only if the terms are taken to refer to transfers of
cash and valuable property. If account were taken of the
transfers within families that take the form of supporting
children until their adulthood, often including large
educational outlays, inheritance would certainly be seen to
constitute a large fraction of the true wealth of many
individuals. Any discussion of gifts and bequests should
take into account that the parent who pays for his child's
college education makes a gift no less than the parent who
makes a gift of the family farm or of cash, even though this
equivalence is not recognized in present tax law.
Where large gifts of cash and property are involved, it
seems likely that enforcement of a double tax on transfers
will be less costly than when gifts are small. This has
proved to be the case under current law.
EFFICIENCY ISSUES IN A CHOICE BETWEEN AN INCOME AND A
CONSUMPTION BASE
In public discussions, the efficiency of a tax system
is often viewed as depending on its cost of administration
and the degree of taxpayer compliance. While these features
are important, one other important characteristic defines
the efficiency of a tax system: As a general principle,
the tax system should minimize the extent to which individuals alter their economic behavior so as to avoid paying
tax. In other words^ it is usually undesIraBTe for taxes to
influence individuals' economic decisions in the private
sector. There may, of course, be exceptions where tax
policies are used deliberately to either encourage or
discourage certain types of activities (for example, tax
incentives for installation of pollution equipment or high
excise taxes on consumption of liquor and tobacco).
- 50 -
Both an ideal consumption tax and an ideal income tax,
though neutral among commodities purchased and produced, do
have important incentive effects that are unintended byproducts of the need to raise revenue. Specifically, individuals can reduce their tax liability under either tax to
the extent it is possible to conduct economic activities
outside of the marketplace. For example, if an individual
pays a mechanic to repair his automobile, the labor charge
will entered into the measurement of consumption or income
and will be taxed under either type of tax. On the other
hand, if the individual repairs his own automobile, the
labor cost will not be accompanied by a measurable transaction and will not be subject to tax. Phrased more generally,
both an income and a consumption tax distort the choice
between labor and leisure, where leisure is defined to
include all activities, both recreational and productive,
that are conducted outside the process of market exchange.
While both consumption and income taxes distort the
choice between market and nonmarket activities, only an
income tax distorts the choice between present and future
consumption.
Under an income tax, the before-tax rate of return on
investments exceeds the after-tax interest rate received by
those who save to finance them. The existence of a positive
market interest rate reflects the fact that society, by
sacrificing a dollar's worth of consumption today and
allocating the dollar's worth of resources to the production
of capital goods, can increase output and consumption by
more than one dollar next year. Under an income tax, the
potential increase in output tomorrow to be gained by
sacrificing a dollar's worth of output today exceeds the
percentage return to an individual, in increased future
consumption, to be derived from saving. In effect, the
resources available to an individual for future consumption
are double-taxed; first, when they are earned as current
income and second, when interest is earned on savings. The
present value of an individual's tax burden may be reduced
by shifting consumption from future periods to the present.
A consumption tax, on the other hand, is neutral with
respect to the choice to consume in different periods
because current saving is exempted from the base. The
expected present value of taxes paid is not affected by the
time
pattern
consumption.
Awould
switch
from
an to
income
an
theequal-yield
thereby
fraction
raiseof
of
future
consumption
national
output
output
tax
and
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savedthus
and
tend
invested,
increase
andtax to
- 51 -
The fact that a tax is neutral with respect to the
savings-consumption decision is not, of course, decisive in
its favor even on efficiency grounds. No taxes are neutral
with respect to all choices. Thus, for example, it has
already been pointed out that neither the income nor the
consumption tax is neutral in the labor/leisure choice; that
is, both reduce the incentive to work in the marketplace.
Economic theorists have developed measures of the amount of
damage done by nonneutrality in various forms. Although
it is not possible on the basis of such research to make a
definite case for one tax base over the other based on
efficiency, when reasonable guesses are made about the way
people react to various taxes it appears that the efficiency
loss resulting from a consumption tax would be considerably
smaller than that from an equal yield income tax.
The possible efficiency gains that would result from
adopting a consumption base tax system relate closely to the
frequently expressed concern about a deficient rate of
capital formation in the United States. Switching from an
income to a consumption base tax would remove a distortion
that discourages capital formation by U.S. citizens, leading
to a higher U.S. growth rate in the short run, and a permanently higher capital/output ratio in the long run.
SUMMING UP
The previous discussions have attempted to provide a
systematic approach to the concept of income as composed of
certain uses of resources by individuals. The current
income tax law lacks such a unifying concept. Indeed, as
has been suggested here, income as implicitly defined in
current law deviates from a consistent definition of accretion
income especially in that it excludes a major part of income
used for savings (often in the form of accruing rights to
future benefits). Eliminating savings from the tax base
changes an income tax to a tax on consumption.
This chapter has considered whether there is any sound
reason for considering substitution of a consumption base
for the present makeshift and incomplete income base. It
has been suggested that there is much to be said for this on
grounds of equity; such a base would not have the drawback,
characteristic of an income tax, of favoring those who
consume early rather than late in life, and of taxing more
heavily those whose earnings occur early rather than late in
life. The argument has been made that the choice is not
- 52 -
between a tax favoring the rich (who save) and the poor (who
do not), as some misconceive the consumption tax, and a tax
favoring the poor over the former rich by the use of progressive rates, as some view the income tax. The choice is
between an income tax that, at each level of endowment,
favors early consumers and late earners over late consumers
and early earners and a consumption tax that is neutral
between these two types of individuals. The relative
burdens of rich and poor are determined by the degree of
progressivity of the tax. Either tax is amenable to any
degree of progressivity of rates.
A distinction has been drawn between a tax based on the
uses of resources for the taxpayer's own benefit and one
based on these uses plus the resources he gives away to
others. The shorthand term adopted for the former is the
"standard-of-living" approach to assigning tax burdens; for
the latter, it is the "ability-to-pay" approach. It has
been suggested that either a consumption or an income tax
could be designed to fit either concept. Examination of
current practice suggests that the basic tax — the present
income tax — is, broadly speaking, of the "standard-ofliving" type. An "ability-to-pay" element is introduced by
special taxes on gifts and estates.
The next two chapters consider two different approaches
to reform of the tax system. Chapter 3 contains a plan for
a comprehensive income tax, and chapter 4 contains a plan
for a very different tax, called a cash flow tax, which is
essentially equivalent to a consumption tax. In both cases,
a "standard-of-living" approach is adopted, under the
assumption that a transfer tax of some sort, perhaps the
existing estate and gift tax, would continue to be desirable
as a complement.
- 53 -
Chapter 3
A MODEL COMPREHENSIVE INCOME TAX
OVERVIEW
This chapter presents a model income tax system based,
as nearly as practicable, on a consistent definition of
"standard-of-living" income as set forth in the previous
chapter. The exceptions to strict conformity with the
conceptual income definition are noted. These exceptions
occur when rival considerations of efficiency or simplicity
have seemed to overrule the underlying principle that all
income should be taxed alike. In addition, those cases
where the concept of income is not readily translated into
explicit rules are noted and discussed. In every case,
a specific model tax treatment, sometimes together with
optional treatments, is defined and highlighted.
Purpose of the Model Tax
The purpose of the model tax is to provide a concrete
basis for the discussion of fundamental tax reform and also
to define a standard for the quantitative analysis presented
in chapter 5. For each major issue of income tax policy, the
model tax reflects a judgment of the preferred treatment.
It is not claimed, however, that the model tax provides
the unequivocally right answer to all the difficult issues
of measurement, definition, and behavioral effects raised.
The chapter does not, therefore, only advocate a particular
set of provisions; it also presents discussions of alternative treatments.
Base-Broadening Objective
Alternative treatments are suggested when a change from
the model tax provision clearly would not violate the basic
principle that an income tax should be based on a practical
measure of income, consistently defined. In some cases,
alternative accounting methods or alternative means of
applying tax rates may be used; and there may also be some
uncertainties in the interpretation of the income concept
itself. Because a low-rate, broad-based tax promises a
general imrpovement in incentives, and because there are
costs associated with recordkeeping and administration,
there is a presumption against deductions, exemptions, and
credits throughout the model tax. In particular instances,
this presumption may be reversed in favor of an alternative
- 54 treatment without offending the basic principle of income
measurement.
Organization of Chapter 3
The first issues taken up in the chapter concern rules
for a definition of income suitable as a tax base. Such
rules are derived for three broad sources of household
income—employee compensation, government transfer payments,
and business income. The first of these is treated in the
next section. The third section considers the tax treatment
of government transfer payments, and the fourth section
deals with problems of accounting for income from businesses.
The next four sections of the chapter discuss some specific
issues in the taxation of income derived from the ownership
of capital. In each of these sections, the model tax is
compared with the existing Federal income taxes. Next are
three sections that treat issues in the definition of
taxable income from all sources. These are the major
"personal deductions" under the existing tax. Here, each of
these items — medical expenses, State and local taxes,
charitable contributions, and casualty losses — is considered as an issue of income measurement and economic
efficiency. Following these is a brief discussion of the
problems and principles of international income tax coordination. Finally, the questions of the proper unit for reporting
taxable income and of appropriate adjustments for family
size and other circumstances are considered. The chapter
concludes with a sample model income tax form that serves as
a summary of the model tax provisions.
EMPLOYEE COMPENSATION
^y The customary starting point for systems of income
accounting is to observe the terms under which individuals
agree to provide labor services to employers. In the
simplest case, described in the previous chapter, the
employee is paid an annual wage that is equal to his consumption plus change in net worth. However, in practice,
complications usually will arise. On the one hand, the
employee may have expenses associated with employment that
should not be regarded as consumption. On the other hand,
he may receive benefits that have an objective market value,
which, in effect, represent an addition to his stated wage.
The model comprehensive income tax attempts to measure
the value to the employee of all the financial terms of his
employment. In general, the accounting for employee compensation is (1) wage and salary receipts, less (2) necessary
- 55 employment expenses, plus (3) the value of fringe benefits.
The remainder of this section discusses the measurement
problems presented by items (2) and (3) .
Expenses of Employment
Model Tax Treatment. The model comprehensive income
tax would allow deduction from wage and salary receipts
for expenses required as a condition of a particular job,
such as the purchase of uniforms and tools, union dues,
unreimbursed travel, and the like. No deduction would be
allowed for expenditures associated with the choice of
an occupation, place of employment, or place of residence,
even though each of these is related to employment. The
latter rule would continue the present treatment of education and commuting expenses, but would disallow moving
expenses.
Inevitably, such rules are somewhat arbitrary. For
example, whether commuting expenses are deemed costs of
employment or consumption expenditures will depend upon
whether the work trip is regarded principally as a part of
one's choice of residence, i.e., the consumption of housing
services, or as a part of the job choice. The guidelines
followed here are that expenses should be deductible only if
they vary little among individuals with the same job and are
specific to the current performance of that job. As at
present, regulations would be required to set reasonable
limits for those expenses that may be subject to excessive
variation, e.g., travel.
A Simplification Option. An option that would simplify
individual recordkeeping and tax administration would be to
allow deduction for employee business expenses only in
excess of a specified amount. If this floor were substantially
higher than expenses for the typical taxpayer, most employees
would no longer need to keep detailed expense records for
tax purposes. The principal disadvantage of this limitation
of deductions is that it would tend to discourage somewhat
the relative supply of labor to those occupations or activities
that have relatively large expenses. Over time, such supply
adjustments could be expected to provide compensating increases
in wages to those whose taxes are increased by this provision, but the inefficiency of tax-induced occupation changes
would remain.
- 56 Employer-Provided Pensions
A substantial share of the compensation of employees is
in the form of the annual increase in the value of rights to
future compensation upon retirement. This increase adds to
the net worth of the employee, so that an annual estimate of
the accretion of these rights is income under the comprehensive
definition. The model tax treatment is intended as a
uniform, practical means to estimate the income for tax
purposes for different types of private pension plans.
The model comprehensive income tax would continue
to exclude employer contributions to pension plans from the
employee's tax base and to tax benefits when received.
In addition, employee contributions would be deductible
in the years paid. However, the earnings of pension plans
would be taxed as they accrued. Liability for tax on
pension plan earnings would be either upon the employer, if
no assignment of rights were made to employees as the earnings
accrue, or upon the employee to whom these earnings are
allocated by the plan.
Types of Pension Plans. Employer-provided pension
plans come in two forms — defined-contribution and definedbenefit. The first form is essentially a mutual fund to
which the employer deposits contributions on behalf of his
employees. Each employee owns a percentage of the assets,
and each employee's account increases by investment earnings
on his share of the assets. Upon retirement, his account
balance may be distributed to him as a lump sum payment or
may be used to purchase an annuity. The income of any
individual from such a plan is simply the contribution made
by the employer on his behalf plus his share of the total
earnings as they accrue.
Most pensions are of the second type, defined-benefit
pensions. This is something of a misnomer because the
benefit is not fully defined until retirement. It usually
depends on the employee's average wage over the years of
employment, the outcome of contract negotiations, etc. The
employee's benefits may not vest for a number of years,
so that the value to him, and the cost to his employer
of his participation are an expectation that depend on the
chance of his continued employment. By a strict definition
of income, the annual change in the present value of expected
future benefits constitutes income from the plan, since this
is conceptually an annual increase in the net worth of the
- 57 employee. In general, it is not possible to determine the
accrued value of future benefits in such a plan without many
arbitrary assumptions about the employee's future employment
prospects, marital status at retirement, and similar issues.
A Practical Measurement System. As an alternative to
estimating pension income as an accrual of value to the
employee, the model plan would approximate such treatment
through the current taxation of plan earnings and full
taxation of actual benefits. If done correctly, this would
be equivalent to the taxation of the increase in present
value of expected future benefit as such increases accrue.
The following example illustrates the equivalence
between taxation of accrued pension earnings and taxation of
both pension plan earnings and benefits received.
Mr. Jones' employer contributes $160 to his pension
plan at the beginning of this year. Over the year,
the contribution will earn 10 percent. Mr. Jones
retires at the beginning of next year, taking his
pension — the contribution plus earnings — in one
payment. Mr. Jones' tax rate in both periods is 25
percent.
Method 1. Under a system of taxation of pensions as
accrued, Mr. Jones would include the contribution in his
taxable income and owe a tax of $40. The earnings of $12 on
the remaining $120 would incur an additional tax liability
of $3, leaving net earnings of $9. (Note that Mr. Jones
could restore the pension fund to $160 only by drawing down
his other savings, with a presumably equal rate of return,
by the amount of the tax.) Upon retirement, Mr. Jones would
receive a tax-prepaid pension distribution of $120 plus ?9,
or $129.
Method 2. The model tax treatment would subject only
the earnings of the fund ~ 10 percent of $160 — to tax in
the first year. This tax of $4 would leave net earnings of
$12. Mr. Jones would then receive $172 upon retirement, but
would owe tax on this full amount. The tax in this case
would be $43, so that the remainder [$172 - $4J - >i^yj
would be identical to that resulting from use of method
1, and Mr. Jones should be indifferent between the two
treatments.
- 58 The method of including actual benefits has the advantage
of avoiding the necessity to allocate prospective benefits
among nonvested participants. Investment earnings would,
however, have ambiguous ownership for the reasons mentioned
above. Consequently, it would be necessary to assess a tax
on the employer for that share of earnings not assigned to
particular employees.
Present Law. Under present law, if an employer-provided
pension plan is legally "qualified," retirement benefits are
taxable to the employee only when received, not as accrued,
even though contributions are deductible to the employer as
they are made. The plan's investment income is tax exempt.
Certain individuals are also allowed tax benefits similar to
qualified pension plans under separate laws. These laws
allow a limited amount of retirement saving to be deducted
from income, its yield to be tax free, and its withdrawals
taxable as personal income. This treatment allows an
interest-free postponement of tax liability that would not
exist under the model tax. Postponement introduces nonneutral
tax treatment among forms of saving and investment, encourages
a concentration of wealth in pension funds, and reduces
the available tax base.
Social Security
Social security retirement benefits (OASI) present
other problems. They are financed by a payroll tax on the
first $15,300 (in 1976) of annual earnings, half of which is
paid by the employer and half by the employee. The half
paid by the employee is included in his tax base under the
current income tax; the tax paid by the employer is not,
although it is a deductible expense to the employer. Social
security benefits are tax free when paid.
For an individual employee, the amount of annual
accrual of prospective social security benefits is ambiguous.
Actual benefits, by contrast, are readily measurable and
certain. Furthermore, because participation in Social
Security is mandatory, failure to tax accruals does not
present the same tax neutrality problem encountered with
private pensions; that is, there is no incentive to convert
savings to tax-deferred forms. Consequently, the model tax
base would allow deduction of employee contributions by
the individual and continue to allow deduction of employer
contributions b£ the employer, but OASI benefit~payments
would
&£ subject to tax. Very low-income retired persons
would be shielded from taxation by provision of a personal
exemption and an additional family allowance.
- 59 Employer-Paid Health and Casualty Insurance
Issues in the tax treatment of health and casualty
insurance are discussed separately below in the sections on
medical expenses and casualty losses. in the case of
employer-paid premiums for insurance unrelated to occupational hazards, the model tax adopts the same treatment
that is recommended for individual purchase. The taxpayer
would include as taxable employee compensation"""the value
of the premiums paid on~~his behalf. Proceeds would not be
included in income. The same model tax treatment would
apply to the health insurance (Medicare) component of Social
Security.
Disability Insurance
Private Plans. Under present law, employees are not
required to include employer-paid disability insurance
premiums in income, and, subject to a number of conditions,
disability grants do not have to be included in the individual 's income tax base. Under the proposed system,
premiums paid into such disability plans by employers
would not be taxable to employers, and employees would
be allowed to deduct their own contributions, but the
benefits would be taxable.
Conceptually, the premiums paid by the employer do
increase the net worth of the employee by the expected value
of benefits. Whether benefits are actually paid or not,
this increase in net worth is income by a comprehensive
definition. However, when benefits are taxable, as they
would be under the model plan, the expected value of tax is
approximately equal to the tax liability under a current
accrual taxation system. The model tax treatment is preferred
because valuing the worth of the future interests would pose
insurmountable administrative difficulties.
Social Security Disability Insurance. The model tax
would provide exactly the same treatment~for the disability
insurance portion of Social Security (PI), that is given for
private plans^ Accrual taxation is impractical because the
annual value of accruing DI benefits is even less certain
than for private plans.
- 60 Life Insurance
Term Life Insurance. There is no similar difficulty of
valuation in employer provision of term life insurance. The
annual value to the employee is equal to the premium paid on
his behalf. Therefore, under the model tax, term life
insurance premium payments made by the employer would be
included in income to the employee; benefits would not be
included In income. This parallels the present treatment of
an individual's own purchase of term insurance, and that
treatment would be continued.
Whole Life Insurance. Whole life insurance involves
some additional considerations. A whole life policy represents
a combination of insurance plus an option to buy further
insurance. When one buys a whole life policy, or when it is
purchased on his behalf, that policy may be viewed as 1
year's insurance plus an option to buy insurance for the
next and subsequent years at a certain prescribed annual
premium. That option value is recognized in the form of the
"cash surrender value" of the policy. It represents the
value, as determined by the company's actuaries, of buying
back from the insured his option to continue to purchase on
attractive terms. Naturally, the value of this option tends
to increase over time, and it is this growth in value that
represents the income associated with the policy. Dividends
paid on life insurance are, in effect, only an adjustment in
the premium paid — a price reduction.
The total annual income associated with a whole life
insurance policy is equal to the increase in its cash
surrender value plus the value of the term insurance for
that year (the term insurance premium) less the whole life
premium, net of dividend. Under the comprehensive tax,
insurance companies would inform each policyholder annually
of this income, which would"~be included in the policyholder's
income. This treatment is recommended whether the premium
is paid by the individual or by his employer. In addition,
the contribution of the employer to the annual payment
°f the premium would be included in income, as with term
insurance.
Unemployment Compensation
Under present law, both the Federal Unemployment Tax
Act (FUTA) taxes to finance the public unemployment compensation system and the unemployment compensation benefits
are excluded from the income of covered employees. Following
- 61 the recommended treatment of disability insurance, which has
similar characteristics, the model comprehensive income tax
would exclude payroll taxes from income as at present, but,
unlike the present law, unemployment compensation benefits
would be included in taxable income.
This treatment has two basic justifications. First, it
conforms with the basic equity principle of subjecting all
income to the same tax. Employed individuals would not be
subject to differentially higher tax than those of equal
income who derive their income from unemployment benefits.
Second, by taxing earnings and unemployment benefits alike,
this treatment would reduce the disincentive to seek alternative or interim employment during the period of eligibility
for unemployment benefits. Acrain, the personal exemption
and family allowance would prevent the tax from reaching
very low-income persons who are receiving such benefits.
PUBLIC TRANSFER PAYMENTS
A large element of the income of many households is
provided by payments or subsidies from government that are
not related to contributions by, or on behalf of, the
recipients. These transfer payments are presently excluded
from the calculation of income for Federal taxes, despite
their clear inclusion in a comprehensive definition of
income.
Model Tax Treatment
The logic of including transfers in a tax base varies
among transfer programs. A distinction may be made between
those grants that are unrelated to the current financial
circumstances of recipients, e.g., veterans' education
benefits, and those that depend upon a stringent test of
means, such as aid to families with dependent children. A
second useful distinction is between cash grants that are
readily measurable in value and publicly provided or subsidized services. The amount of income provided by these
"in-kind" benefits, such as public housing, is not readily
measurable.
The model income tax would include in income all
cash transfer payments from government, whether determined
by a test of means or not. Such payments include veterans'
disability and survivor benefits, veterans' pensions, aid
to families with dependent children, supplemental security
- 62 income, general assistance, workmen's compensation, black
lung benefits, and the subsidy element of food stamps.1/
The model tax would not require reporting the value of
government-provided or subsidized services. Hence, there
would be no extra tax associated with the benefits of such
programs as Medicaid, veterans' health care, and public
housing.
Rationale for Taxing Transfer Payments
Horizontal Equity. The principal argument for taxing
transfer payments is horizontal equity. Under present law,
families that are subject to tax from earnings or from
taxable pensions may face the same financial circumstances
before tax as others that receive transfer income. If an
adequate level of exemption is provided in the design of a
tax rate structure, these families would have no tax in
either case. But for those whose incomes exceed the exemption level, the present treatment discriminates against the
earning family. This is both an inequity and an element of
work disincentive.
Those transfer payments that are not contingent on a
strict means test are especially likely to supplement family
incomes that are above the level of present or proposed
exemptions. These programs are the various veterans'
benefits, workmen's compensation, and black lung benefits.
The taxation of benefits from any government transfer
program would effectively reduce benefits below the level
that Congress originally intended, and restoration of these
levels may require readjustment of the rates of taxation.
However, with a progressive rate tax, the benefits to individual
would be scaled somewhat to family circumstances and, in
addition, the tax consequences of earnings and grants would
be equalized.
Vertical Equity. The means-tested programs — Aid to
Families with Dependent Children, Supplemental Security
Income, general assistance, Food Stamps, Medicaid, and
public housing — have rules to determine eligibility and to
scale the value of benefits according to income and wealth
of the recipient family. However, these rules may be based
on measures of well-being that are different from those
appropriate for an income tax. The rules also vary by
region, and certain grants may supplement each other or be
supplemented by other forms of assistance. Consequently, it
- 63 -
is possible that families with similar financial circumstances before transfers will diverge widely after transfer
payments are added. To the extent that some recipient
households have total incomes that exceed the tax exemption
level, inclusion of these grants in the tax base would
reduce this divergence. Taxation of grants is no substitute
for thorough welfare reform, but it may be regarded as a
step toward reducing overlap of the various programs and of
reducing regional differences in payment levels.
Valuing In-Kind Subsidies
Those programs of assistance to families that provide
particular commodities or services, such as housing and
medical care, present difficult administrative problems of
income evaluation. One objective approximation of the
income to households/ from these services is the cost of
providing them. This is the principle employed to value
pension contributions, for example. But in the case of inkind transfers, costs are not readily allocable to particular
beneficiaries. Consider how difficult it would be to allocate
costs among patients in veterans' hospitals, for example.
Furthermore, because a recipient's choices regarding these
services are restricted, the cost of the services may be
substantially larger than the consumption (i.e., income)
value to the beneficiary. The recipient family would almost
certainly prefer an amount in cash equal to the cost of
provision. Because of these uncertainties and because of
the attendant costs of tax administration and reporting, the
in-kind programs might reasonably be excluded from the tax
base.
BUSINESS INCOME ACCOUNTING
Basic Accounting for Capital Income
What is meant here by "business income" is that part of
the annual consumption or change in net worth of the taxpayer that derives from the ownership of property employed
in private sector production. In the ordinary language of
income sources, this income includes those elements called
interest, rent, dividends, corporate retained earnings.
Proprietorship and partnership profits, and capital gains,
each appropriately reduced by costs. Unfortunately, there
is no generally accepted set of accounting definitions for
all of these ordinary terms. An important objective of the
model income tax is to outline an accounting system for
Property income that is at once administrable and in close
conformance with a comprehensive definition of income.
- 64 -
It is apparent from the definition that income is an
attribute of families and individuals, not of business
organizations. Furthermore, it is useful analytically to
think of income in terms of uses of resources, rather than
receipts of claims. Nonetheless, accounting for income is
most easily approached by beginning with receipts of individual
business activities (or firms), then specifying adjustments
for costs, and, finally, allocating income earned in each
business among its claimants. The sum of such claims for
all activities in which a taxpaying unit has an interest is
that taxpayer's business income for purposes of the model
tax.
In broad outline, accounting for business income
proceeds as follows. Begin with gross receipts from the
sale of goods and services during the accounting year and
subtract purchases of goods and services from other firms.
Next
' subtract the share of income from the activity that is
compensation to suppliers of labor services, generically
called wages. Next, subtract a capital consumption allowance,
which estimates the loss in value during the year of capital
assets employed in production. The remainder is net capital
income, or, simply, business income. Finally, subtract
interest paid or accruing to suppliers of debt finance. The
remainder is income to suppliers of equity finance, or
profit. A business activity thus generates all three sources
of income to households — wages, interest, and profit.
Major problems in defining rules of income measurement
for tax purposes include (1) issues of timing associated
with a fixed accounting period, such as inventory valuation;
(2) estimation of capital consumption, i.e., depreciation
and depletion rules; and (3) imputations for nonmarket
transactions, e.g., self-constructed capital assets. In
each of these cases, there are no explicit market transactions within the accounting period to provide the appropriate valuations. Rules for constructing such valuations
are necessarily somewhat arbitrary, but the rules described
here are intended to be as faithful as possible to the
concept of income.
Capital Consumption Allowances
Rules for capital consumption allowances should not be
regarded as arbitrary allowances for the "recovery of
capital costs." Rather, they are a measure of one aspect of
annual capital cost; namely, the reduction in value of
productive capital occasioned by use, deterioration, or
- 65 obsolescence. Rules for estimating this cost should be
subject to continuous revision to reflect new evidence on
actual experience and changing technology. For machinery
and equipment, the model tax would require that depreciation
he estimated by means of a system similar, in some respects,
to the existing Asset DeprecT"ation"~Range (ADR) systerrTbut
with annual adjustment of basis for increases in the
general price level. The essential features of this system
are (1) classification of all assets by type of activity,
(2) mandatory vintage accounting, (3) a guideline annual
repair allowance, (4) a specified annual depreciation rate
(or permissible range) to be applied to the undepreciated
balance (together with a date on which any remaining basis
may be deducted) and (5) annual adjustment of basis in each
account by a measure of the change in price levels. The
inflation adjustment would be a factor equal to the ratio of
the price level in the previous year to the current price
level, each measured by a general price index. Notice that
the recommended depreciation rules would establish a constant
relative rate of depreciation as the "normal" depreciation
method instead of straight-line depreciation, and it would
disallow all other methods.
Depreciation of Structures. Depreciation of structures
would be treated in a way similar to that for equipment
except that prescribed depreciation rates may be made to
vary over the life of a structure. For example, depreciation of x percent per year may be allowed for the first 5
years of an apartment building, £ percent for the next 5
years, and so on. However, in no case would total depreciation deductions be allowed to exceed the original basis,
after annual adjustment for inflation. Gains and losses
would be recognized when exchanges or demolitions occur.
Depreciation and repair allowance rates for exchanged
properties always would be determined by the age of the
structure, not by time in the hands of the new owner.
Expenditures for structural additions and modifications that
exceed a guideline repair allowance would be depreciated as
new structures.
Depletion of Mineral Property. For mineral property
capital assets include the value of the unexploited deposits
in addition to depreciable productive equipment. The value
°f the mineral deposit depends upon its accessibility as
well as the amount and auality of the mineral itself. This
value may change as development proceeds, and this change in
value is a component of income. The value of the deposit
w
ill be subsequently reduced, i.e., depleted, as the mineral
- 66 is extracted. To measure income accurately, a depletion
allowance should then be provided that is equal to the
annual reduction in the value of the deposit.
Unfortunately, the value of a mineral deposit becomes
known with certainty only as the mineral is extracted and
sold. Its value at discovery becomes fully known only after
the deposit has been fully exploited. Yet, the value on
which to base a tax depletion allowance and an annual
depletion schedule must be estimated from the beginning of
production. Uncertainty about the amount of mineral present,
the costs of extraction and marketing, and future prices of
the product make estimation of annual capital consumption
particularly difficult in the case of minerals. The uncertainties are especially great for fluid minerals.
An objective market estimate of the initial value of a
mineral deposit prior to the onset of production is the
total of expenditures for acquisition and development, other
than for depreciable assets. The model tax would require
that all preproduction expenses be capitalized. All such
expenditures, except for depreciable assets, would be
recovered according to "cost depletion" allowances computed
on the basis of initial production rates combined with
guideline decline rates derived from average experience.
The treatment would be similar to the model tax treatment of
depreciation for structures. After each !5 years of experience,
or upon exchange of property ownership, the value of the
deposit would rJe reestimated and corrections made to
subsequent annual allowances. But^ as with depreciation,
total deductions are not to exceed the (inflation-adjusted)
cost basis. All postproduction expenditures, except for
depreciable assets, also must be capitalized and recovered
by cost depletion according to the rules in effect for that
year.
Self-Constructed Assets
Capital assets that are constructed for use by the
builder, rather than for sale, are an example of a case in
which a market transaction normally used in the measurement
of income is missing. The selling price for a building,
machine, or piece of transportation equipment constructed by
one firm for sale to another helps to determine the income
of the seller and, simultaneously, establishes the basis for
estimating future tax depreciation and capital gain of the
buyer. Income to the seller will be determined by subtracting
- 67 his costs from the selling price, so that (with proper
accounting for inventories over the construction period) all
income generated in the construction process will have been
subject to tax as accrued. However, when a construction
firm builds an office building, or a shipping company a
ship, for its own use or rental, no explicit transfer price
is attached to that asset. If any costs associated with
construction of the building or ship can be deducted currently for tax purposes, or if any incomes arising from
construction can be ignored, current income is understated
and a deferral of tax is accomplished.
Unrecognized income is derived from inventories of
unfinished buildings, for example. An independent contractor who produces a building for sale must realize
sufficient revenue from the proceeds of that sale to compensate
suppliers of all capital, including capital in the form of
the inventory of unfinished structures during the construction period. But, for self-constructed assets, incomes
accruing to suppliers of equity during construction are not
recognized for tax purposes because there is no sale. Under
current law, certain construction costs, such as taxes and
fees paid to governments, may be deducted as current expenses.
The result of these lapses of proper income measurement is a
tax incentive for self-construction and for vertical integration
of production that would otherwise be uneconomic. The
present treatment also encourages various arrangements to
defer income taxes by providing the legal appearance of
integration. These arrangements are popularly known as tax
shelters.
To provide tax treatment equivalent to that of assets
constructed for sale, the model tax would require that
all payments for goods and services associated with construction of capital goods not for sale (including property
taxes and other fees to government, depreciation of own
equipment, but not interest paid) be segregated into a
special account. During the construction period, a guideline
gate of return would be imputed to the average value of
this account and added to the income tax base of the
builder and also to the~~depreciable basis of the assets.2/
When such assets are placed in service, they would be
depreciated according to the regular rules.
2£hgr Business Income Accounting Problems
A number of other problems of inventory valuation
m
ust be faced in order to specify a fully operational comPrehensive income tax. Also, special rules would be required
for several specific industries, in addition to minerals,
- 68 -
to improve the measurement of income as compared to the
present law. For example, agriculture, banking, and
professional sports have presented special difficulties.
This section has not spelled out all of these special rules,
but has attempted to suggest that improvement of business
income measurement for tax purposes is possible and desirable.
INTEGRATION OF THE INDIVIDUAL AND CORPORATION INCOME TAXES
Strictly speaking, the uses concept of income — consumption plus change in net worth — is an attribute of
individuals or families, not of business organizations.
Corporations do not consume, nor do they have a "standard of
living." The term "corporate income" is shorthand for the
contribution of the corporate entity to the income of its
stockholders.
The Corporation Income Tax
Under existing law, income earned in corporations is
taxed differently from other income. All corporate earnings
are subject to the corporate income tax, and dividend
distributions are also taxed separately as income to shareholders. Undistributed earnings are taxed to shareholders
only as they raise the value of the common stock and only
when the shareholder sells his stock. The resulting gains upon sale are taxed under the special capital gains provisions
of the individual income tax. Thus, the tax on retained
earnings generally is not at all closely related to the
shareholder's individual tax bracket.
Subchapter S Corporations. An exception to these
general rules exists for corporations that are taxed under
subchapter S of the Internal Revenue Code. If a corporation
has 10 (in some cases 15) or fewer shareholders and meets
certain other requirements, it may elect to be taxed in a
manner similar to a partnership. The income of the entity
is attributed directly to the owners, so that there is no
corporate income tax and retained earnings are immediately
and fully subject to the individual income tax. For earnings
of these corporations, then, complete integration of the
corporate and individual income taxes already exists.
Inefficiency of the Corporation Income Tax
The separate taxation of income earned in corporations
is responsible for a number of serious economic distortions.
It raises the overall rate of taxation on earnings from
- 69 -
capital and so produces a bias against saving and investment. It inhibits the flow of saving to corporate equities
relative to other forms of investment. Finally, the separate
corporate tax encourages the use of debt, relative to
equity, for corporate finance.
The existing differential treatment of dividends and
undistributed earnings also results in distortions. Distribution of earnings is discouraged, thus keeping corporate
investment decisions from the direct test of the capital
market and discouraging lower-bracket taxpayers from ownership of stock.
Owners of closely held corporations are favored relative
to those that are publicly held. Owner-managers may avoid
the double taxation of dividends by accounting for earnings
as salaries rather than as dividends, and they may avoid
high personal tax rates by retention of earnings in the
corporation with eventual realization as capital gains.
Provisions of the law intended to minimize these types of
tax avoidance add greatly to the complexity of the law and
to costs of administration.
A Model Integration Plan
In the model tax system, the corporate income tax
would be eliminated, and the effect of subchapter S corporation treatment would be extended to all corporations. There
are alternative methods of approximating this result.
Because the direct attribution of corporate income to
shareholders most nearly matches the concept of an integrated tax, a particular set of rules for direct attribution
is prescribed as the model tax plan. However, there are
potential administrative problems with this approach. These
problems will be noted and alternative approaches described.
The model tax treatment of corporate profits may be
summarized by the following four rules:
1. The holder of each share of stock on the first day
of the corporation's accounting year (the "tax
record date") would be designated the "shareholder
of record."
2. Each shareholder of record would add to his tax
base his share of the corporation's income
annually. If the corporation had a loss for the
year, the shareholder would subtract his share or
loss.
- 70 -
3.
The basis of the shareholder of record in his
stock would be increased by his share of income
and decreased by his share of loss.
4. Any shareholder's basis in his stock would be
reduced, but not to below zero, by cash dividends
paid to him or by the fair market value of property
distributed to him. Once the shareholder's basis
had been reduced to zero, the value of any further
distributions would be included in income. (A
distribution after the basis had been reduced to
zero would indicate the shareholder had, in the
past, income that was not reported.)
Designation of a shareholder of record to whom to
allocate income earned in the corporation is necessary for
large corporations with publicly traded stock. This treatment is designed to avoid recordkeeping problems associated
with transfers of stock ownership within the tax year and to
avoid "trafficking" in losses between taxpayers with different
marginal rates.
Importance of the Record Date. Suppose that the record
date were at the end of the taxable year when reliable
estimates of the amount of corporate earnings or losses
would be known. Shortly before the record date, shareholders
with high marginal rates could bid away shares from shareholders with relatively low marginal rates whose corporations are expected to show a loss.
The losses for the year then would be attributed to the
new shareholders for whom the offset of losses against other
income results in the greatest reduction in tax liability.
Thus, a late-year record date would have the effect of
reducing the intended progressivity of the income tax
and would bring about stock trading that is solely tax
motivated.
The earlier in the tax year that the record date were
placed the more the shareholder's expected tax liability
would become just another element in the prediction of
future returns from ownership of stock in the corporation,
as is now the case under the corporation income tax.
If the record date were the first day of the tax year,
the tax consequences of current or corporate earnings
or losses already accrued in the corporation could not
be transferred to another taxpayer.
- 71 Treatment of the Full-Year Shareholder. Under the
model tax scheme, a shareholder who holds his stock for
the entire taxable year would be taxed on the full
amount of income for the year (or would deduct the full
amount of loss) . Any gain from sale of the stock in a
future year would be calculated for tax purposes by
subtracting from sale proceeds the amount of his
original basis plus the undistributed earnings upon
which he has been subject to tax. His corporation
would provide him with a statement at the end of each
taxable year that informed him of his share of corporate
earnings. He then could increase his basis by that
amount of earnings less the sum of distributions
received during the year. For full-year stockholders,
then, basis would be increased by their share of taxable
earnings and reduced by the amount of any distributions.
It should be noted that, under this treatment, dividends
would not be considered income to the shareholder, but would
be just a partial liquidation of his portfolio. Income would
accrue to him as the corporation earned it, rather than as
the corporation distributed it. Hence, dividend distributions
would merely reduce the shareholder's basis, so that
subsequent gains (or losses) realized on the sale of his
stock would be calculated correctly.
Treatment of a Shareholder Who Sells During the Year.
A shareholder of record who sells his stock before the end
of the tax year would not have to wait to receive an end-ofyear statement in order to calculate his tax. He simply
would calculate the difference between the sale proceeds and
his basis as of the date of sale. The adjustment to basis
of the shareholder's stock to which he would be entitled at
the time of the corporation's annual accounting would always
just offset the amount of corporate income or loss that he
would normally have to report as the shareholder of record.
Therefore, the income of a shareholder who sold his shares
would be determined fully at the time of sale, and he would
have no need for the end-of-year statement.
A numerical example may be useful in explaining the
equivalence of treatment of whole-year and part-year stockholders. Suppose that, as of the record date (January 1 ) ,
shareholder X has a basis of $100 in his one share of stock.
By June 20, the corporation has earned $10 per share, and X
sells his stock for $110 to Y. The shareholder would thus
realize a gain of $10 on the sale, and this would be reported
as
income.
- 72 To illustrate that subsequent corporate earnings would
be irrelevant to the former shareholder's calculation of
income for taxes, suppose the corporation earns a further
$15 after the date of sale, so that as the shareholder of
record X receives a report attributing $25 of income to him,
entitling him to a $25 basis increase (on shares he no
longer owns). One might insist that X take into his tax
base the full $25 and recalculate his gain from sale. In
this event, the increase in basis from $100 to $125 would
convert his gain of $10 from sale to a loss of $15 (adjusted
basis = $125; sale price = $110). The $15 loss, netted
against $25 of corporate income attributed to him as the
shareholder of record, yields $10 as his income to be
reported for tax, the same outcome as a simple calculation
of his gain at the time of sale. The equivalence between
these two approaches may not be complete, however, if the
date of sale and the corporate accounting occur in different
taxable years. Nonetheless, in the case cited, the model
plan appears superior in the simplicity of its calculations,
in allowing the taxpayer to know immediately the tax consequences of his transactions, and in its better approximation to taxing income as it is accrued.
In the event there had been a dividend distribution to
X of the $10 of earnings before he sold, this distribution
would be reflected in the value of the stock, which would
now command a market price of $100 on June 20. The amount
of the dividend also would reduce his basis to $90, so that
his gain for tax purposes would be $10, just as before. The
dividend per se has no tax consequences. At the end of the
year he again would be allocated $25 of corporation income,
but, as before, an offsetting increase in basis. Thus, he
will not report any income other than his gain on the sale
of the share on June 20.
Note that the same result would obtain in this case if
the shareholder included the dividend in income but did not
reduce his basis. There would then be $10 attributable to
the dividend and no gain on the sale. This treatment of
dividends in the income calculation gives correct results for
the shareholder who disposes of his shares. However, it
would attribute income to a purchaser receiving dividends
before the next record date even though such distributions
would represent merely a change in portfolio composition.
This approach (all distributions are taken into the tax
base with only retained earnings allocated to record date
shareholders and giving rise to basis adjustments) might,
- 73 nevertheless be considered an alternative to the treatment
of the model plan because it is more familiar and would
involve fewer basis adjustments and hence a reduced recordkeeping burden. The substance of the full integration
proposal would be preserved in this alternative treatment.
The proposed full integration system would make it
possible to tax income according to the circumstances of
families who earn it, regardless of whether income derives
from labor or capital services, regardless of the legal form
in which capital is employed, and regardless of whether
income earned in corporations is retained or distributed.
To the extent that retained earnings increase the value of
corporate stock, this system would have the effect of taxing
capital gains from ownership of corporate stock as they
accrued, thereby eliminating a major source of controversy
and complexity in the present law.
Administrative Problems of Model Tax Integration
The Liquidity Problem. Some problems of administration
of the system just described would remain. One such problem
is that income would be attributed to corporate shareholders
whether or not it actually was distributed. To the extent
the corporation retained its earnings, the shareholders
would incur a current tax liability that must be paid in
cash, even though their increases in net worth would not
be immediately available to them in the form of cash.
Taxpayers with relatively small current cash incomes might
then be induced to trade for stocks that had higher rates
of dividend payout to assure themselves sufficient cash
flow to pay the tax.
Imposition of a withholding tax at the corporate level
would help to reduce this liquidity problem and perhaps also
reduce the cost of enforcement of timely collections of the
tax.
One method of withholding that is compatible with the
model tax method for assigning tax liabilities is to require
corporations to remit an estimated flat-rate withholding tax
at regular intervals during the tax year. This tax would be
withheld on behalf of stockholders of record. Stockholders
of record would report their total incomes, including all
attributed earnings, but also would be allowed a credit for
their share of taxes withheld. Taxpayers who hold a stock
- 74 -
throughout the entire year would receive one additional
piece of tax information from the corporation — the amount
of their share of tax withheld throughout the year — and
would subtract the tax withheld as a credit against their
individual liability.
This withholding system would complicate somewhat the
taxation of part-year stockholders. As explained above, the
taxable income of the corporation attributed to stockholders
could be determined fully at the time of sale as the sum of
dividends received during the year and excess of sale price
over basis that existed on the record date. However, if
withholding were always attributed to the shareholder of
record, he would be required to wait until corporate income
for the year had been determined to know the amount of his
tax credit for withholding during the full tax year. The
selling price of the stock may be expected to reflect the
estimated value of this prospective credit in the same way
that share prices reflect estimates of future profits. But,
in this case, the seller who was a stockholder of record
would retain an interest in the future earnings of the
corporation, because the earnings would determine tax credit
entitlement to the end of the tax year. Despite this
apparent drawback, such corporate-level withholding would
insure sufficient liquidity to pay the tax, except in cases
where the combination of distributions and withheld taxes
is less than the amount of tax due from the shareholder of
record.
Audit Adjustment Problem. Another administrative
problem could arise because of audit adjustments to corporate
income, which may extend well beyond the taxable year. This
would appear to require reopening the returns of shareholders of earlier record dates, possibly long after shares
have been sold. In the present system, changes in corporate
income and tax liability arising from the audit process are
borne by shareholders at the time of the adjustment. Precisely
this principle would apply in the model plan. Changes in
income discovered in audit, including possible interest or
other penalties, would be treated like all other income and
attributed to shareholders in the year the issue is resolved.
Naturally, shares exchanged before such resolutions but
after the matter is publicly known would reflect the anticipated outcome.
Deferral Problem. There are also some equity considerations. A deferral of tax on a portion of corporate
income may occur in a year when shares are purchased. The
- 75 -
buyer would not be required to report income earned after
the date of purchase but before the end of the taxable year.
All earnings in the year of sale that were not reflected in*
the purchase price would escape tax until the buyer sells
the stock.
The 1975 Administration Proposal for Integration
In the context of a thorough revision of the income
tax, integration of the corporate and personal tax takes on
particular importance. The model tax plan has provisions
designed to assure that the various forms of business income
bear the same tax, as nearly as possible. If incomes from
ownership of corporate equities are subject to greater, or
lesser, tax relative to incomes from unincorporated business
pension funds, or bonds, the economic distortions would be
concentrated on the corporate sector. For this reason, a
specific plan for attributing to stockholders the whole
earnings of corporations has been presented here in some
detail.
A significant movement in the direction of removing the
distortions caused by the separate corporation income tax
would be accomplished by the dividend integration plan
proposed by the Administration in 1975. That proposal may
be regarded as both an improvement in the present code, in
the absence of comprehensive tax reform, and as a major step
in the transition to a full integration of the income taxes,
such as the model tax.
CAPITAL GAINS AND LOSSES
Capital gains appear to be different from most other
sources of income because realization of gains involves two
distinct transactions — the acquisition and the disposition
of property — and each transaction occurs at a different
time. This difference raises several issues of income
measurement and taxation under an income tax.
Accrual Versus Realization
The first issue is whether income (or loss) ought to be
reported annually on the basis of changes in market values of
assets — the accrual concept — or only when realized. The
annual change in market value of one's assets constitutes a
change in net worth and, therefore, constitutes income under
the "uses" definition. If tax consequences may be postponed
- 76 until later disposition of an asset, there is a deferral of
taxes, which represents a loss to the government and a gain
to the taxpayer. The value of this gain is the amount of
interest on the deferred taxes for the period of deferral.
Distinct from, but closely related to, the issue of deferral
is the issue of the appropriate marginal tax rate to be
applied to capital gains. If capital gains are to be
subject to tax only when realized, there may be a substantial
difference between the applicable marginal tax rate during
the period of accrual and that faced by the taxpayer upon
realization. Also, the extent to which adjustment should be
made for general price inflation over the holding period of
an asset must be considered. Finally, the desirability of
simplicity in the tax system, ease of administration, and
public acceptability are important considerations.
The range of possible tax treatments for capital gains
can be summarized in an array that ranges from the taxation
of accrued gains at ordinary rates to the complete exclusion
of capital gains from income subject to taxation. Alternatives within the range may be modified to allow for (a)
income averaging to minimize extra taxes resulting from the
bunching of capital gains and (b) adjustments to reflect
changes in the general price level.
Present Treatment of Capital Gains
Present treatment for individuals is to tax gains when
realized, at preferential rates, with no penalty for deferral.
There are a number of special provisions. When those assets
defined in the code as "capital assets" have been held for 6
months or more,3/ gains from their realization are considered "long-term" and receive special tax treatment in two
respects: one-half of capital gains is excluded from
taxable income, and individuals have the option of calculating the tax at the rate of 25 percent on the first
$50,000 of capital gains. There are complex restrictions on
the netting out of short- and long-term gains and losses,
and a ceiling of $1,0004/ is imposed on the amount of net
capital losses that may be used to offset ordinary income in
any 1 year, with unlimited carryforward of such losses.
Also, there are provisions in the minimum tax for tax
preferences that limit the extent to which the capital gains
provisions can be used to reduce taxes below ordinary rates
and that deny the use of the 50-percent maximum tax on
earned income by the amount of such preferences. Limited
averaging over a 5-year period is allowed for capital gains
as well as for most other types of income.
- 77 There are many other capital gains provisions in the
tax law that (1) define what items may be considered capital
assets, (2) specify when they are to be considered realized,
(3) provide for recapture of artificial accounting gains,
and (4) make special provisions for timber and certain agricultural receipts. There also are special provisions that
allow deferral of capital gains tax on the sale or exchange
of personal residences. Much of the complexity of the tax
code derives from the necessity of spelling out just when
income can and cannot receive capital gains treatment.
Model Tax Treatment of Capital Gains
Under the model income tax, capital gains would be
subject to full taxation upon realization at ordinary rates
after (ll adjustment to basis of corporate stock for
retained earnings (as explained in the integration proposal)
an<
^ (2) adjustment to basis for general price inflation.
Capital losses could be subtracted in full from positive
elements of income to determine the base of tax, but there
would be no refund for losses that reduce taxable incomes
below zero. Adjustment for inflation would be accomplished
by multiplying the cost basis of the asset by the ratio of
the consumer price index in the year of purchase to the same
index in the year of sale. These ratios would be provided
in the form of a table accompanying the capital gains
schedule. Table 1 is an example of such a table. (Note
that for the last 3 years, the ratios are given monthly.
This is to discourage December 31 purchases coupled with
January 1 sales.) No inflation adjustment would be allowed
for intra-year purchases and sales.
- 78 -
Table 1
Inflation Adjustment Factors
(Consumer Price Index based on December, 1975)
1930
3.326 : 1940
3.960 : 1950
2.307 : 1960
1.875 : 1970
1.430
1931 3.647 1941 3.771 1951 2.138 1961 1.856 1971 1.371
1932 4.066 1942 3.408 1952 2.092 1962 1.836 1972 1.327
1933 4.286 1943 3.210 1953 2.076 1963 1.814
1934 4.147 1944 3.156 1954 2.066 1964 1.790
1935 4.046 1945 3.085 1955 2.074 1965 1.760
1936 4.007 1946 2.843 1956 2.043 1966 1.711
1937 3.867 1947 2.486 1957 1.973 1967 1.663
1938 3.941 1948 2.307 1958 1.920 1968 1.596
1939 3.998 1949 2.329 1959 1.905 1969 1.515
1973 : 1974 : 1975
January
February
March
April
May
June
July
August
September
October
November
December
1.302
1.293
1.281
1.272
1.265
1.256
1.253
1.231
1.227
1.217
1.209
1.201
1.190
1.175
1.162
1.156
1.143
1.133
1.124
1.109
1.096
1.087
1.078
1.070
Source:
Office of the Secretary of the Treasury
Office of Tax Analysis, September 28, 1976
1.065
1.058
1.054
1.049
1.044
1.035
1.025
1.021
1.017
1.101
1.004
1.000
- 79 -
Capital Losses
With adequate adjustment for inflation, and for depreciation in the case of physical assets, capital losses under
the model tax should measure real reductions in the current
income of the taxpayer. There is, consequently, no reason
to limit the deduction of such losses, as in current law.
A forced postponement of the realization of such losses
would be like requiring the taxpayer to make an interestfree loan to the government. Of course, some asymmetry in
the treatment of gains relative to losses would remain,
because taxpayers could benefit by holdinq gains to defer
taxes but could always take tax-reducing losses immediately.
Taxation of Accruals in the Model Tax
Corporate Stock. As just described, the model tax
would continue the present practice of recognizing income
from increases in the value of capital assets only upon sale
or exchange, but some income sources that presently are
treated as capital gains would be put on an annual accrual
basis.
If the individual and corporate income taxes were fully
integrated into a single tax so that shareholders are
currently taxed on retained earnings, a large portion of
capital gains — the changes in value of common stock that
reflect retention of earnings — would be subject to tax as
accrued. The remainder of gains would be subject to tax
only as realized. These gains would include changes in
stock prices that reflect expectations about future earnings,
and also changes in the value of other assets, such as
bonds, commodities, and land.
Physical Assets. Depreciable assets, such as machinery
and buildings, are also subject to price variations, but
these variations would be anticipated, as nearly as possible,
by the inflation adjustment and the depreciation allowance.
If these allowances were perfectly accurate measures of the
change in value of such assets, income would be measured
correctly as it accrues, and sales prices would always match
the remaining basis. Apparent capital aains on physical
assets may, therefore, be regarded as evidence of failure to
accurately measure past income from ownership of the asset.
Consequently, if under the model tax, depreciation would
be measured more accurately, the problem of tax deferral due
to taxation of capital gains at realization would be further
reduced. However, as in the case of corporate stock,
- 80 some unaccounted-for variation in asset prices undoubtedly
will occur despite improvements in rules for adjustments
to basis. Sales of depreciable assets will, therefore,
continue to give rise to taxable gains and losses. Such
gains and losses are the difference between sales price and
basis, adjusted for depreciation allowances and inflation.
The taxation of capital gains on a realization basis
would produce significantly different results than current
taxation of accrual of these gains. Even if capital gains
were taxed as ordinary income (no exclusion, no alternative
rate), the effective tax rate on gains held for long periods
of time but subject to a flat marginal rate would be much
lower than the nominal or statutory rate applied to the
gains as if they accrued ratably over the period the asset
was held. This consequence of deferral of tax is shown in
Table 2 for an assumed before-tax rate of return of 12
percent on alternative assets yielding an annually taxable
income. Each item in the table is the percent by which the
before-tax rate of return is reduced by the imposition
of the tax at the time of realization.
Table 2
Effective Tax Rates on Capital Gains
Taxed as Realized at Ordinary Rates
Holding Period ~~
1 year
5 years
25 years
50 years
Statutory rate of
50 percent
50%
44%
23%
13%
Statutory rate of
25 percent
25%
21%
10%
5%
- 81 Ancrual Taxation Alternative
Accrual taxation of capital gains poses three problems
that, taken together, appear to be insurmountable. These
are (1) the administrative burden of annual reporting; (2)
the difficulty and cost of determining asset values annually;
and (3) the potential hardship of obtaining the funds to pay
taxes on accrued but unrealized gains. Under accrual taxation, the taxpayer would have to compute the crain or loss on
each of his assets annually. For common stock and other
publicly traded securities, there would be little cost or
difficulty associated with obtaining year-end valuations.
But for other assets, the costs and problems of evaluation
would be very formidable, and the enforcement problems would
be substantial. It would be very difficult and expensive to
valuate assets by appraisal; valuation by concrete transactions, which taxing realizations would provide, has
distinct advantages.
For taxpayers with little cash or low money incomes
relative to the size of their accrued but unrealized capital
gains, accrual taxation may pose cash flow problems. This
circumstance is similar to that encountered with local
property taxes assessed on homeowners. There is no cash
income associated with the asset in the year that the tax
liability is owed. However, in cases of potential hardship
certain taxpayers could be allowed to pay a later tax on
capital gains, with interest, at the time a gain is realized.
Realization-With-Interest Alternative
An alternative method that attempts to achieve the same
economic effect as accrual taxation is taxation of capital
gains at realization with an interest charge for deferral.
But, in addition to the present complex rules defining
realizations that would not be avoided in the model tax
Plan, rules would be required for the computation of interest
on the deferred taxes. An appropriate rate of interest
would have to be determined and some assumption made about
the "typical" pattern of accruals. In order to eliminate
economic inefficiency, the interest rate on the deferral
should be the individual taxpayer's rate of return on his
investments. However, because it is impossible to administer
a
program based on each investor's marginal rate of return,
the government would have to charae a sinale interest rate.
The single interest rate would itself tend to move alternatives away from neutrality. Moreover, for simplicity, it
would have to be assumed that the gain occurred equally over
- 82 the period or that the asset's value changed at a constant
rate. This assumption would be particularly inappropriate
in those cases where basis was changed frequently by inflation adjustments, depreciation allowances, capital improvements, etc. Because a simple time pattern of value change
would reflect reality in very few cases, the deferral charge
would introduce additional investment distortions. To the
extent that gains occur early in the holding period, capital
gains would be undertaxed; when gains occur late in the
period, capital gains would be overtaxed.
The Income Averaging Problem
Under a progressive income tax system, the tax rate on
a marginal addition to income differs depending on the
taxpayer's other income. Generally, the higher the income
level, the higher the tax rate. Similarly, under a progressive tax system, people with fluctuating incomes pay
tax at a higher average rate over time on the same amount of
total income than do those persons whose incomes are more
nearly uniform over time.
Clearly, if a taxpayer's income (apart from any capital
gains) is rising over time, the longer he delays realization, the higher his tax rate will be. Similarly, if he
realizes gains only occasionally, his gains will tend to be
larger, and the average tax rate on the gains will be increased.
The bunching problem could be solved by spreading the gain,
via income averaging, over the holding period of the asset.
This flexibility would involve great complexity, but the
result could be approximated reasonably well by a fixedperiod averaging system similar to the general 5-year
averaging system or the special 10-year averaging system
for lump sum distributions, both of which are in present
law. The problem of postponement of tax to periods of higher
marginal rates is a more difficult one. One optional
solution would be to calculate an average marginal tax rate
over a fixed number of years and to modify the amount of
gain included in the tax base for the year of realization to
reflect the ratio of the average marginal rate over the
period to the marginal rate in the current year. Thus, if
the current rate were higher, some of the gain could be
excluded from income; if the current rate were lower, more
- 83 than 100 percent of the gain would be included. As is the
case with charges of interest for deferral, however, such
systems would add significantly to the complexity of the tax
law, and represent inexact adjustments besides.
Inflation Adjustment
The proper tax treatment of capital gains is further
complicated by general price inflation. Capital gains that
merely reflect increases in the general price level are
illusory. For example, suppose an individual's capital
assets increase in value, but at a rate precisely equal to
the rise in the cost of living. His net worth will not have
increased in real terms, and neither, therefore, will his
standard of living. If no basis adjustment is made to
account for inflation, the reported capital gain for an
asset held over a period of time will largely reflect the
level of prices in previous years. This contrasts with
other income flows, such as salaries, that are always
accounted for in current dollars.
Accounting for other transactions that are affected by
inflation, such as borrowing and lending, is largely corrected for anticipated inflation by market adjustments. For
example, a lender will insist on a higher interest rate to
compensate for taxes against the depreciating value of the
principal. Therefore, an adjustment of basis for inflation
is desirable in the case of ownership of capital assets to
avoid overtaxation of capital gains relative to other
income sources, even if general indexing of income sources
and/or tax rates is not prescribed.
Inflation adjustment would introduce additional complexity. The basis for each asset would have to be revised
annually, whether sold or not. For this reason, it might be
desirable to restrict the inflation adjustment to those
years in which the inflation rate exceeds some "normal"
amount, such as 2 or 3 percent.
Clearly, there are competing objectives of simplicity,
equity, and economic efficiency involved in the tax treatment of capital gains. In this case, the model tax treatment would favor simplicity by foregoing accrual treatment
that would require annual valuation of all assets, or interest
charges for deferral. On the other hand, clear moves in the
direction of accrual taxation are taken by introducing current
taxation of corporate-retained earnings and more accurate
measurement of depreciation. Annual adjustment of basis for
general inflation also is judged to be worth the additional
administration and compliance cost.
- 84 -
STATE AND LOCAL BOND INTEREST
The annual receipt or accrual of interest on State and
local obligations unquestionably increases the taxpayer's
opportunity to consume, add to wealth, or make gifts. It
is, therefore, properly regarded as a source of income.
However, such interest is not included in income under
current law? this is not to say that owners of such bonds
bear no consequence of the present income tax. Long-term
tax-exempt bonds yield approximately 30 percent less than
fully taxable bonds of equal risk — a consequence that may
be regarded as an implicit tax. However, because problems
of equity and inefficiency remain, this lower yield on taxexempt bonds does not substitute for full taxation. Under
the model income tax, interest on State and local bonds
would be fully taxable.
Inefficiency of Interest Exclusion
The difference in interest costs that the State or
local government would have to pay on taxable bonds and that
which they actually pay on tax-exempt bonds is borne by the
Federal Government in the form of reduced revenues. The
subsidy is inefficient in that the total cost to the Federal
Government exceeds the value of the subsidy to the State and
local governments in the form of lower interest payments.
Estimates of the fraction of the total Federal revenue loss
that is not received by the State and local governments vary
widely, but the best estimates seem to be in the 25- to
30-percent range.
Inequity of the Exclusion
The subsidy also may be regarded as inequitable. The
value of the tax exemption depends on the investor's marginal
tax rate. Thus, higher-income taxpayers are more willing
than lower-income individuals to pay more for tax-exempt
securities. The concentration of the tax savings among the
relatively well-off reduces the progressivity of the Federal
income tax as compared with the nominal rate structure. The
exemption also results in differential rates of taxation among
higher-income taxpayers who have incomes from different
sources. Investors who would otherwise be subject to
marginal rates above 30 percent may avoid these rates by
purchasing tax-exempt bonds. Those with equal incomes from
salaries or from active management of business must pay
higher rates.
- 85 Alternatives to Tax-Exempt Bonds
The taxation of interest from State and local bonds
would present no special administrative problems, except for
transition rules, but alternative means of fiscal assistance
to State and local governments may be desirable. Among the
alternatives that have been suggested are replacement of the
tax exclusion with a direct cash subsidy from the Federal
Government (as under revenue sharing), or replacement with a
direct interest subsidy on taxable bonds issued by State and
local governments at their option. The mechanism for an
interest subsidy may be either a direct Federal payment or a
federally sponsored bank empowered to buy low-yield State
and local bonds and issue its own fully taxable bonds.
OWNER-OCCUPIED HOUSING
Under present law, homeowners are allowed personal
deductions for mortgage interest paid and for State and
local property taxes assessed against their homes. Furthermore, there is no attempt to attribute to owner-occupiers
the income implied by ownership of housing equity. (In
the aggregate, this is estimated in the national income and
product accounts at $11.1 billion per year, an amount that
does not include untaxed increases in housing values.)
Imputed Rental Income
Any dwelling, whether owner-occupied or rented, is an
asset that yields a flow of services over its economic
lifetime. The value of this service flow for any time
period represents a portion of the market rental value of
the dwelling. For rental housing, there is a monthly
contractual payment (rent) from tenant to landlord for the
services of the dwelling. In a market equilibrium, these
rental payments must be greater than the maintenance expenses,
related taxes, and depreciation, if any. The difference
between these continuing costs and the market rental may
be referred to as the "net income" generated by the housing
unit.
An owner-occupier may be thought of as a landlord who
rents to himself. On his books of account will also appear
maintenance expenses and taxes, and he will equally experience
depreciation in the value of his housing asset. What do
not appear are, on the sources side, receipts of rental
payment and, on the uses side, net income from the dwelling.
Viewed from the sources side,this amount may be regarded as
- 86 the reward that the owner of the dwelling accepts in-kind,
instead of the financial reward he could obtain by renting
to someone other than himself. Since a potential owneroccupier faces an array of opportunities for the investment
of his funds, including in housing for rental to himself or
others, the value of the reward in-kind must be at least the
equal of these financial alternatives. Indeed, this fact
provides a possible method for approximating^the flow of
consumption he receives, constituting a portion of the value
of his consumption services. Knowing the cost of the asset
and its depreciation schedule, one could estimate the reward
necessary to induce the owner-occupier to rent to himself.
In practice, to tax this form of imputed income, however
desirable it might be from the standpoint of equity or of
obtaining neutrality between owning and renting, would
severely complicate tax compliance and administration.
Because the owner-occupier does not explicitly make a rental
payment to himself, the value of the current use of his
house is not revealed. Even if market rental were estimated,
perhaps as a fixed share of assessed value of the dwelling,
5/ the taxpayer would face the difficulties of accounting
for annual maintenance and depreciation to determine his net
income.
The present tax system does not attempt to tax the
imputed income from housing. This is, perhaps, because
there would be extreme administrative difficulties in determining it and because there is a general lack of understanding of its nature. The incentive for home ownership
that results from including net income from rental housing
in the tax base while excluding it for owner-occupied housing
also has strong political support, although the result is
clearly a distortion from the pattern of consumer housing
choices that would otherwise prevail. Primarily for the
sake of simplification, the model plan continues to exclude
from the tax base the portion of housing consumptIon"^attributable
to owner-occupied dwellings. No imputation of the net
Income arising from these assets is proposed.
Deductibility of Homeowners' Property Tax
Present law allows the homeowner to deduct State and
local property taxes assessed against the value of his
house as well as interest paid on his mortgage. The appropriateness of each of these deductions is considered next,
beginning with the property tax.
- 87 The model tax would allow no deduction for the local
property tax on owner-occupied homes or on other~types of
property that also have tax-free rental values, e.g.,
automobiles. This treatment is based on the proposition
that deduction of the property tax results in further understatement of income in the tax base, in addition to the
exclusion of net rental income. This cannot be justified,
as can the exclusion of net income from the dwelling, on
grounds of measurement difficulty. Allowing the deduction
of property taxes by owner-occupiers results in unnecessary
discrimination against tenants of rental housing. Elimination of the deduction would simplify tax administration and
compliance and reduce the tax bias in favor of housing
investment in general, and owner-occupancy in particular.
Local housing market adjustments normally will insure
that changes in property taxes will be reflected in rental
values. When the local property tax is increased throughout
a market area, the current cost of supplying rental housing
increases by the amount of the tax increase. Over time,
housing supplies within the area will be reduced (and prices
increased) until all current costs are again met and a
normal return accrues to owners of equity and suppliers of
mortgages. Accordingly, rents eventually must rise dollarfor-dollar with an increase in property tax. (Note that,
in a equilibrium market, deductibility of the local tax
against Federal income tax would not result in reduced
Federal liability for landlords because the increase in
gross receipts would match the increased deduction.) Tenants
will experience an increase in rent and no change in their
income tax liability.
Owner-occupiers provide the same service as landlords,
and, therefore, must receive the same rental for a dwelling
of equal quality. Hence, market rentals for their homes
also would rise by the amount of any general property tax
increase. If owner-occupiers were allowed to deduct the tax
increase from taxable income while not reporting the increased
imputed rent, they would enjoy a reduction in income tax
that is not available either to tenants or to landlords.
To summarize the effect of the property tax increase,
the landlord would have the same net income and no change in
income tax; the tenant would have no change in income tax
and higher rent; and the owner-occupier would have higher
(imputed) rent as a "tenant," but the same net income and a
reduction i n h i s i n c o m e t a x a s a "landlord." He would be
- 88 favored relative to the renter first by receiving income
from assets free of tax, and, in addition, his advantage
over the tenant and landlord would increase with higher
rates of local property tax. This advantage would not be
present if the property tax deduction were denied to the
owner-occupier. He would be treated as the tenant/landlord
that he is — paying higher rent to himself to cover the
property tax while his net income and income tax were unchanged.
Deductibility of Mortgage Interest
The mortgage interest deduction for owner-occupiers is
often discussed in the same terms as the foregoing property
tax argument. There are, however, quite significant differences, and, because of these, the model tax treatment
would continue to allow deductibility of home mortgage
interest.
The effect of this policy may be equated to allowing any
taxpayer to enjoy tax-free the value of consumption services
directly produced by a house (or other similar asset),
regardless of the method he uses to finance the purchase of
this asset. The tax-free income allowed is thus the same
whether he chooses to purchase the asset out of funds
previously accumulated or to obtain a mortgage loan for
the purpose.
This position is based on the reasoning that, given
the preliminary decision (based on measurement difficulty)
not be attempt to tax the net income received from his
house by the person who purchases it with previously accumulated or inherited funds, it would be unfair to deny a
similar privilege to those who must borrow to finance the
purchase.
There is a related reason in favor of allowing the
mortgage interest deduction, having to do with the difficulty
of tracing the source of funds for purchase of an asset.
Prospective homeowners of little wealth are obliged to
offer the house as security to obtain debt financing. By
contrast, an individual of greater wealth could simply
borrow against some other securities, use the proceeds to
purchase housing equity, and take the normal interest
deduction. In other words, a mortgage is not the only way
to borrow to finance housing, and it is very difficult, if
not impossible, to correlate the proceeds of any other loan
with the acquisition of a house.
- 89 Nevertheless, a case may be made for disallowing interest
deduction for borrowing identifiably for the purpose of
financing an owner-occupied home (or other consumer durable) .
There is no doubt that most people finance home purchases
with a mortgage using the home as security. Mortgage interest
payments are surely highly correlated with net income produced by the associated housing, and denying the deduction
would increase the tax base by an amount equal to a significant fraction of the aggregate net income from owner-occupied
dwellings. For those who cannot otherwise finance home purchases, it would end the tax bias against renting. These
considerations deserve to be weighed against the view taken
here that the efficiency and equity gains from denying the
mortgage interest deduction are insufficient to counterbalance the equity losses and the increased administrative
complexity of the necessary rules for tracing the sources of
funds.
Consumer Durables
Precisely the same arguments that have been made
concerning houses also apply to consumer durables, such as
automobiles, boats, and recreational vehicles. These assets
generate imputed incomes and may be subject to State and
local personal property taxes. The model tax would treat
these assets in the same way. That is, property tax assessed
against consumer durables would not be deductible, but
all interest payments, Including those related to purchase
of durables, would be allowed as deductions.
MEDICAL EXPENSES
The present tax law allows the deduction of uninsured
medical expenses, in excess of a floor, and partial deduction for medical insurance premiums. The principal argument
for deductibility is that medical expenses are not voluntary
consumption. Rather, they are extraordinary outlays that
should not be included in the consumption component of the
income definition.
Opponents of deductibility can cite a fairly high
degree of "consumer choice" in the extent, type, and quality
of medical services that may be elected by persons of
similar health. At the extreme, health care choices include
cosmetic surgery, fitness programs at resorts and spas,
frequent physical examinations, and other expenditures that
are not clearly distinguishable from ordinary consumption.
The remainder of medical expenditures is generally insurable,
- 90 and insurance premiums may be regarded as regular, predictable
consumption expenditures. Indeed, tax deductibility of
medical expenses may be viewed itself as a type of medical
insurance that is inadequate in amount for most taxpayers
and has some quite unsatisfactory features.
Model Tax Treatment
The model tax would not allow deductions for medical
expenses or medical insurance premiums. The benefits
of medical insurance would not be included in income.
Nondeductibility of medical expenses would simplify the tax
law as well as recordkeeping for households. It also would
eliminate the necessity of making the sometimes difficult
administrative determination of eligibility of a medical
expense for deduction.
An optional treatment is presented here that would
provide a refundable tax credit for a taxed share of large
medical expenses. This optional approach is intended as an
explicit medical insurance program, administered under the
tax law. There is a presumption here, however, that administration of such a program by the tax authorities would be
preferred to other alternatives.
"Tax Insurance" Under Present Law
Under present law, eligible medical expenses in excess
of 3 percent of adjusted gross income (AGI) are partially
reimbursed by "tax insurance" equal to the deductible
expenses multiplied by the taxpayer's marginal tax rate,
e.g., 25 percent. The taxpayer pays only the coinsurance
rate, in this example 75 percent, times the medical expenses.
Therefore, itemizers are uninsured (by the tax system) for
medical expenses up to an amount that varies in proportion
to their income, and above that amount they pay a coinsurance
rate that decreases as marginal tax rates increase. Lowincome taxpayers are more likely to exceed the floor on
deductibility (3 percent of AGI), but higher-income taxpayers receive a higher rate of insurance subsidy.
A family with $10,000 of salary receipts might be at
the 19-percent marginal tax rate, and thus have a "tax
insurance" policy that requires that family to pay 81
percent of medical expenses in excess of $300 per year. A
family with $50,000 of salary at the 48-percent marginal
rate has a "policy" that requires payment of only 52 percent
of expenses above $1,500 per year. The same type of tax
insurance is provided for medicines and drugs to the extent
that they exceed 1 percent of AGI.
- 91 Present law also allows deduction of half of private
insurance premiums (up to a deduction limit of $150) without
regard to the floor, the balance being treated as uninsured
medical expenses subject to the 3-percent floor. Insurance
proceeds are not taxable so long as they do not exceed
actual expenses. In the case of fully insured expenses, the
result is the same as including all insurance proceeds in
income, allowing deduction of all outlays without floor, and
allowing deduction for a share of premiums as well. Hence,
total medical costs — insurance premiums plus uninsured
losses — are partially deductible without floor to the
extent of insurance coverage and fully deductible above a
floor for the uninsured portion. Those who cannot itemize
have no "tax insurance," while itemizers pay a coinsurance
rate — ranging from 30 percent to 86 percent — that varies
inversely with income.
Optional Catastrophe Insurance Provision
Viewed as a mandatory government insurance program, the
present tax treatment of medical expenses deserves reconsideration. One alternative is a policy that would provide
a subsidy -- either in the form of a refundable tax credit
or direct appropriation — for very large medical expenses.
Under such a scheme, the floor for the deduction would be
raised, but the "coinsurance" rate would be increased for
all taxpayers and made uniform, rather than dependent
on the taxpayer's marginal rate. For example, if a tax
credit were used, its amount might be equal to 80 percent of
expenses in excess of a flat floor, say, $1,000 per year.
Alternatively, the floor amount might be made a share of
income.
While a catastrophe insurance provision would be a
major change in the system of financing medical care, it
need not have a large budgetary consequence when combined
with repeal of the present deductions. For the level of
medical expenses prevailing in 1975, elimination of the
present deduction for premiums and expenses would finance
complete reimbursement of all medical expenditures that
exceed 10 percent of AGI. Full reimbursement would, however,
have the undesirable effect of eliminating the market
incentives to restrain medical costs. Some rate of coinsurance
is desirable to help ration medical resources. Supplemental
private insurance would undoubtedly be made available for
insurable medical expenses not reimbursed by the tax credit.
No deduction would be allowed for private medical insurance
premiums, but proceeds would not be taxable.
- 92 STATE AND LOCAL TAXES
The way State and local government should be treated in
a comprehensive income measurement system presents difficult
conceptual problems. These units might be treated simply as
the collective agencies of their citizens. Ideally, in this
view, the value of consumption services provided in-kind to
the members of the group would be attributed to the individuals
and counted on the uses side of their individual income
accounts. The same amounts would appear on the sources
side, as imputations for receipts in the form of services.
Payments to the group would be deducted, as not directly
measuring consumption, and payments received from the group
would be added to the sources side of the individual income
calculation.
The difficulty is in measuring the value of services
provided by the collective unit. This problem is solved for
such a voluntary collective as a social club by disallowing
any deductions for payments made to it by members. In
effect, these payments are regarded as measuring the consumption received by members. When it comes to a larger
collective organization, such as a State government, this
approach is much less satisfactory. The payments to the
organization are no longer good proxies for the value of
services received. For that reason there is a strong equity
case for allowing a deduction of such payments in calculating
individual income (including, in individual income, any
grants received — "negative taxes").
Unfortunately, there is no practical method for
imputing to individuals the value of services received,
so that it is not possible to carry out the complete
income measurement system. As in the case of services from
owner-occupied homes, the model plan concedes that the
value of most services provided collectively will be
excluded from the tax base. And as with owner-occupied
housing, there is a resulting bias introduced by the
Federal tax system in favor of State and local collection
expenditure over individual expenditures. The general
principle, then, is that payments to the State or local
government are excluded from the tax base other than in
cases when there is a reasonable correspondence between
payments and value of services received. There remains,
however, the question of what constitutes "payment" for
- 93 this purpose, and here particular difficulty is presented
by indirect taxes such as sales taxes. Analysis of this
issue, together with considerations of simplicity in
administration, lead to the prescription of the model
tax system that a deduction is allowed only for State and
local income taxes" Other taxes may be deducted only
as
costs of doing business.
Income Tax Deductibility
Income taxes represent the clearest analogy with dues
paid into a voluntary collective. These payments reduce
the resources available to the payor for consumption or
accumulation, and hence they are properly deductible.
Property Tax Deductibility
The issue of property tax deductibility for homeowners
has been discussed above. Deduction of that tax should not
be allowed so long as the associated implicit rental income
from housing is excluded from taxable income. Other State
and local taxes that are generally deductible under present
law are income taxes, general sales taxes, and motor fuel
taxes.
Sales Tax Deductibility
General sales taxes, it may be argued, should not be
deducted separately because they do not enter household
receipts. Unlike the personal income tax, which is paid by
households out of gross-of-tax wages, interest, dividends,
and the like, the sales tax is collected and remitted to
government by businesses that then pay employees and suppliers
of capital out of after-sales-tax receipts. Therefore, the
sum of all incomes reported by households must be net of the
tax; the tax has already been "deducted" from income sources.
To allow a deduction to individuals for the sales tax would
be to allow the full amount of the tax to be deducted twice.
The argument above is modified somewhat to the extent
that the rate of sales tax varies among States and localities
that trade with each other. Jurisdictions with high sales
tax rates may sustain locally higher prices if they can
effectively charge the sales tax to their own residents who
purchase goods outside the jurisdiction. In this case,
compensating higher wages, rents, etc. (in money terms) must
also prevail in the high-rate area to forestall outmigration
of labor and capital. The additional tax will increase
nominal income receipts in the region of high tax rates.
- 94 The question is an empirical one on the degree to which
sales taxes do result in price level differences among
jurisdictions. Iri view of the difficulty of establishing
this relationship and of measuring the individual expenditures on which sales taxes are paid, the deduction for sales
taxes Ts not allowed in the model comprehensive income tax.
A disadvantage of this treatment is that to the extent sales
taxes do cause price level differences, the choice of financing investment by State and local governments will be
biased toward income and away from sales taxes.
Alternative Treatments of Sales and Income Taxes
An alternative treatment of both sales and income taxes
may be considered, whereby a deduction is allowed only for
amounts in excess of a significant floor (possibly expressed
as a fraction of the tax base). As at present, standard
amounts of sales tax, related to income, could be included
in the income tax form, with sales taxes on large outlays
(e.g., for an automobile) could be allowed in addition to
making the calculation. This approach would relieve most
taxpayers of recordkeeping and be roughly equivalent to
including at least some of consumption services that are
provided by State and local governments in the tax base.
(The floor could even be related to an estimate of the
extent to which State and local taxes finance transfer
payments, included in the base by recipients.)
Benefit Taxes
Certain State and local government services are financed
by taxes and charges that are closely related to the taxpayer's own use of those services. Such taxes can be looked
upon as measures of the value of consumption of those
services and so should not be excluded from income. This
argument holds especially for State and local taxes on motor
fuels that are earmarked for the construction of highways
and for other transportation services. The amount of
gasoline consumed is a rough measure of the value of these
services used, and, conversely, the consumer can choose the
amount of highway services used, and taxes paid, by choosing
the size of vehicle and the amount of his drivina.
Other State and local user charges and special taxes,
such as sewer assessments, fishing licenses, and pollution
taxes, are not deductible under current law. This treatment
is consistent with the arguments above. In addition, there
- 95 are a number of local excise taxes that were enacted at
least partly for the purpose of controlling consumption.
Allowing deduction of such taxes, e.g., on gambling,
alcohol, tobacco, firearms, etc., would be adverse to this
purpose.
CONTRIBUTIONS TO CHARITIES
Contributions to qualified charitable organizations are
presently deductible, subject to certain limits, as an
indirect subsidy to philanthropy. Gifts are arguably also
of a different nature than ordinary consumption for the
donor, and therefore not part of income. Against this view,
the voluntary nature of contributions may be cited as
evidence that contributors derive satisfaction from giving
just as they do from other uses of resources. Since contributions are not taxed to donees, either when received by
philanthropic organizations or when distributed to ultimate
beneficiaries, a component of income is clearly lost to the
tax base as a result of the present policy. Taxation of the
donor may be regarded as a substitute for taxation of the
donee.
Accordingly, the model tax would allow no deduction
to the donor for gifts to charitable organizations and
would not include benefits of such donations in income
to recipients.
The question of how to treat charitable contributions
extends beyond issues of income measurement, however. Many
persons would regard the benefits of a tax incentive to
philanthropy as more valuable than the potential benefits of
tax simplification and horizontal equity of the model tax
treatment. Consequently, optional methods for providing an
incentive to charity, in the form of donor deductibility or
a tax credit, also are discussed.
Charity as Income to Beneficiaries
A charitable contribution is a transfer between a donor
and beneficiaries with a philanthropic organization as an
intermediary. The philanthropic organization usually converts
cash contributions into goods and services, such as hospital
care, education, or opera performances, that are subsidized
or provided free to the beneficiaries. In many cases, e.g.,
cancer research, the benefits are very broadly diffused
throughout society. The value of these services is a form
of income-in-kind to the beneficiaries, but under present
law there is no attempt to tax beneficiaries on that income.
- 96 The logic of the tax treatment of charitable contributions is much the same as that for gifts or bequests to
individuals. A gift does not add to the standard of living
of the donor, although it does for the beneficiary. If the
taxpayer's standard of living is the appropriate criterion
for taxability, proper treatment would be to allow deduction
of the gift as at present, but with taxation to the recipient,
subject only to the general exemption of very low-income
taxpayers.
There is, however, no generally satisfactory way to
measure or allocate the benefit-in-kind resulting from
charitable donations. While total benefits might be measured
by their cost, a large input to benefits-in-kind is voluntary
effort that is very difficult to value.
Charities as Public Goods
Even if it were practical to tax benefits-in-kind, it
still could be argued that the benefits should not be taxed
because they flow to society generally as well as to the
individual recipient. Many philanthropic activities provide
services, e.g., basic research, education, etc., that
benefit the public at large. Deductibility of contributions
to such activities provides an incentive for this provision
without direct government control.
On the other hand, some persons argue that this kind of
hidden public finance should not be given to programs that
are under private, and perhaps even individual, control.
Moreover, it may be viewed as inequitable that some beneficiaries should receive untaxed benefits if others must pay
the full cost for similar benefits (e.g., education, health
care, etc.).
A Practical Alternative to Taxing Charitable Organizations
If it is considered logical but impractical to tax
benefits to the beneficiary, an alternative approximation is
to tax the donor by denial of deductibility. The charitable
contribution is easily measurable and taxable in a practical
sense. If the donor reduces his contributions by the amount
of the additional tax he pays, the donor indirectly shifts
the tax burden to beneficiaries. Denial of deductibility,
therefore, may be viewed as a proxy for taxing beneficiaries.
This describes the present treatment of gifts between
individuals. The model tax repeats this treatment for gifts
to organizations.
- 97 Alternative Tax Incentives for Philanthropy
The rationale for deductibility of gifts and exemption
from income of charitable institutions comes down to providing a tax incentive to encourage their activities. On
the other hand, concern for tax equity only would suggest
taxation of the full value of the charitable contribution
on at least one side of the transfer. The latter conclusion
may be reached whether one invokes a "standard-of-living"
or an "ability-to-pay" criterion of equity.
Optional Tax Credit. The use of the tax system to
provide an incentive for charitable activities may be
accomplished by an alternative policy option — the replacement of the deduction with a tax credit. A flat credit
(percentage of contribution) could be provided at a level
that would just balance the revenue gain from denying
deductibility. A credit of, for example, 25 percent would
provide additional tax savings to those with marginal tax
rates below 25 percent and impose more taxes on those with
marginal rates in excess of 25 percent. In addition to this
redistributive effect, this alternative tax incentive may
result in certain activities," such as education, health
care, and the arts, bearing the additional burden nominally
imposed on the higher-income contributors. Other activities,
such as religion and welfare, might be more likely to
benefit from the tax savings given to lower-income contributors .
The choice between tax credits and deductions thus
requires a judgment about the desired amount of stimulus
among types of charities. The relative fairness of these
devices may be judged according to one's concept of income.
If gifts are regarded as reductions in the donor's income,
and if rates of tax are chosen to produce a desirable degree
of tax progressivity, then the deduction is to be preferred
on equity grounds. Conversely, if charitable giving is a
use of one's income that is to be encouraged by public
subsidy, a subsidy per dollar of gift that does not vary
with the taxable income of the donee may be more appropriate .
CASUALTY LOSSES
Model Tax Treatment
The issue of deductibility of casualty losses is
analogous to that of the property tax deduction. Damage to
Property due to accidents or natural disasters reduces
- 98 the present and potential income from ownership of that
property. Consequently, casualty losses are properly
deductible business expenses. However, as argued previously,
owner-occupied houses and consumer durables produce incomes
equal to a certain portion of the current rental value to
the user, and that income is fully exempt from tax under
present law and would be under the model tax. Deduction of
casualty losses would represent an asymmetric treatment of
these household assets — their income is exempt from tax,
but interruption of the flow of income due to casualty would
provide a tax reduction. The model tax would allow no
deduction for casualty losses except to business property.
Casualty insurance premiums for household property would
not be deductible and insurance benefit~would not be
IrT^l^ded in income:
Present Law Treatment
Under current law, insurance premiums are not deductible,
but proceeds offset the deduction for actual losses. Hence,
the effect for insured losses is the same as full deduction
of losses, without floor, and inclusion of insurance proceeds
in income.
The logic cited above for refusing the deduction of
losses would suggest that insurance premiums for household
assets also are a cost of maintaining tax-exempt income.
Such costs, therefore, should not be deductible. Because
insurance premiums are approximately equal to the expected
value of insurance benefits, if no deduction is allowed for
premiums, the aggregate of insurance benefits may be regarded
as tax-prepaid. Consequently, these benefits should not be
taxable as income when paid.
INTERNATIONAL CONSIDERATIONS
The Residence Principle
There are two basic prototype approaches to the taxation of international flows of income. The first is the
residence principle, under which all income, wherever
earned, would be defined and taxed according to the laws of
the taxpayer's own country of residence. The second prototype is the source principle, which would require the
taxpayer to pay tax according to the laws of the country or
countries in which his income is earned, regardless of his
residence. Adoption of one prototype or the other, as
- 99 compared with the mixed system that now prevails, would
have the desirable effect of insuring that no part of
an individual' s income would be taxed by more than one
country, and would reduce the number of bilateral treaties
necessary to assure against double taxation.
A number of considerations point to the residence
principle as the more desirable principle to establish.
First, the concept of income as consumption plus change in
net worth implies that attribution of income by source is
inappropriate. Income, by this definition, is an attribute
of individuals, not of places. Second, if owners of factor
services are much less mobile internationally than the
factor services they supply, variations among countries in
taxes imposed by residence will have smaller allocation
effects than tax variations among places of factor employment. Third, the income redistribution objective manifested
by the use of progressive income taxes implies that a
country should impose taxes on the entire income of residents.
The usual concept of income distribution cannot be defined
on the basis of income source.
For these reasons, the model plan recommends that
the United States seek, as a long-run objective, a world
wide system of residence principle taxation. This objective
would be made much more feasible with the integration of
individual and corporate income taxes. Clearly, the residence
principle requires that a taxable income be attributable to
persons. If taxable income were attributed to corporations,
they would be encouraged to move their residence to
countries with, low tax rates.
Even after establishment of the residence principle,
some problems would remain. For example, individuals who
live in countries that tax pensions upon realization might
be induced to retire to those countries that require prepayment of taxes on pensions by including pension contributions
in taxable income. Such international differences in tax
structure would contine to require bilateral treaty agreements .
Establishing the Residence Principle
To encourage the establishment worldwide of the residence
Principle, the model tax would reduce in stages, and according
to the outcome of international treaty negotiations, the
^ ^ 2£ U*S. withholding taxes on income paid to foreign
- 100 residents and the foreign tax credit allowed to U.S.
residents on foreign source income. This process would
depend upon corresponding reductions by foreign countries in
the taxation of income of U.S. residents.
The first step in the process of establishing the
residence principle is to define a unique tax residence for
each individual. These definitions would be established
initially by national statute, and ultimately settled by
international tax treaty. The second step would be
to devise a tax system that encouraged other countries to
forego taxation of U.S. residents on income earned abroad.
This fundamental change in tax jurisdiction will take time,
and it is important that international flows of labor,
capital, and technology not be hampered by double taxation
during the transition period. Accordingly, transition to
the model U.S. tax system would be designed as a slow but
steady movement toward residence principle taxation.
Interim Rules
Foreign Shareholders. As a practical matter, it would
not be feasible to exempt foreign shareholders from U.S.
taxation until such time as the residence principle received
broad political acceptance both in the United States and
abroad. Initially, therefore, foreign shareholders might be
subject to a withholding tax of perhaps 30 percent on their
share of corporate income (whether or not distributed), with
the rate of taxation subject to reduction by treaty. Other
forms of income paid to foreign residents would continue to
be subject to withholding tax at existing statutory or
treaty rates. These rates also could be reduced by treaty.
Foreign Tax Credits. Eventually, a deduction — not a
credit — should be allowed for foreign income taxe, because
they are not significantly different from State and local
income taxes, for which a deduction is also allowed. This
approach would encourage foreign governments to provide U.S.
firms operating abroad with benefits approximately equal to
the amount of taxes. Otherwise, U.S. firms would gradually
withdraw their investments. However, it will take time for
foreign governments to accept the residence principle, just
as the United States is not immediately willing to forego
withholding taxes on U.S. source income paid to foreign
residents. In the meantime, for reasons of international
comity, and in order not to interrupt international flows of
factor services, the United States would continue to allow a
foreign tax credit to the extent of its own withholding tax
- 101 on foreign income. In the case of corporate-source income,
the initial credit limitation rate would be 30 percent (and
the remainder of foreign taxes would be allowed as a deduction) . In the case of other income, the credit limitation
would be determined by the U.S. statutory or treaty withholding
rate on the particular type of income.
Foreign Corporations. In keeping with the model income
tax definition of income, the earnings of a foreign corporation controlled by U.S. interests would flow through to the
domestic parent company and then to the shareholders of the
domestic parent. The U.S. parent corporation would be
deemed to receive the before-foreign-tax income of the
subsidiary even if no dividends were paid. This would
eliminate deferral here just as the integration plan
eliminates shareholder deferral of tax as income in the
form of corporate retained earnings. A foreign tax credit
would be allowed for the foreign country's corporate income
tax and withholding tax to the extent of the 30-percent
limit. Excess foreign taxes would be deductible.
The earnings of foreign corporations that are not controlled by U.S. interests would be taxable in the hands of
U.S. shareholders only when distributed as dividends, and,
therefore, a deduction rather than a credit would be allowed
for any underlying foreign corporate income tax. A foreign
tax credit would be allowed to U.S. shareholders only to the
extent of foreign withholding taxes, and limited by the U.S.
withholding rate on dividends paid to foreign residents.
(The remainder of foreign withholding taxes would be allowed
as a deduction.)
Other Foreign Income. Other types of foreign income
paid to U.S. residents would be similarly eligible for a
foreign tax credit, again limited by the U.S. tax imposed on
comparable types of income paid to foreigners. Thus, a U.S.
resident earning salary income abroad would be allowed to
claim a foreign tax credit up to the limit of U.S. withholding
taxes that are imposed on the salary incomes of foreign
residents in the U.S.
THE FILING UNIT
To this point, the concern of this chapter has been to
develop a practical definition of income for purposes of a
comprehensive income tax. That discussion has involved
issues of timing, valuation, and scope, as well as considerations of administrability. The major issues that
remain to be discussed have to do with assessment of the tax
against income as defined.
- 102 Model Tax Treatment
Among the more difficult problems of translating an
income definition into a tax system are (1) to determine
what social or economic unit should be required (or allowed)
to file a tax return and (2) how rates are to be applied to
filing units having different characteristics. The model
tax would designate the family as the primary tax unit,
with separate rate schedules, as under current law, for
three types of families -- unmarried individuals without
dependents, unmarried individuals with dependents (heads
of households), and married couples with or without
dependents. Other provisions for two-earner families and
for dependent care are described below.
Problems of Taxation of the Filing Unit
To illustrate the issues involved in choosing among
alternative tax treatments of families, consider the
following potential criteria:
1. Families of equal size with equal incomes should
pay equal taxes.
2. The total tax liability of two individuals should
not change when they marry.
Both of these appear to be reasonable standards. Yet, there
is no progressive tax system that will satisfy them simultaneously. This is readily illustrated by the following
hypothetical case. Both partners of married couple A work,
and each has earnings of $15,000. Married couple B has
$20,000 of earnings from the labor of one partner and
$10,000 from the other.
If individual filing were mandatory, with the same rate
structure for all, couple A may pay less tax than couple B.
This is a consequence of applying progressive rates separately
to the earnings of each partner. Suppose marginal rates
were 10 percent on the first $15,000 of income and 20 percent
on any additional income. In this example, couple A would
owe $1,500 on each partner's income, or a total of $3,000.
Couple B would owe $2,500 on the larger income and $1,000 on
the smaller, or a total of $3,500. This violates the first
criterion.
- 103 Now consider a system of family filing in which all
income within the family is aggregated and the tax is calculated without regard to the relative earnings of each
partner. (Unmarried individuals would be subject to the
same rates as a family.) In this case, the two couples
would pay the same tax on their total income of $30,000.
However, both couples would be financially worse off than if
they were unmarried. Each couple would now pay a tax of
$3,500 on the total of $30,000. As compared with separate
filing, more income is taxed at the higher marginal rate.
This violation of the second criterion is sometimes referred
to as a "marriage tax."
The simplest device for dealing with this penalty on
marriage is "income splitting," whereby the combined income
of a married couple is taxed as though it were attributed
half to one spouse, and half by the other. Each half is
subject to the rate schedule applicable to an unmarried
individual. To continue the above example, each couple with
a total income of $30,000 would, with income splitting, pay
a rate of 10 percent on each $15,000 share, or a total of
$3,000 in tax. Notice that there may be a "marriage benefit"
so long as each prospective spouse does not have the same
income. Upon marriage, the combined tax for couple B would
fall from $3,500 to $3,000.
Choice of the Filing Unit
Direct appeal to the concept of income does not settle
these issues, because that concept presupposes the definition
of an accounting unit. There are legal, administrative, and
even sociological factors involved in the choice. The major
arguments in favor of mandatory individual filing can be
summarized as follows: (1) no marriage tax; (2) no discrimination against secondary workers; and (3) the administrative
ease of identifying individuals without the requirement of a
definition of families. By contrast, the arguments in favor
of family filing are: (1) families with equal incomes should
pay equal taxes; (2) families typically make joint decisions
about the use of their resources and supply of their labor
services; and (3) family filing makes it unnecessary to
allocate property rights, as in the case of community
property laws, and to trace intrafamily gifts.
The last point is critical. A concept of income as a
use of resources implies that each individual's ability to
Pay includes consumption and net worth changes financed by
- i
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- 104 transfers from other family members. Carried to extreme,
this separate treatment of family members would suggest
assessment of tax even to minor children. Chiefly because
of this problem, it i£ recommended that the family be
made the primary tax unit.
The definition of a family is, of necessity, somewhat
arbitrary, as is the application of progressive rate schedules
to families of different types. The following definition of
a family is adopted here 6/: The family unit consists of
husband and wife and their children. The children are
included until the earliest date on which one of the following events occurs:
. They reach 18 years of age and they are not then
attending school; or
. They receive their baccalaureate degree or;
. They attain age 26; or
. They marry.
Single persons are taxed separately. Persons not currently
married and their children living with them are treated as
family units.
The Problem of Secondary Workers
A system of joint family filing may cause an efficiency
loss to the economy; namely, the discouragement of labor
force participation by secondary workers in a family. If a
partner not in the labor force is thinking of entering it,
the tax rate that person faces is the marginal rate applying
to the prospective total family income. This rate may be
much higher than that for a single wage earner. This
consequence of family filing is sometimes referred to as the
"wife tax."
Two-earner families and single-adult families with
dependents also face expenses for dependent care, which may
be regarded as altering such families' ability to pay taxes.
Hence, taxability of families will vary according to the
number of adults, the number of wage earners, and the number
of children.
- 105 Compare the circumstances of three three-person families
of equal income: family X has two adult wage earners;
family Y has two adults, only one of whom is a wage earner;
and family Z has only one adult, who is a wage earner.
Family Y alone receives the full-time household and child
care services of one adult member and may be regarded as
better off on this account. Family X alone bears the wife
tax associated with secondary wage earners. Family Z has
the additional child care responsibility but also the
smaller subsistence outlays associated with two children in
place of an adult and one child. The model tax would
recognize the difference of the type illustrated by these
three families by two special adjustments to taxable income,
and by separate rate schedules — one for families with one
adult and another for those with two adults.
Tax Adjustments for Differences in Family Status
The first adjustment in the model tax is that only 75
percent of the wage income of secondary earners would be
IncludedTn family income. This lower rate of inclusion
would apply only to a limited amount of earnings of the
secondary worker. In the model tax this limit would be
$10,000. Earnings of the secondary worker means the income
of all family wage earners, except that of the member with
the largest wage income. This provision would reduce the "wi
tax" on families with more than one wage earner.
The second adjustment would be a child care deduction
equal to half of actual child caLre costs up to a limit of
either $5,000 or the taxable earnings of the secondary
worker, whichever is smaller. This deduction would be
allowed only for a spouse who is a secondary worker, or for
an unmarried head of household. The dependent care adjustment would provide some allowance for the reduced standard
of living associated with the absence of full-time household
services of a parent.
The model tax would provide separate rate schedules, as
in present law, for single individuals, for families with a
married couple, and for families with a single head of
household. Rate schedules applicable to individuals would
be set so that a two-adult family would pay slightly higher
tax than two unmarried individuals whose equal taxable
incomes sum to the same taxable income as the family. A
single individual would, of course, owe more tax than a
family with the same amount of taxable income. The schedule
- 106 of rates for a family with a single head of household
would be designed so that the tax liability would be the sum
of (1) half the tax calculated from the single rate schedule
and (2) half the tax from the rate schedule for couples.
The model tax also would have, as part of its rate
schedule, a "zero rate bracket" that would exempt a fixed
amount of income on each return from tax. The level of this
exemption could be adjusted to reduce the potential marriage
benefit that may result from different schedules of positive
rates for married as compared to single filers. The desired
relation in level and progressivity of tax among taxpayers
of different family status would be achieved, therefore,
by a combination of rates and rate brackets that is different
for each type of family, and also by specifying a level of
exemption per filing unit.
Provision of an exemption for each filing unit would
have much the same effect as the standard deduction under
present law. The exemption would provide a minimum level of
income for each family or individual that would not be
subject to tax. However, unlike the present law, the use of
the exemption by a family would not disallow any other
subtractions from receipts in the determination of taxable
income. Under the model tax, deductions for employee
business expenses, State and local income taxes, pension
contributions, interest payments, etc. would not be reduced
by, nor dependent upon, the exemption of a subsistence
amount of income.
ADJUSTING FOR FAMILY SIZE
Most observers would agree that the tax treatment of
families should vary by family size, as well as by marital
status and the number of wage earners. The model tax would
adjust for family size by means of a specified exemption
per family member, as in present law.
Exemptions Versus Credits
The use of the personal exemption as an adjustment for
family size has been much criticized. One line of criticism
is that the dollar value of an exemption increases with the
family's marginal tax rate, so that it is worth more for
rich families than for poor families. This observation has
led some people to suggest either a vanishing exemption,
which diminishes as income increases, or institution of a
- 107 tax credit for each family member in place of the exemption.
The latter approach has been adopted, in a limited way, in
the "personal exemption credit" provision of the 1975 Tax
Reduction Act, which has been extended temporarily by the
1976 Tax Reform Act. A tax credit reduces tax liability by
the same amount for each additional family member regardless
of family income.
The argument for a vanishing exemption or family credit
often reflects a misunderstanding of the relationship of
these devices to the overall progressivity of the income
tax. It is true that trading an exemption for a credit
without changing rates will alter the pattern of progressivity,
making the tax more progressive for large families, less for
small families and single persons. But it is also true
that, for any given level of exemption or credit, any degree
of progression among families of equal size may be obtained
by altering the rate schedule. Therefore, in the context of
a basic reform of the tax system that involves revision of
the rate structure, there is no reason that the substitution
of tax credits for exemptions should result in a more
progressive tax.
If the change in the standard of living that accompanies the addition of a family member is akin to a reduction in the family's income, then an exemption would be an
appropriate family-size adjustment. If, on the other hand,
one views the family-size adjustment as a type of subsistence
subsidy for each member of a taxpayer's family, a credit may
be more appropriate. The model tax reflects the former
view.
The point to be emphasized here is that this choice is
often argued in the wrong terms. If tax rates are adjustable, the issue of exemptions versus credits is essentially
a question of the proper relative treatment of equal-income
families of different sizes at various points of the income
distribution. Should the tax reduction on account of
additional family members be greater as family income
increases? Or is this, per se, inequitable?
SAMPLE COMPREHENSIVE INCOME TAX FORM
In order to summarize the major provisions of the model
comprehensive income tax, and to provide a ready reference
to its provisions, a listing of the items of information
that would be required to compute the tax is provided below.
In a few cases — unincorporated business income, capital
- 108 gains and losses, and income from rents and royalties —
supplemental schedules would be required to determine
amounts to be entered. However, as compared with present
law, recordkeeping requirements and tax calculation would be
simplified greatly, despite the fact that several presently
excluded items of income are added.
For most taxpayers, the only calculations that would
be complicated would be the exclusion of a portion of wages
of secondary workers and the child care allowance for
working mothers and heads of households. The rest of the
calculation would simply involve the addition of receipts,
subtraction of deductions and exemptions, and reference to a
table of rates. For single individuals and couples with
one wage earner who have only employee compensation and
limited amounts of interest and dividends, a still simpler
form could be devised.
Sample Tax Form for the Comprehensive Income Tax
Filing Status
1. Check applicable status
a. Single individual
b. Married filing joint return
c. Unmarried head of household
d. Married filing separately
Family Size
2. Enter one on each applicable line
a. Yourself
b. Spouse
3. Number of dependent children
4. Total family size (add lines 2a, 2b, and 3)
- 109 Household Receipts
5a. Wages, salaries, and tips of primary wage earner
(attach forms W-2)7/
b. Wages, salaries, and tips of all other wage earners
(attach forms W-2)
c. Multiply line 5b by .25; if greater than $2,500, enter
$2,500
d. Included wages of second worker, subtract line 5c from
line 5b
e. Wages subject to tax, add lines 5a and 5d
6. Receipts of pensions, annuities, disability compensation, unemployment compensation, workmen's compensation, and sick pay. (Includes social security benefits,
except Medicare, and veteran's disability and survivor
benefits.)
7. Interest received (attach forms 1099)
8. Rents, royalties, estate and trust income, and allocated earnings from life insurance reserves (attach
schedule E)
9. Unincorporated business income (attach schedule C)
10. Net gain or loss from the sale, exchange, or distribution of capital assets (attach schedule D)
11. Allocated share of corporate earnings (attach forms Wx)
12. Public assistance benefits, food stamp subsidy, fellowships, scholarships, and stipends (attach forms W-y)
13. Alimony received
14. Total receipts (add lines 5e and 6-13)
- 110 Deductions
15. Employee business expense (includes qualified travel,
union and professional association dues, tools, materials,
and education expenses)
16. Nonbusiness interest expense (attach statement)
17. State and local income tax
18. Alimony paid
19. Child care expenses
a. If line lc is checked and line 3 is not zero, or
if line lb is checked and both lines 3 and 5b
are not zero, enter total child care expenses
b. Multiply line 19a by .5
c. Enter smaller of line 19b or $5,000
d. Child care deduction. If unmarried head of household, enter smaller of line 19c or line 5a
e. If married filing joint return, enter smaller of
line 19c or line 5d
20. Total deductions (add lines 15-18, and 19d or 19e)
Tax Calculation
21. Income subject to tax. Subtract line 20 from line 14
(if less than zero, enter zero)
22. Basic exemption. Enter $1,600
23. Family size allowance. Multiply line 4 by $1,000
24. Total exemption. Add lines 22 and 23
25. Taxable income. Subtract line 24 from line 21
26. Tax liability (from appropriate table)
27. a. Total Federal income tax withheld
b. Estimated tax payments
c. Total tax prepayments (add lines 27a and 27b)
- Ill -
28.
If line 26 is greater than line 27c, enter BALANCE DUE
29. If line 27c is greater than line 26, enter REFUND DUE
- 112 FOOTNOTES
The use of food stamps is restricted to a class of
consumption items, but the range of choice allowed to
recipients is sufficiently broad that the difference
between the face value and the purchase price of the
coupon may be regarded as a cash grant.
This imputed income estimates the return to both equity
and debt supplied during construction. To include
interest paid in the calculation would count the debt
portion twice.
To be increased in increments to 12 months according to
the Tax Reform Act of 1976.
To be increased in increments to $3,000 according to
the Tax Reform Act of 1976.
A rule of thumb that is commonly suggested is that
monthly rental is 1 percent of market value. However,
as experience with local property taxes has shown,
accurate periodic assessment is technically and politically
difficult.
This definition is based upon that of Galvin and
Willis, "Reforming the Federal Tax Structure," p. 19.
Wages reported by the employer would exclude employee
contributions to pension plans and disability insurance,
and would also exclude the employee's share of payroll
taxes for social security retirement and disability
(OASDI). Wages would include employer contributions to
health and life insurance plans, the employee's allocated share of earnings on pension reserves, and the
cash value of consumption goods and services provided
to the employee below cost.
- 113 -
Chapter 4
A MODEL CASH FLOW TAX
INTRODUCTION
This chapter presents a proposal for a consumption
base tax as an alternative to a comprehensive income tax.
Called a "cash flow" tax because of the simple accounting
system used, this tax is designed to replace the current
taxes on the income of households, individuals, trusts, and
corporations.
The major difference between the cash flow tax and the
comprehensive income tax outlined in chapter 3 is that the
change in an individual's net worth is effectively excluded
from the base of the cash flow tax. In many other respects,
the two taxes are alike. Consumption is included in both
tax bases. The measure of consumption in the cash flow
proposal is broadly similar to that in the comprehensive
income tax proposal; it differs mainly in that it includes
the flow of consumption from consumer durables and owneroccupied housing and certain other forms of in-kind consumption. The treatment of the family unit for tax purposes
is the same in both the comprehensive income and cash flow
proposals.
The concern of this chapter is to define the appropriate
base of the cash flow tax system. The issue of the progressivity of the tax system is a separate problem that
would have to be resolved for either the cash flow tax or
the comprehensive income tax. This issue is considered for
both taxes in chapter 5.
Cash Flow Accounting
The central feature of the model tax system is the use
of cash flow accounting for financial transactions to obtain
a measure of annual consumption for any individual or household. The principle involved is very simple. A household
could use monetary receipts in a year for three purposes:
personal consumption, saving, and gifts. By including all
monetary receipts in the tax base, including the entire
proceeds of sales of assets and gifts received, and allowing
deductions for purchases of assets and gifts given, the
annual consumption of a household could be measured without
directly monitoring the purchases of goods and services.
- 114 -
The use of cash flow accounting of financial asset
transactions to compute the tax base is illustrated, for an
average wage earner, in the following example. Suppose a
worker earns $10,000 per year in wages, of which he uses
$9,000 for personal consumption and $1,000 for saving.
Under the cash flow tax outlined in this proposal, the
worker could deduct $1,000 from his $10,000 of wages, if
he had deposited the $1,000 in a qualified account.
Use of Qualified Accounts. Qualified accounts would be
established by banks and other financial institutions, which
would keep records of deposits and withdrawals. The worker's
$1,000 deposit in the account could be used to purchase any
type of financial asset — savings bank deposits, corporate
shares, bonds, mutual funds, or any other claim to current
or future income. The future balance in the qualified
account would depend, of course, on the profitability of
his investments. No tax would be assessed against interest,
dividends, or capital gains as they are earned, but the
taxpayer would be required to include in his tax base
the full value of any withdrawals from his qualified
account that were not reinvested in similar accounts. The
use of qualified accounts to handle financial transactions
would ease the taxpayer's recordkeeping burden and would
enable tax authorities to trace the annual flow of funds
available for consumption uses.
The qualified accounts described here are very similar
to qualified retirement accounts under current law. These
accounts include Keogh plans and Individual Retirement
Accounts (IRA's), which provide the taxpayer a current
deduction for contributions to funds for retirement and,
then, include withdrawals from the fund in the tax base
after retirement. There are two major differences between
the qualified accounts proposed here and qualified retirement accounts provided for in the current tax code. First,
withdrawal of funds from the qualified account would be
allowed without penalty at any time during a taxpayer's
lifetime. Second, there would be no statutory limit to the
amount a taxpayer could contribute to a qualified account.
Thus, in the example above, if the worker deposited
$1,000 in a savings account, his tax would be computed on an
annual cash flow base of $9,000. If, in the following year,
he consumed his entire salary of $10,000 and in addition
withdrew $500 from his savings account to purchase a color
television set, his cash flow tax base in that year would be
$10,500.
His taxcurrently
base is geared
use of his receipts
for
consumption,
or in to
thethe
future.
- 115 -
Alternative Treatment of Investments. An alternative
way of handling investments that would enable an individual
to alter the timing but not the expected present value of
his cash flow tax base would be to include the purchases of
assets in the tax base, but to exempt all returns from
assets from tax. To continue the example above, the worker
could deposit $1,000 of his $10,000 of annual wages in a
savings bank, but without using a qualified account. If he
did so, the entire $10,000 of wage receipts would be included
in his tax base in the initial year, but any future interest
earned on the savings deposit and any withdrawal of the
principal would be excluded from the tax base. As will be
discussed more fully below, the expected present value of
the worker's lifetime tax base would be the same for either
method of accounting, if he consumes the proceeds of his
account during his lifetime.
Investments handled in this alternative way would be
treated very simply for tax purposes. The amount invested
would be included in the tax base — the same as consumption •
but all subsequent returns on the investment would be
untaxed. In effect, the tax that would otherwise be due on
consumption from the proceeds of the investment would be
prepaid at the time the investment is made. Allowing
taxpayers the choice of this alternative way of handling
investment accounts has some advantages, but could create
problems, which are discussed below.
The possibility is discussed of dealing with these
problems by introducing restrictions on the types of investments that may or must be made through qualified accounts.
Although few restrictions are recommended in the model plan,
it should be stressed that to increase their number or
stringency would be fully consistent with the basic concept
of the cash flow tax and would not alter its most important
features.
The remainder of this chapter presents the details of a
model cash flow tax base and discusses its most important
characteristics. The next section points out the tax
issues that have common solutions in the model comprehensive
income tax and the model cash flow tax. Then, a section is
devoted to the major differences between the two tax bases,
including a full description of the cash flow tax treatment
of investment assets and consumer durables. Another section
discusses the economic consequences of adopting a cash flow
tax, and the final section presents a sample tax calculation
form.
- 116 ELEMENTS IN COMMON WITH THE COMPREHENSIVE INCOME TAX
Several of the issues discussed in the preceding
chapter would be resolved similarly for a cash flow tax.
These questions include the measurement of consumption —
to be taxed alike in both models — and the related issue of
the appropriate treatment of families of varying size and
circumstances.
Family Size and Family Status
Under this proposal, the family would be taxed as a
unit for reasons analogous to those argued in chapter 3. In
order to assess tax to each family member as an individual,
it would be necessary to allocate consumption among family
members. This would destroy much of the administrative
simplicity of the cash flow tax, which rests upon deducting
from receipts certain cash outlays that are usually made on
behalf of the family as a unit. Receipts are also usually
combined at the family level. The argument that standard of
living varies by family size holds for a consumption measure
of living standard as well as for an income standard. The
adjustment device in the model cash flow tax plan discussed
in this chapter — one exemption per family member — is
the same as that proposed for the comprehensive income tax.
However, differences in the size of the tax base under the
two taxes might require that the exemption levels be different for model taxes intended to raise the same revenue.
As in the case of the comprehensive income tax, other
approaches to the adjustment for family size would be fully
consistent with the cash flow tax base.
Adjustments that account for differences among families
in the number of wage earners and the availability of a
full-time adult in the household apply to labor-related
earnings and expenses only. They would be just as appropriate,
therefore, under a consumption tax as under an income tax.
The structure of rates required to achieve the desired
pattern of progressivity might be different, however.
Deductions for Charitable Contributions, Medical
Expenses, and Taxes
Contributions to Charities. As in the case of the
comprehensive income tax base, deductions for charitable
contributions would not be allowed under the model cash flow
- 117 -
tax. Conceptually, under a cash flow tax, itemized gifts
should be deductible by the donor and included in the
receipts of the donee. Following the discussion in chapter
3, including receipts from charities in the tax base of the
recipient is rejected as impractical. Charity is not
usually given in cash or in goods that are easy to value,
and sometimes the benefit is to society generally, so that
beneficiaries cannot be separately identified. Nor should
the charitable institutions be taxed. They do not consume;
they merely act as intermediaries to distribute the benefits
to the ultimate recipients. The foregoing suggests that the
best way to tax consumption resulting from charitable
activities would be to count charitable contributions as
consumption by the donor and not to allow a tax deduction.
In opposition to this proposal, it may be argued that
tax-free consumption of goods and services provided by
charities should be maintained because these goods and
services provide a public service function. Proponents of
this view would argue for either a deduction or some form of
tax credit for charitable contributions. As noted in chapter
3, however, the decision whether or not to allow the deduction of charitable contributions is not essential to the
basic integrity of the overall proposal.
There is one element of the comprehensive income tax
discussion of charities that does not apply to a cash flow
tax. The undistributed portion of endowment earnings of
charitable organizations should not be taxed even if taxation
of organizations on the basis of contributions is viewed as
feasible and recommended as a general policy.
Medical Expenses. The issues involving medical expenses
and medical insurance are exactly the same for the cash flow
tax as for the income tax. Consequently, the same policy
options are prescribed for both model taxes.
State and Local Income Taxes. The model cash flow tax
treatment of State and local taxes also would be the same as
that under the model accretion tax: income taxes would be
fully deductible because they are not regarded as part of
consumption. Other taxes would not be deductible, except as
business expenses.
Property Taxes. No property tax deduction would be
allowed to homeowners under either of the model taxes. The
rationale for denying deduction of the property tax for
- 118 -
owner-occupied homes is, however, somewhat different in the
case of the cash flow tax. The cash flow tax would measure
the owner's consumption of housing services as the purchase
price (or capital value) of the dwelling. In a market
equilibrium, this price is the present value of the prospective stream of imputed rents less current costs. These
costs include property taxes. Therefore, a higher local
property tax, if uncompensated by services to the property,
would result in a lower market price of the dwelling. In
this way, the property tax is excluded from the base of the
cash flow tax without an explicit deduction.
Health, Disability, and Unemployment Insurance
Those types of insurance that are purchased for a 1year term and pay benefits directly to the insured — health,
disability, and unemployment insurance — are no different
in concept or model tax treatment under the cash flow tax
than under the accretion tax. They are included in the
definition of consumption. The differences in treatment
among them — taxation of benefits in the case of disability
and unemployment, and of premiums for health insurance —
are explained in the preceding chapter. The model tax
treatment is the same for each of these items whether the
insurance is public or private, employer-paid or employeepaid. However, life, casualty, and old-age insurance do
present differences in concept under the consumption tax and
will be discussed below.
Casualty Losses
Casualty losses would not be deductible under the model
comprehensive income tax or under the cash flow tax. Again,
however, the rationale for not allowing the deduction under
the cash flow tax is slightly different. Under the cash
flow tax, changes in net worth would not be included in the
tax base, and, therefore, reductions in net worth, in
general, should not be deducted. Further, as explained
below, all taxation for the consumption of consumer durables
would be prepaid at the time of purchase, and subsequent
sales of consumer durables, at whatever price, would not be
included in the tax base. Following the same reasoning, the
premiums for casualty insurance would not be deductible
under the cash flow tax proposal, and the proceeds would be
excluded from the tax base.
- 119 -
DIFFERENCES BETWEEN THE CASH FLOW TAX AND THE COMPREHENSIVE
INCOME TAX
The major difference between the cash flow tax outlined
here and the comprehensive income tax presented in chapter
3 follows directly from the definition of the two bases.
Under the cash flow system, changes in net worth would not
be included in the tax base, but the comprehensive income
tax would attempt to include all changes in net worth to the
extent administratively feasible. Thus, the cash flow tax
and the income tax differ in their treatment of purchases of
assets and returns from asset ownership. Specifically, the
two taxes differ most in the handling of corporate profits,
income from unincorporated business, capital gains, interest
received on savings and interest paid on loans, rental
income, income accrued in retirement plans and life insurance,
and casualty losses.
The first part of this section discusses in some detail
the treatment of investment assets and consumer durables
under the cash flow tax proposal. In the second part,
a comparison is made between specific provisions of the
model comprehensive income tax and the handling of corresponding items under the model cash flow tax.
The Treatment of Assets Under a Cash Flow Tax
The cash flow tax would greatly simplify tax accounting
and tax administration regarding real and financial assets.
Accounts to determine capital gains, depreciation, and
inventories — among the most complex necessitated by the
current tax code — would no longer be required. For many
individuals, no accounting would be necessary for asset
purchases nor for receipts associated with asset ownership.
For other taxpayers, simple annual cash flow data would
provide all the necessary information for computing tax
liability. The taxpayer would merely record the net annual
deposits or withdrawals from qualified accounts. Accounting
for the cash flow tax would rest solely on marketplace
transactions for the current year, thus minimizing the need
for long-term recordkeeping.
Family-Owned Businesses. The simplicity of cash flow
tax accounting is best illustrated by the model tax treatment of a family-owned business. All cash in-flows would be
counted as receipts. Cash outlays that represent business
expenses -- including all purchases of equipment, structures,
- 120 -
and inventories — would be deducted from receipts; that is,
instantaneous depreciation for tax purposes would be allowed
on all investments regardless of the durability of the asset
purchased. The difference between receipts and cash outlays
would be included in the individual's tax base. If cash
outlays exceed business receipts in any year, the difference
would reduce receipts from other sources.
For example, suppose a family derived all its receipts
from a family-owned grocery store. To compute its tax base,
the family would add up all cash receipts from sales and
subtract from this amount all business outlays, including
payments to employees and cash outlays for electricity, rent
payments for the store, purchases of machinery, and purchases
of inventories. These would be the only calculations the
family would make to determine its tax base under the cash
flow tax. No data on capital gains or depreciation would be
required to determine taxable receipts.
Financial Assets. Financial assets, including stocks,
bonds, and savings deposits, owned by taxpayers via qualified
accounts would be recorded for tax purposes in the same way
as annual purchases and sales associated with a family-owned
business. All deposits for purchases of assets would be
deducted from other receipts in computing the tax base. All
withdrawals, whether arising from dividends, interest, or
asset sales, would be included in the tax base. No distinction
would have to be made between the gain from sale of an asset
and the return of capital invested.
For example, suppose an individual deposits $100 in a
qualified savings bank account, where it earns 10 percent
annual interest. In the year he makes the $100 deposit, he
would be allowed to deduct $100 from current receipts in
computing his tax base. If, in the following year, he
withdraws the principal plus earned interest — now equal
to $110 — the amount withdrawn would be added to receipts
from other sources in computing the tax base. If, instead,
the savings deposit were left in the bank to accumulate
interest, there would be no current tax consequences. Any
future withdrawal would add to taxable receipts in the year
it is made.
Deductions for the purchase of assets would be allowed
only if the purchase were made through a qualified account.
This device would offer a simple way to insure compliance
with the cash flow tax. Individuals would be permitted to
- 121 keep qualified accounts with savings banks, corporations,
stockbrokers, and many other types of financial institutions.
The net amount of deposits in, and withdrawals from, qualified
accounts during the year would be reported by the institution to both the taxpayer and tax authorities. The present
dividend-reporting requirements for corporations may be
viewed as a model for the way financial institutions would
report net withdrawals and deposits from qualified accounts
for the cash flow tax.
The tax base of an individual would include the sum of
net withdrawals from all qualified accounts. If deposits
exceeded withdrawals, the excess would be subtracted from
other receipts in computing the tax base. The sale of one
asset out of a qualified account and subsequent purchase in
the same year of another asset of equal dollar value would
have no net tax consequences if the new asset were also
purchased in a qualified account.
Consumer Durables. It is technically feasible, but
practically unattractive, to apply the cash flow concepts
just described to the purchase of consumer durables. Unlike
financial assets, consumer durables such as automobiles,
houses, and major home appliances, all yield flows of
services to the owners that are not measured by annual
monetary payments. Thus, to allow a deduction for consumer
durable purchases and then to include only future monetary
receipts in the tax base would amount to excluding from the
tax base the value of consumption services yielded by
durable goods. Because it is difficult to determine the
annual value of the use of consumer durables the same concepts
used for financial assets cannot be easily applied.
For example, suppose an individual purchased an automobile for $4,000 and sold it for $2,000 3 years later. If
a deduction were allowed for the purchase and, then, the
sale value included in receipts, the individual's total tax
liability would be lowered by owning the automobile.
However, the individual would have expended $2,000 plus some
foregone interest for the consumption services of the
automobile over the 3-year period. The depreciation and
foregone interest measure the cost of the consumption
services and should be included in the tax base. If the
automobile were taxed the same way as an asset in a qualified
account, this consumption value would escape the tax.
- 122 To assure that the entire consumption value is included
in the tax base, the appropriate treatment of consumer
durables is to allow no deduction on purchase and to exclude
sales receipts from the tax base. In other words, purchase
of a consumer durable would be treated the same way as
current consumption of goods and services. The reason for
this approach is that the price paid for a consumer durable
should reflect the present value of future services the
buyer expects to receive. Including the value of durable
goods in the tax base at the time of purchase produces, in
effect, a prepayment of the tax on the value of future
consumption services.
According to this treatment, the $4,000 for the purchase
of the automobile would not be deducted from the tax base.
Similarly, the $2,000 from sales of the automobile 3 years
later would not be included in the tax base. Thus, if an
individual sold a used car and bought another used car for
the same price, or used the proceeds for current consumption,
there would be no tax consequences. If he sold a used car
for $2,000 and invested the proceeds in a qualified asset,
he would deduct $2,000 from his tax base in the year of the
transaction.
In summary, the purchase of a durable good would be
treated as present consumption even though the good yields
consumption services over time. The reason for this approach is that the price of the good reflects the expected
present value of its future stream of services. Measuring
annual service flows directly would require the measurement
of annual depreciation and annual imputed rent on the value
of the asset. This would introduce unwanted and unnecessary
complexity into the cash flow tax system.
Checking Accounts. Deductions should also be derived
for purchases of certain types of financial assets that
yield their primary benefits in the form of services received,
rather than monetary returns. For example, non-interestbearing demand deposits provide services for depositors in
place of interest. Deductions, therefore, should not be
allowed for deposits in checking accounts, and withdrawals
from checking accounts should not be included in the tax
base. That is, checking accounts should not be qualified
accounts.
- 123 -
Equivalence of Qualified Account Treatment and Tax Prepayment
Approach
The equivalence noted above between the purchase price
of a consumer durable good and the present value of its
expected future services suggests an analogous equivalence
between the price of a business or financial asset and the
present value of its expected future stream of returns.
This equivalence can best be illustrated by a simple example.
Suppose an individual deposits $100 in a savings account at
10 percent interest in year 1. In year 2, he withdraws the
$100 deposit plus $10 earned interest and uses it to buy
consumption goods.
Qualified Accounts Treatment. If the savings account
is a qualified account, the individual would reduce his tax
base by $100 in year 1 and raise it by $110 when he withdraws his funds from the account in year 2. At an interest
rate of 10 percent, the discounted present value in year 1
of his second-year tax base would be $110/1.10, or $100.
Tax Prepayment Approach. Now, suppose instead that the
savings account is not a qualified account. In this case,
the individual is not allowed a deduction for the deposit
and is not taxed on interest earned or on funds withdrawn in
year 2. The discounted present value of his tax base would
be the same in this case as under the cash flow rules
initially presented. The tax base in year 1 would be $100
higher, and the discounted present value of the tax base in
year 2 would be $100 lower, than if a qualified account were
used. In other words, allowing a deduction for purchases of
assets and taxing withdrawals — the qualified accounts
treatment — i s equivalent to allowing no deduction for the
asset purchase and exempting all interest earnings from
tax — the "tax prepayment" approach.
The consequences to the government of the two ways of
taxing the purchase of assets would also be the same in
present value terms. If the individual bought the asset
through a qualified account, the Government would collect
revenue on a tax base of $110 in year 2. If the interest
were exempt from tax, and no deduction for the asset purchase
allowed, the government would collect revenue on a tax base
of $100 in year 1. This revenue would grow to $110 by year
2
at 10 percent interest. Ignoring possible variations in
average tax rates, the government would be left with the
same revenue at the end of year 2 in both cases.
- 124 -
The example above suggests that all assets may be
treated according to the tax prepayment method for required
consumer durables. Asset purchases would not be deducted
from the tax base, and all earnings from assets and sales of
assets would not be included in the tax base. Thus, for
assets not purchased through qualified accounts, it would
not be necessary to keep any records for tax purposes. The
expected present value of the tax base would be the same for
both methods of tax treatment of assets, although the
timing of payments would be different. Both methods of tax
treatment of assets are consistent with a cash flow approach
to taxation.
It is worth repeating that allowing an alternative
treatment of financial assets outside of qualified accounts,
tax prepayment, is not essential to the integrity of the
proposal, but it would provide convenience and some other
advantages. In the cash flow proposal presented in this
study, purchases of financial assets except for investments
in a family business or closely held corporation, would be
allowed to have tax-free returns if the investment were not
deducted. Alternative rules are possible: (1) to require all
asset purchases, except for consumer durables, to be made
through qualified accounts; or (2) to continue to tax returns
from assets purchased outside of qualified accounts (i.e.,
dividends, interest, rental income, capital gains) as they
would be taxed under either a comprehensive income base
(described in chapter 3) or under the current tax law. The
current taxation of returns would strongly encourage, but
not require, taxpayers to purchase income-earning assets
through qualified accounts. Otherwise, the present value of
tax liability would ordinarily be higher and recordkeeping
and tax accounting more costly.
Treatment of Borrowing and Lending
The equivalence between the amount invested in an asset
and the expected present value of returns also permits two
alternative ways of treating loan transactions. Normally,
under cash flow accounting, receipts from a loan would be
handled through qualified accounts. An individual would be
required to report the loan proceeds in his tax base in the
initial year. (Of course, if he used the loan proceeds to
purchase investment assets through a qualified account in
the same tax year, there would be no net tax consequence.)
Subsequent interest and principal payments would then be
- 125 -
deductible from the tax base in the following years. If the
individual sold assets that had been purchased through
qualified accounts in an amount just sufficient to pay the
loan interest and principal, the net tax consequence would,
again, be zero. On the other hand, if the loan were taken
outside a qualified account, proceeds of the loan would not
be included in the tax base, and repayments of interest and
principal would not be deductible. Note, again, that the
present value of the tax liability would be the same in
either case. The discounted value of future interest and
principal payments on a loan would be equal to the current
proceeds of the loan.
Advantages of Taxpayer Option Treatment of Asset Purchases
and Borrowing
~"~~
~~
There are significant advantages to a flexible cash
flow tax that allows a taxpayer to chose, subject to certain
limits, whether or not to use qualified accounts to make
financial transactions.
Averaging of Consumption. One advantage is the potential
for evening out over time large outlays that are made
irregularly, such as the purchase of a house or an automobile,
or payment for college. According to the rules suggested
above, cash outlays for consumer durables would not be
deductible, so that borrowing via a qualified account would
produce taxable receipts for which there would be no immediate
offset. In buying a home, an individual probably would wish
to borrow outside a qualified account. Otherwise he would
pay tax on the entire mortgage in the year of the purchase.
If the loan were not obtained through a qualified account,
the proceeds of the loan would not be included in the tax
base, but future principal and interest payments would not
be deductible. Thus, tax liabilities from consumption of
the good financed by such a loan would be spread out over
the period of repayment, as the taxpayer used receipts from
other sources, such as current wages, to pay the loan
interest and principal.
The existence of alternative ways of treating financial
assets and loans for tax purposes would give individuals
considerable flexibility in the timing of their tax liabilities.
This feature of the cash flow tax is desirable because it
would minimize the need for special averaging provisions.
Averaging is desirable because increasing marginal rates
would be applied to increases in the tax base for any single
year.
- 126 -
With increasing marginal rates, an individual with a
tax base of $10,000 in year 1 and $30,000 in year 2 will pay
higher taxes than an individual with a tax base of $20,000
in both years. Whether the tax base is comprehensive income
or consumption, it is hard to see why the first individual
should be considered to be in a better position to pay taxes
than the other.
An example of the optional use of qualified accounts
for the purpose of averaging consumption is the following:
Suppose an individual purchased a $40,000 house, on which
the bank made available a $30,000 mortgage. If the individual chose not to include the loan proceeds from the
$30,000 mortgage in his tax base, he could not deduct
mortgage payments in future years. In effect, the individual could pay the principal and interest on the mortgage
every year out of current receipts from other sources. The
receipts used for the annual mortgage payments would be
included in the tax base. Thus, the tax base on the mortgage
could be made to approximate the schedule of mortgage
payments on the house.
This leaves the problem of the down payment. The
$10,000 used for the down payment, if withdrawn from a
qualified account, would be included in entirety in the tax
base in the year the house was purchased. The individual,
if he had foreseen buying a house, could have avoided this
problem by saving outside the qualified account. The money
devoted to acquiring these financial assets would have been
included in the tax base every year but, the tax having been
prepaid, the lump sum withdrawal would not be subject to
tax. These savings could then be transferred to the purchase
of equity in housing. The prepayment of taxes would continue to apply to the stream of consumption services from
housing, as it did to the yield from financial assets.
In most other cases, individuals would probably want to
save in qualified accounts for averaging purposes. Most
people save during their most productive years, when income
is highest. The savings are used to finance consumption
after retirement. By saving in qualified accounts, an
individual could reduce his tax liability in the years when
his income is high relative to consumption, and raise it in
the future when income is low. On the other hand, saving
outside of qualified accounts might be an individual's best
strategy when he anticipates large consumption expenditures
- 127 such as a down payment for a house or college expenses. To
the extent that the taxpayer remains in the same tax bracket
for substantial variations in his tax base, the choice among
types of accounts for reasons of averaging would be unnecessary.
Privacy. A second advantage of allowing optional
treatment of asset purchases is that taxpayers would not be
compelled to make all financial investments through a thirdparty broker. The existence of assets not monitored by
third parties, or by the government, would allow a person
to maintain the privacy of his accounts without changing the
present value of his tax base.
Equality of Treatment Among Asset Types. A third
advantage of allowing optional treatment for financial
assets is that it would give investors in such assets the
same opportunities available to investors in consumer
durables. For both types of investments the initial and
subsequent amounts would not be deductible and all returns,
including sale of the asset, would not be subject to tax.
Lifetime Perspective of the Cash Flow Tax
At this point, it is worth emphasizing again the lifetime perspective of the cash flow tax system. The flexibility of asset treatment and the use of individual
discretion over any 1_ year's tax liability would allow both
postponement and advancement of tax liabilities. By allowing
individuals to avoid taxes totally in some years by judicious
rearrangement of asset purchases, these provisions might
appear to provide a tax loophole. However, this loophole is
apparent only — any reduction in tax base must be matched
by a future tax base increase of equal present value. There
could be no advantage to deferral if interest earnings were
positive. Furthermore, because of progressive tax rates,
it would be to the advantage of taxpayers to try to
average their tax base over time. Thus, taxpayers would
have an incentive to pay some tax every year, even though
the means to postpone the tax is available.
An Example. To see how an individual could use the
system to avoid taxes in a given year, and why it would not
be to his advantage, consider this example. Suppose a
worker earned $20,000 per year and accumulated wealth equal
to $20,000 by saving outside a qualified account. In another
year, he deposits the entire $20,000 in a qualified account,
deducting the deposit from his wages. He would then report
- 128 -
taxable receipts of zero in that year and, thereby, succeed
in "sheltering" his consumption. (Less than $20,000 would
need to be switched to a qualified account if there are
personal exemptions.) However, this way of managing his
financial portfolio probably would increase, rather than
decrease, the present value of his tax payments over his
lifetime.
This point can be illustrated by showing that taking
part of the $20,000 deduction in either a previous or future
year, would yield tax savings. For example, suppose he
deposited only $19,000 in a qualified account in the year in
question, deducting the additional $1,000 by depositing it
in a qualified account on the first day of the following
year. With increasing marginal tax rates, the increased tax
liability from increasing the tax base from zero to $1,000
in the current year will be much smaller than the reduction
in tax liability from the slightly greater than $1,000
reduction in tax base in the following year, when taxable
consumption is much higher.
Alternatively, the individual might have taken a $1,000
deduction by depositing money in a qualified account in the
last day of the previous year, leaving only $19,000 in
assets outside qualified accounts in the year in question.
Again, the increased tax liability from a $1,000 increase in
tax base in the year in question would be smaller than the
reduced tax liability from a $1,000 reduction in tax base
through taking the deduction in the previous year, when
taxable consumption is much greater than zeroThus, with increasing marginal rates, the taxpayer who
uses the asset flexibility features of the model cash flow
tax to acquire a year of tax-free consumption pays for that
privilege. The present value of his tax liability would be
increased in either prior or future years by an amount
greater than the present value of tax saving in the "taxfree" year.
Uncertain Outcomes: A Problem with the Tax-Prepayment Approach
Tax Liability Can Be Independent of Outcome for Risky
Investments. The major disadvantage of allowing a wide
variety of financial assets to be purchased outside qualified
accounts is that some large gains would go untaxed. When an
asset has been purchased through a qualified account, the
government could be viewed as participating in the investment,
- 129 -
by allowing a tax deduction, and also participating in the
return on the investment, by taxing the gross proceeds. For
assets purchased outside of qualified accounts, however, the
investment would not be deducted and the entire proceeds of
the investment could be liquidated for consumption purposes
tax-free.
If taxes were proportional, the after-tax rate of return
would be the same in both cases. With qualified accounts,
the Government in a sense would be a partner in the investment, sharing in the cost and appropriating a fraction of
the return. When the tax is prepaid, however, the Government "share" in the returns would be zero. For assets
bought outside of qualified accounts, large winners would
not pay a higher tax and losers would not receive a loss
offset. Although both types of tax treatment would allow
investors equal opportunity to earn after-tax dollars, the
tax treatment of assets purchased outside of qualified
accounts would not distinguish between winners and losers of
investment gambles. Thus, lucky investors might become very
rich and owe no additional tax liability on future consumption
of their wealth, if the initial investment were tax prepaid.
Conversely, unlucky investors will have prepaid a tax on
expected returns and will then obtain no deduction for the
losses they incur.
A second potential problem with tax-prepayment of
returns from assets would arise if tax rates were subsequently increased sharply — for example, to finance a war.
In that case, individuals who had prepaid tax on assets at
the lower rates would escape taxation at the higher rates
even if they were using the proceeds of profitable investments to finance current consumption. Of course, in making
the tax-prepaid investments, those individuals ran the risk
that tax rates might have been lowered, in which case they
would have reduced their tax liability by buying assets
through a qualified account.
It may be viewed as desirable in view of these problems
to modify the current proposal by restricting, or even
eliminating, the provision for purchase of income-earning
assets outside of qualified accounts. One possible compromise
would be to force all "speculative" investments, i.e., land,
stocks, etc., to be purchased through qualified accounts but
to allow the tax-prepayment option for fixed interest
securities and savings deposits.
- 130 Consumer Durables. A similar problem would exist for
consumer durables. Because consumer durables could not be
purchased using qualified accounts, unanticipated increases
in the value of consumer durables would be untaxed and
there would be no tax offset for unanticipated losses. For
example, if the value of an individual's house doubled in a
year, his tax liability would not be affected. The option
of requiring qualified-account treatment is not available
here, as it is in the case of financial assets, because of
the difficulty of measuring the value of the consumption
services these assets provide.
No Optimal Treatment for Nonfinancial Business Assets
As explained above, investments in individual businesses
would be eligible only for tax treatment on a current cash
flow basis. All outlays for the business would be eligible
for deduction, while all net receipts would be subject to
tax. The reason for not allowing the alternative "taxprepayment" treatment is that it is sometimes difficult to
distinguish between the profits and wages of individual
businessmen. If profit alone were exempted from tax, the
businessman would have an incentive to avoid tax on the
value of his labor services by paying himself a low wage and
calling the difference return from investment. This problem
would exist for individual proprietorships and possibly for
small partnerships and closely held corporations. For such
enterprises, all net receipts should be taxable and outlays
for capital goods should be eligible for immediate deduction.
Table 1 below summarizes the proposed rules for tax
treatment of financial assets, durable goods, loans, and
family business enterprises. Note that the only restrictions
are that all investments in a family business must be treated
as if they were purchased in qualified accounts and consumer
durable goods could not be purchased through qualified
accounts. Financial assets could be purchased, and loans
obtained, either through qualified accounts or outside of
the system.
- 131 -
Table 1
Summary:
Tax Treatment of Assets Under Cash Flow Tax
Qualified Accounts
Accounts Outside of System
1. Financial
Assets
purchases deductible;
all withdrawals of
earnings and principal
taxed
purchases not deductible;
interest and return of
capital not taxed
2. Durable
Goods
not available
purchases not deductible;
sales not included in tax
base
3. Loans
receipts in tax base;
repayments deductible
receipts not in tax base;
repayments not deductible
4. Family
Business*
all outlays deductible, not available
including capital
outlays; all receipts
taxed
* Includes a limited class of small businesses owned and
operated by the same person(s).
DIFFERENCES BETWEEN CASH FLOW AND COMPREHENSIVE
TAXES: SPECIFIC PROVISIONS
INCOME
Pension Plans and Social Security
Under the cash flow tax, all contributions to pension
plans may be viewed as contributions to qualified accounts,
whether by the employee or by the employer. By this logic,
contributions would not be included in the tax base, while
retirement benefits would be included in full. Similarly,
all contributions for social Security would be excluded
from the tax base, while all Social Security retirement
benefits would be taxable. There would be no need, under
the cash flow tax, to compute the income on pension funds
attributable to individual employees because the accumulation
would not be subject to tax.
Life Insurance
Both term life insurance and whole life insurance would
b
e treated differently under the cash flow tax than under
the comprehensive income tax.
- 132 -
With term life insurance, there is no investment
income and, thus, no expected change in net worth. Under
the comprehensive income tax proposal, premiums for term
life insurance, whether paid by the employer or the employee,
would be included in the insured's tax base, while proceeds
from term life insurance policies would be tax-exempt. The
general principle of treatment of gifts under a cash flow,
or consumption, base tax argues for a different treatment.
Term life insurance may be viewed as a wealth transfer from
the policyholder to the beneficiary. Purchase of a term
life insurance policy lowers the lifetime consumption of the
policyholder and raises the expected lifetime consumption of
the beneficiary. Thus, a cash flow tax that taxes consumption of individuals should not tax premiums paid by the
policyholder but should include proceeds from a term life
insurance policy in the tax base of the beneficiary. In
practice, this would mean that employer contributions to
term life insurance would not be imputed to the tax base of
the policyholder, while term life insurance premiums paid
directly by the policyholder would be deductible.
Whole life insurance poses a different issue, although
it would receive the same treatment as term insurance under
the cash flow tax. A whole life insurance policy does
provide investment income to the policyholder in the form of
an option to continue to buy insurance at the premium level
appropriate for the initial year. Under a cash flow tax,
unlike the comprehensive income tax, the increase in the
value of the option would not need to be computed for tax
purposes because it would represent a change in net worth
and not in consumption. However, if the individual cashed
in the option value, the receipts from this transaction
would be included in the cash flow tax base.
Under the model cash flow tax, all premiums paid by
policyholders for whole life insurance would be tax deductible, while premiums paid by employers for policyholders
would not be imputed to policyholders' tax bases. All
receipts from life insurance policies, whether in the form
of cash surrender value to policyholder or proceeds to
beneficiaries, would be included in the tax base of the
recipient.
- 13:3 -
state and Local Bond Interest
Under the model cash flow tax, State and local bond
interest for securities not purchased through a qualified
account would remain tax-exempt, as under the present law.
However, as with the comprehensive income tax proposal,
State and local bonds would lose their special status
relative to other assets. Under the comprehensive income
tax, these bonds would lose their special status because
their interest would become taxable. Under the cash flow
tax, the bonds would lose their special status because
returns from all other assets would also become tax-exempt.
If State and local bonds were purchased through a
qualified account, all contributions to the account would be
deductible from the cash flow tax and all withdrawals from
the account would be subject to tax. Thus, the purchase
price of a State or local bond would be deductible, while
withdrawals of interest payments and principal from the bond
to pay for consumption would be subject to tax.
Interest Paid
Under the comprehensive income tax, all interest paid
would be tax deductible because such outlays represent
neither consumption nor additions to net worth. This would
include interest payments for mortgages on owner-occupied
homes. Under the cash flow tax, however, if a loan were
taken through a qualified account, the initial proceeds of
the loan would be taxable, while subsequent interest and
principal repayments would be tax deductible. In presentvalue terms, the net effect of a loan on the tax base would
be zero.
Corporate Income
Corporations would not be taxed as entities under
either the cash flow tax or the comprehensive income tax.
However, under the cash flow tax, there would be no need to
impute undistributed income to individuals because taxes
would be assessed only on funds available for personal
consumption. Consequently, a single cash flow tax applied
at the household level could be accomplished without the
rules for integrating corporate and household accounts that
are conspicuous features of the model income tax.
- 134 -
The treatment of returns from corporate activity under
the cash flow tax would be exactly the same as the treatment
of returns from other kinds of investments. There would be
no separate tax at the corporation level. Individuals would
be permitted to purchase corporate stock through qualified
accounts held with brokers. The initial purchase price
would be deductible from the tax base at the time of purchase,
and subsequent withdrawals from the account as dividends
received, return of capital, or proceeds from the sale of
stock would be added alike to the tax base. For stock
purchased outside of a qualified account, no deduction would
be allowed for purchases, and neither dividends nor proceeds
of future sales would be added to the tax base. Capital
gains and capital losses would, therefore, have no tax
consequences.
Capital Gains and Losses
Under the cash flow tax, there would be no need to keep
records of the basis of asset purchases to compute capital
gains. As explained above, when assets are purchased outside
of qualified accounts, capital gains would be exempt from
tax and capital losses would not be deductible. If assets
are purchased within qualified accounts so that a deduction
may be taken for the initial purchase price, no distinction
would be made between the part of the sale that represented
capital gain and the part of the sale that represented
return of basis. In this latter case, the full amount of
the sales proceeds, if not reinvested, becomes part of the
tax base. The size of the capital gain would affect the
amount of withdrawals for future consumption- Hence, when
qualified accounts are used, the size of capital gains would
have tax consequences even though no explicit calculation
of gains (or losses) is necessary.
Because the cash flow tax does not tax accumulation,
the issues of deferral, inflation adjustment, and the appropriate rate of tax on capital gains need not be considered,
as they were in the discussion of a comprehensive income
tax. The concept of deferral of tax would be relevant for
the cash flow tax only if one could postpone without interest
the tax liability associated with current consumption.
Similarly, the value of assets or changes in the value of
assets, whether related to general inflation or not, would
not be relevant for the cash flow tax until they are withdrawn to finance consumption.
- 135 Business Income Accounting
Income accounting for any individual's business under
the cash flow tax would be strictly on a cash accounting
basis. The individual would have to compute in any year net
receipts from operating the business. To perform this
computation, he would add to the sale of goods and services
during the accounting year any receipts from borrowing and
would subtract the purchases of goods and services from
other firms, wages paid to employees, interest paid to
suppliers of debt finance, and all purchases of plant and
equipment. Net receipts calculated by this method would be
included in the individual's tax base, if positive, and
would be deducted, if negative.
Note that the major difference between the cash flow
tax and the comprehensive income tax with respect to business
accounting is the treatment of assets. Under the cash flow
tax, purchases of assets would entitle the businessman to an
immediate deduction for the amount of purchase. Under the
comprehensive income tax, deductions each year would be
limited to a capital consumption allowance (depreciation),
which estimates the loss in value during the year of those
assets.
Also, business loans would be treated differently
under the cash flow tax. All receipts of loans to a business
would be included in the base, while interest and amortization payments would be deductible. Under the comprehensive
income tax, loan receipts and amortization payments would
have no tax consequences; only the interest payments would
be deductible. When the proceeds of the loan are used
immediately to purchase materials or services for the
business, the deduction allowed under the cash flow tax
just matches the addition of loan proceeds to the base.
For partnerships, the rules are simpler. A partnership
would be required to report the annual cash contribution of
each owner to the business and the annual distribution to
each owner. The difference between distributions from
partnerships and net contributions to partnerships would
enter the individual owner's tax base. If the owner sold
his shares, it would enter the tax base as a negative
contribution.
- 136 SPECIAL PROBLEMS: PROGRESSIVITY, WEALTH DISTRIBUTION,
AND WEALTH TAXES
The cash flow tax outlined in this proposal would tax
consumption but not individual accumulation of assets.
People are likely to conclude that such a tax would be
regressive and that it would encourage excessive concentration of wealth and economic power. This section examines
both these concerns, showing that concern about regressivity
is a misconception and suggesting that the cash flow tax
could be complemented in any desired degree by a transfer
tax to influence wealth distribution. The complexities in
the tax treatment of transfers at death caused by the
existence of two kinds of financial assets are discussed
below and some potential solutions are proposed.
Progressivity of the Tax
Exemption of Capital Earnings. The assertion that a
consumption base tax is regressive stems from the fact that
wealth is concentrated among relatively few households as
compared to labor earnings. Because the cash flow tax is
equivalent in present-value terms to exemption of earnings
from capital, it would necessarily tax labor earnings more
heavily to raise the same revenue. Thus, it might appear
that the cash flow tax is a way of shifting the tax burden
to the wage-earner class and relieving the wealthy taxpayer.
Such criticism of the cash flow tax may be superficially
plausible but it is misleading on several grounds. First,
much of what is generally labeled capital income is really
a reward for postponing immediate consumption of past wages.
Laborers as a class do not necessarily lose when the tax
rate applied to wages immediately consumed is raised to
enable forgiveness of taxes on the returns for saving out
of wages. Second, the only other source of funds for
investment aside from wages is transfers received (including
inheritances), and these would be subject to tax at the
same rate schedule applied to labor earnings under the
cash flow tax. (This point is elaborated below.) Finally,
the progressivity of any individual tax is to a large
degree determined by the rate structure. The choice between
a comprehensive income and a consumption base is independent
of the degree of vertical progressivity of the rate structure.
- 137 -
Transfers of Wealth. The mechanism by which gifts and
inheritances would be included in the tax base is simple.
In order to be eligible for deduction by the donor, all
gifts would have to be included in the tax base of the
recipient. Gifts would be recorded only if they were
transfers between taxable entities. Thus, a gift of a
father to his 9-year-old son would not be included in the
family's taxable receipts (unless it were removed from a
qualified account) . When the son left the family unit, say
when he turned 26, he would become a separate taxpayer. At
that point, all accumulated wealth from past gifts and
inheritances would be included in his initial tax base and
deducted from the family's base. If the initial base were
large, the individual would have an incentive to purchase a
qualified account to avoid a steep progressive tax, but
would have to pay tax on subsequent withdrawals for consumption out of that account. Thus, an individual would not
have the opportunity to realize tax-free consumption from
a past inheritance.
Similarly, if the family's deduction for transfers to
the son were large, the family would have an incentive to
withdraw assets from a qualified account and treat such
assets thereafter as held outside a qualified account. The
family need suffer no adverse tax consequence, thereby.
The taxation of gifts and accessions to the donee and
the deduction of itemized gifts by the donor are a logical,
integral part of the cash flow tax system necessary to
assure that the tax base is related to the lifetime consumption of every individual.
To see how inheritances would be included in the tax
base of a cash flow tax, consider the following example.
Suppose a man died on January 2, 1977 at the age of 70,
leaving $300,000 in qualified accounts to his 35-year-old
son. The tax base of the decedent in 1977 included a
$300,000 withdrawal from the qualified account in receipts
and a $300,000 deduction for the bequest of funds, for a net
tax base of zero. The tax base of the son included the
receipt of $300,000. With progressive rates, it is likely
that the son would wish to deposit a large part of the
$300,000 in a qualified account, paying tax only as the
money was withdrawn for consumption.
- 138 A difficulty would arise if the $300,000 of the decedent, or a fraction thereof, were held outside a qualified
account. While the tax treatment of the recipient's
inheritance would be the same ($300,000 of receipts), the
estate of the decedent has a large deduction, possibly with
no current tax base to offset. The estate might then be
entitled to a tax refund before the estate were divided up.
This treatment would be appropriate because the decedent
had, in effect, prepaid tax for consumption of the proceeds
of the investment that was never consumed in his lifetime.
However, an amount, or rate, of refund must be specified.
One possibility would be to allow a refund to the estate
equal to the value of investment assets outside of qualified
accounts multiplied by the rate applicable to the lowest tax
bracket. An alternative solution would be to give no refund
at all. The inability to consume expected proceeds of a
tax-prepaid investment because of death may be viewed as one of
the risks an individual knowingly undertakes when he invests
in a tax-prepaid asset. This treatment would also provide
further incentive for investments to be made through qualified
accounts.
If initial financial endowments and receipts of transfers
are included in the tax base, there would be no difference
in tax treatment between an individual who invests an
inheritance and one who invests his savings out of wages.
Neither would have any additional tax until he consumes the
amount invested or the earnings. In effect, earnings from
investment could be viewed as a reward for deferring consumption from wage income or inheritance. If the rate structure
were appropriately progressive, so that the high-wage
earners with large accessions would be paying a significantly
higher tax than low-wage earners with small accessions,
there would seem to be no particular reason to discriminate
in tax liability between persons with different patterns of
lifetime consumption. Viewed in that manner, the cash flow
tax would not favor the wealthy but would favor, relative to
a comprehensive income tax, those individuals who, at
any given income level, chose to postpone consumptionLucky Gambles. Another potential objection to the
proposed system on progressivity grounds is the opportunity
it would afford individuals to acquire wealth by a lucky
investment gamble, and to have paid only a small tax on the
amount wagered. Some regard this possibility as inequitable.
As noted above, this possibility could be largely avoided,
- 139 at a price in complexity and compliance costs, by taxing the
future returns on some or all investments that are not made
through qualified accounts, or by restricting the types of
investment that could be made outside of qualified accounts.
Accumulation of Wealth. The second major concern about
a cash flow tax is that it would place no restraint on the
accumulation of wealth. Although all consumption out of
accumulated wealth would be taxed, the cash flow tax, compared
with an income tax, would make it easier for individuals to
accumulate wealth. The effect of this on the distribution
of wealth in the United States cannot be forecast precisely.
Presumably, individuals at all levels would tend to hold
more wealth, so that the dispersion of wealth might either
increase or decrease. At the same time, there might be an
increase in the size of the largest wealth holdings.
The cash flow tax — with wealth transfers deductible
to the donor and included in the tax base of the recipient —
would be a tax on the standard of living of individuals
(with some exemption, or credit, for a small consumption
amount) . Like the model comprehensive income tax, it could
be converted to the concept of "ability-to-pay" discussed
in chapter 2. According to that concept, wealth transfers
would be regarded as consumption by the donor and included
in the tax base of both donor and recipient. To accomplish
this conversion, gifts would not be deductible to the donor
and bequests would be taxed as a use of lifetime receipts.
A simpler approach, and one that is more consistent
with present policies, would be to retain the estate and
gift tax as the principal instrument for altering the distribution of wealth. Such a tax, which is levied according to
the situation of the donor, would be a logical complement to
the model cash flow tax. The existence of a separate estate
and gift tax would not damage either the basic simplicity
inherent in the treatment of assets under the cash flow tax
or the neutrality in tax treatment of those individuals with
the same endowment who have different time patterns of labor
earnings or consumption. Under this option, all features of
the cash flow tax would remain exactly as explained above,
except for the wealth transfer tax. Tax rates on gifts and
bequests could be designed to achieve any desired degree of
equalization in initial wealth of individuals.
- 140 INFORMATION ON SAMPLE TAX FORM FOR CASH FLOW TAX
Filing Status
1. Check applicable status
a. Single
b. Married filing joint return
c. Unmarried head of household
d. Married filing separately
Exemptions
2. If applicable, enter 1 on line
a. Regular
b. Spouse
3. Number of dependent children
4. Total exemptions (add lines 2a, 2b, 3)
Receipts
5a.l/Wages, salaries, and tips of primary wage earner
(attach forms W-2)
b. Wages, salaries, and tips of all'other wage earners
(attach forms W-2)
c. Multiply line 8b by .25; if greater than $2,500, enter
$2,500
d. Included wages of secondary worker (subtract line 5c
from 5b)
e. Wages subject to tax
6. Gross business receipts (from schedule C)
7. Gross distributions from partnerships (from schedule E)
- 141 8.
Distributions from pension funds and trusts (includes
social security benefits)
9. Gifts and inheritances received
10. Withdrawals from qualified accounts (if positive)
11. Disability pay, unemployment compensation, workmen's
compensation, sick pay, public assistance, food stamp
subsidy, fellowships, and other cash stipends
12. Alimony received
13. Total receipts (add lines 5c, and 6 through 12)
Deductions
14. Gross business expenses (schedule C)
15. Contributions to partnerships (schedule E)
16. Contributions to trusts
17. Deposits in qualified accounts (form S-2)
18. Other deductions (schedule A)
19. Total deductions (add lines 14 through 18)
Computation of Tax
20. Cash flow subject to tax (subtract line 19 from line 13)
21. Basic exemption (enter $1,500)
22. Family size allowance (multiply line 4 by $800)
23. Total exemption (add lines 21 and 22)
24. Taxable cash flow (subtract line 23 from line 20)
25. Tax liability (from appropriate table)
26. a. Total Federal cash flow tax withheld
b. Estimated tax payments
c. Total tax prepayments (add lines 27a and 27b)
- 142 27.
If line 26 is greater than line 27c, enter BALANCE DUE
28. If line 27c is greater than line 26, enter REFUND
DUE
Schedule A — Deductions
Taxes
1. State and local income taxes
Gifts, Charitable Contributions, and Alimony
2. Gifts or donations to an identified taxpayer or entity
(itemize)
3. Alimony paid
Cost of Earning Income
4. Union dues
5. Child care expenses (only for secondary workers or
single adult households)
6. Multiply line 5 by one-half
7a. Enter line 6 or $5,000, whichever is smaller
b. Enter line 7a or line 4b (line 4a for unmarried head of
household) from form 1040, whichever is smaller
8. Other costs (itemize)
9. Add lines 4, 7b, and 8
10. Subtract $300 from line 9
11. If line 10 positive, enter line 10; if line 10 negative
enter 0
12. Add lines 1, 3, and 11; enter on form 1040, line 18
Schedule C (Business Receipts and Expenses)
Like current schedule C except
Line 5 total outlays for purchases of assets
- 143 -
Enter line 5 (total income) on form 1040, line 6
Enter line 20 (total deductions) on form 1040, line 14
Schedule E — Note: Partnership will have to send information on form 1065 of gross distributions and gross
contributions
Form S-2's —
Supplied by brokers of qualified accounts
1. Total deposits
2. Total Withdrawals
3. Net Withdrawal (line 2 minus line 1), if positive
4. Net Deposit (line 1 minus line 2), if positive
TJ
Wages reported by the employer would exclude employee
contributions to pension plans, disability insurance,
health insurance and life insurance plans. Wages would
also exclude the employee's share of payroll taxes for
Social Security (OASDHI), and the cash value of
consumption goods and services provided to the employee
below cost.
- 145 -
Chapter 5
QUANTITATIVE ANALYSIS
This chapter presents quantitative analyses of the two
model plans and compares them to present law. The first
section discusses briefly the nature of the data base used
to develop and simulate the effects of the model plans. The
chapter then discusses the estimated magnitudes of the
various income concepts used in the report and the following
section uses these data to derive exemption and rate structures
for the comprehensive income tax consistent with achieving
present revenue yield. This is followed by estimates of the
magnitude of the cash flow tax base. Finally, the chapter
develops specific provisions of the cash flow tax — exemptions and rates — and compares the two model plans and
current law.
THE DATA BASE
The first step in the quantitative analysis of the
reform plans was to construct a data base representative of
the relevant characteristics of the U.S. population. A
file of records was created and stored in a computer, with
each record containing information for a tax return filing
unit, such as the amount of wages earned by the member or
members of that unit, dividends received, etc. In all, some
112,000 records are contained in the file.
Each of these records stands for a group of taxpayers
with similar characteristics. Thus, a given record may be
taken to represent 100 or 1,000 filing units in the U.S.
population as a whole. To simulate the effect of some
change on the whole population, the effect on each record in
the file is calculated and multiplied by the number of
units represented by that record.
The records in the file were constructed by combining
information from two separate sources: a sample of 50,000
tax returns provided by the Statistics Division of the
Internal Revenue Service, and a sample of 50,000 households
(representing about 70,000 tax filing units) from the
Current Population Survey of the Census Bureau. The two
data sets were needed because the reform plans base tax
liabilities on information not now provided on tax returns.
Furthermore, a realistic picture of the U.S. economy requires
- 146 -
obtaining characteristics of "nonfilers," individuals and
families who are not obliged to file income tax returns
because they do not have sufficient taxable income.
To represent the incomes generated by the U.S. economy,
these two data sets were merged by matching records of
taxpayers from the sample of tax returns with records of
participants in the Current Population Survey. Since
confidentiality strictures on the release of identifier
information from each of these sources prevented the literal
pairing of data on any given taxpayer, the matching was
accomplished by matching records of similar characteristics
(age, race, total income, etc.). The resulting file of
records is not quite the same as if the information in each
record had been obtained for the same individual or family.
For technical reasons, it has been possible to achieve a
more faithful representation of the U.S. population by using
some records more than once. Therefore, the number of
records in the final data file reflects an artificial
expansion of the number of records in the two original
files.
Both samples use 1973 data. Because more recent data
would be more relevant, the 1973 population and its attributes
were adjusted by extrapolation to represent the 1976 population.
The resulting simulations of the U.S. population should
be interpreted with some sense of the nature of the data
set. The original data were subject to the usual sampling
and processing errors. The processes of merging the two
data sources and extrapolating the resulting file to a later
year represent further sources of error. Furthermore, many
items needed were not recorded in either of the original
surveys, and had to be estimated and imputed to each record.
For these reasons, the file should not be regarded as a
perfect description of the U.S. population.
Nonetheless, the data have been assembled with great
care. In some cases, adjustments were made to insure that
the data file produces aqgregate figures (say, on total
wages paid in the economy) in line with those derived from
independent statistical sources. In other cases, such
aggregates were used to "validate" the file; that is, to
check its reasonableness. By and large, the data pass the
test of these checks, and the file may be used with some
confidence. At the same time, it would be a mistake to
equate the data file with the real world, for example, by
being concerned about small differences in a simulated tax
burden.
- 147 -
ESTIMATION OF THE INCOME CONCEPTS
The first few tables present various definitions of
income that were used in the computer simulations.
Table 1 describes adjusted gross income, or AGI, the
broadest before-tax concept used for the present income tax.
Like all of the income concepts, its source is primarily
current money wages and salaries. The remainder, labeled "other
AGI" in the table, comes from net self-employment and
partnership income, capital income, such as interest and
dividends, capital gains, and miscellaneous other elements
of income. The table shows that "other AGI" is a larger
share of adjusted gross income in the highest income classes.
The data in table 1 cannot be compared directly with
AGI as reported on tax returns because information is
included for nonf ilers as well as filers. Thus, table 1
shows adjusted gross income that would be reported if all
families and individuals were required to file tax returns
under current law, and displays the distribution of all such
filing units by income class.
The income classes in table 1 are defined in terms of
"economic income," the broadest before-tax income concept
used in this report. As discussed more fully below, this
income concept is even broader than the tax base described
in the comprehensive income tax proposal of chapter 3.
Economic income is used as the classifier in the early
tables of this chapter. In later tables, other classifiers
are used for reasons explained below.
Adjusted gross income is not the base of the present
individual income tax. Starting from AGI, taxpayers are
allowed several kinds of deductions to arrive at income
subject to tax. Table 2 displays the major elements of the
present individual income tax base. Again, as in table 1,
the information shown includes data for nonfilers as well as
filers, although nonfilers do not add anything to the
aggregate taxable income under present law because their
exemptions and deductions reduce their taxable incomes to
zero.
In each category of table 2, the amounts shown include
only income that enters into the calculation of AGI. Thus,
f
or example, portfolio income includes only one-half of
Table 1
Present Law
Adjusted Gross Income
(1976 levels)
Current
money
wage
income
Number of
filing
units 1/
Economic
income
class
(... millions
($000)
Less than 0
Total
adjusted
gross
income
-0. 9
0.2 0.9 -1.8
38.0
0 -
) (
Other
adjusted
gross
income
$ billions
29.5
12.2
41. 7
5 -
10
19.5
81.3
20.6
101. 9
10 -
15
13.9
117.4
16.1
133. 5
15 -
20
12.1
151.9
16.3
168,,1
20 -
30
15.0
261.0
25.8
286 .8
30 -
50
7.1
157.1
34.4
191 .5
50 - 100
2.3
56.0
30.9
86 .9
100 or more
0.5
20.0
25.7
45 .7
875.1
180.1
Total
108.6
1,055.2
Office of the Secretary of the Treasury, Office of Tax Analysis
1/ Includes all filing units whether or not they actually file returns or pay tax under present
~" law. The estimated number of filing units that do not currently file tax returns is 21.5 million;
their adjusted gross income is $4.1 billion.
Table 2
Components of the Present Law Individual Income Tax Base
(1976 levels)
Net
money
wage
income
Economic
income
class
($000)
(
Less than 0 0.8
0 5 -
Pension
income
Selfemployment
income
5
10
29.2
80.4
: Deduc- : MiscelPort- : tions
: laneous
folio :for State: income Total
income :and local: minus
: taxes : deductions:
$ billions
0.2
-4.2
1.5
-0.1 0.2
5.5
0.1
4.9
-0.5
10.3
4.7
4.3
1/
Tax
base
2/
S tandard
deductions
Exemptions
3/
Present
law
income
subject
to tax
)
-1.6
0.5
0.0
-0.1
0.4
0.8
40.0
40.6
-26.3
-7.7
6.6
i
-1.9
-1.6
96.2
96.7
-28.7
-24.3
43.7
•^
I
10 -
15
115.6
2.6
5.6
5.5
-4.1
-3.9
121.3
121.5
-19.2
-26.5
75.8
15 -
20
149.8
1.9
6.9
2.5
-7.3
-5.9
147.9
148.1
-14.6
-27.8
105.7
20 -
30
257.5
2.1
11.2
3.6
-15.2
-10.3
248.9
249.3
-16.9
-37.2
195.2
30 -
50
154.8
1.7
16.4
11.1
-12.1
-8.5
163.4
163.7
-5.4
-18.0
140.3
50 - 100
55.1
0.8
15.2
12.6
-6.1
-4.7
72.9
73.1
-1.5
-5.8
65.8
100 or more
19.7
0.3
9.8
14.2
-3.3
-3.7
37.0
37.3
-0.1
-1.4
35.8
863.0
19.8
65.3
66.3
-50.6
-37.6
926.0
930.7
-112.7
-148.7
669.2
Total
Office nf t-
nn,-~-.
Note: The amounts shown in each category include only the income that . actually enters into adjusted gross income
under present law.
/ The amounts shown in this column are the sum of the amounts in the preceding columns
Zlur^T^*^0™
*? thiiS c o i u m n / i f f e ^ f ™ m nthe a m o u n t s ^ the "total" column because of the exclusion of negative
5
amounts in the total column for individual filing units.
- The amounts shown in this column exclude the value of exemptions that would reduce income subiect to tax to
Deiow zero.
M
- 150 -
realized net long-term capital gains. As appropriate,
expenses were netted against the associated income. Thus,
wage receipts are net of the recognized expenses of earning
it. Similarly, "portfolio income," consisting of interest,
dividends, rent, estate and trust income, and realized
capital gains, is net of interest expense. "Miscellaneous
income minus deductions" is an amalgam of income not otherwise classified, net of all deductions not directly allocable
to particular income sources. Its negative value results
from the fact that the itemized deductions allowed under
present law and not separately deducted from other components of income are much larger than the miscellaneous
income items included here, such as State income tax refunds,
alimony received, prizes, and the like.
The present tax base is shown in the column labeled
"tax base." Exemptions and standard deductions (but not
itemized deductions) are thus treated here as part of the
rate structure. As table 2 shows, the tax base under
present law is somewhat larger than AGI less itemized
deductions because negative net income is never allowed to
reduce the tax base for an individual return to below zero.
Similarly, the value of the standard deduction and exemptions cannot reduce income subject to tax to below zero.
Table 2 indicates that present law income subject to
tax is only about 63 percent of adjusted gross income.
Exemptions, the standard deduction, and itemized deductions
account for this difference.
The major components of economic income are tabulated
separately in table 3. Many of these components require
some explanation. "Deferred compensation" consists of
employer contributions to pension and insurance plans,
including social security. "Household property income"
consists of rents, interest income net of interest expense,
estate and trust income, dividends, capital income of the
self-employed, and imputed returns from homeownership, life
insurance policy reserves, and pension plans. "Noncorporate
capital gains accruals" represents the growth in the real
value of assets held by individuals except for corporate
stock. The latter accruals are assumed to be included in
corporate retained earnings, as indicated in the next
column. In constructing the simulation of the U.S. taxpayer
population, corporate retained earnings were allocated to
shareholders in proportion to their dividend income.
Table 3
Economic Income
(1976 levels)
Net
Economic
income
class
($000)
money
wage
income
Deferred
compensation
Selfemployment
labor
income
Household
property
income
(
Less than 0 0.8
0.0
Non- :
:
corporate:Corporate: o r P o r a '
capital :retained : . t l o n
_ .
.
income
gams : earnings :
accruals :$ billions: a x
0.1
-3.9
2.6
1.0
4.3
0.6
0.3
80.4
8.8
4.7
11.5
1.4
10 - 15
115.6
14.4
5.9
11.6
15 - 20
149.8
18.7
9.0
20 - 30
257.5
33.7
30 - 50
154.8
50 - 100
0.1
0.1
-0.6
Implicit
taxes
Net
transfers
:State and
: local
Economic
: income tax
income
: deduc: tions
)
0.4
0.3
-0.1
0.9
-0.5
41.4
-0.1
1.1
2.5
-1.2
34.3
-0.3
1.8
1.0
2.6
-1.0
20.8
-1.0
171.9
14.3
2.9
1.1
3.4
-0.7
15.1
-2.1
211.5
14.8
30.4
5.2
2.3
7.1
-0.8
17.8
-4.9
362.9
20.9
17.7
44.8
6.2
3.4
10.5
0.3
9.6
-4.7
263.5
55.1
6.8
13.9
51.9
5.8
4.0
12.3
2.6
3.0
-3.0
152.4
100 or more 19.7
1.6
9.4
28.5
3.6
6.2
7.5
0.8
10.2
-2.0
85.4
Total
107.6
76.5
193.3
27.7
19.6
46.0
0.0
152.4
-18.1
1,467.9
0 - 5
5-10
29.2
-2.8
79.9 _
143.2
M
I
863.0
Office of the Secretary of the Treasury
Office of Tax Analysis
- 152 -
The entries in the columns "corporation income tax"
and "implicit taxes" are derived from concepts that may not
be generally familiar. Since the corporation income tax is
before-tax income that would be received by individuals were
it not taken by taxation first, this tax is included in
before-tax economic income. The burden of the corporation
income tax was assumed to fall evenly on all individual
owners of capital. The logic underlying this position is
that, in a market system, capital is allocated to equalize
rates of return. Because of the corporation income tax,
the capital stock in the corporate sector is smaller than
it would be otherwise, and the before-tax rate of return
higher. By the same reasoning, the capital stock in the
noncorporate sector is higher and rates of return lower
than they would be otherwise. Through this tax-induced
movement of capital from the corporate to the noncorporate
sector, the burden of the corporate tax, that is, its
effect on reducing after-tax returns, is spread across all
capital income.
Cases can be constructed in which labor income as well
as capital income bears the real burden of the corporation
income tax, but for the simulations presented in this chapter,
this tax has been allocated in proportion to all capital
income, with the result shown in table 3. Capital income in
this table is composed of household property income, noncorporate
capital gains accruals, corporate retained earnings, corporation income tax, and implicit taxes.
The "implicit taxes" shown in table 3, although small
in amount, illustrate an important phenomenon affecting the
progressivity of the tax structure. Implicit taxes, which
are quite subtle in concept, are best explained by an
example. Present law does not tax the interest on municipal
bonds; therefore, a holder of such bonds receives less
interest than he might receive if he invested his funds in
fully taxable securities. The difference between what he
receives and what he could receive is his implicit tax. It
^-s implicit because no revenue is paid to the U.S. Treasury.
It is nonetheless a tax because the bondholder's after-tax
income is reduced in the same way as if he paid a tax. Of
course, the implicit tax may be lower than the actual tax
payable on fully taxable bonds, and this is why tax-exempt
securities are attractive to high-bracket taxpayers.
- 153 Other persons receive benefits from the tax-exemption
of municipal bonds. The attractiveness of municipal bonds
draws capital out of the private sector, thereby increasing
slightly the before-tax return to investors in other forms
of capital. The increase in their return is an implicit
subsidy or negative implicit tax. If total income is kept
constant in the economy, and efficiency losses ignored, the
positive and negative implicit taxes must balance exactly in
the aggregate, although not for any particular taxpayer or
any income class.
There is an implicit tax corresponding to many tax
benefits to capital income in the current tax structure.
The simulations included implicit taxes for real estate,
agriculture, mining, and capital gains arising from corporate retained earnings and tax-exempt bonds. In each
case, the tax preference accorded to the activity in question
attracts capital that would otherwise be applied elsewhere,
and thus reduces the before-tax returns. Since the advantages of these tax benefits — even taking into account
the reduced before-tax returns — are worth more to those in
high tax brackets, positive implicit taxes are paid by
higher income taxpayers. Therefore, implicit taxes make the
present tax structure as measured by effective tax burdens
somewhat more progressive than it may at first appear.
Nonetheless, some positive implicit taxes are borne by
filing units in the below-zero income class. This income
class consists of households sustaining real economic
losses. To the extent that these losses occurred in taxpreferred activities, they are even greater than they would
have been in the absence of the tax preference, and,
accordingly, implicit taxes are generated for this income
class.
"Net transfers" include income support in cash and in
kind and the excess of accruing claims to future social
security benefits over current employer and employee contributions.
Finally, economic income is net of some State and local
taxes. Since property taxes are netted in calculating
capital income in the previous columns and sales taxes as
discussed in chapter 3 are treated as consumption outlays,
only State and local income taxes are subtracted here.
- 154 Economic and Comprehensive Income
Economic income is an accrual concept. However, as
chapter 3 makes clear, a pure accrual income concept is not
practical as a tax base. Table 4 shows the difference
between economic income and "comprehensive income," which
was the starting point for developing the tax base used in
the comprehensive income tax proposal.
Four categories of adjustments are involved in moving
from economic income to comprehensive income. The first
adjustment is for pensions. Economic income includes the
accruing value of future pension benefits for both private
pensions and social security. Comprehensive income, however,
is on a realization basis in that actual social security and
pension benefits, rather than their accruing value, are
included. The difference is shown in column 2.
The second adjustment is for homeowner preferences and
agricultural income. Comprehensive income does not include
the imputed rental income from owner-occupied housing.
Furthermore, all agricultural activity cannot reasonably be
placed on the accrual accounting standard applied in calculating economic income. The third adjustment accounts for
the fact that capital gains on noncorporate assets are
included in comprehensive income when realized rather than
accrued. Finally, in-kind transfers, such as Medicaid, are
not included in comprehensive income. As table 4 makes
evident, the partial shift from an accrual to a realization
concept of income results in a substantial shrinkage in the
value of the income measure that serves as the starting
point for the model comprehensive income tax.
As discussed in chapter 3, it was principally the
difficulties in measuring income on an accretion basis
that underlay the decision to use comprehensive rather than
economic income as the tax base. This decision also
influenced the way in which taxpayers were classified and
tax burdens calculated in the simulations. While economic
and comprehensive income are generally highly correlated,
there are some classes of taxpayers for whom income as
accrued and income as realized are quite different. This
is especially the case for taxpayers receiving pension
income, who are drawing down their past accruals of pension
plan assets. Such taxpayers would find themselves in
relatively low economic income classes but would be in
higher comprehensive income classes as a result of realizing
the benefits of past contributions to pension plans.
Economic and Comprehensive Income
(1976 levels)
Economic
income
class
Economic
income
Pensions
($000)
Adjustments (subtract)
Nontaxed
homeowner
Nonpreferences
corporate
and
capital
agricultural
gains
income
$ billions
In-kind
transfers
Comprehens ive
income
)
Less than 0
-2.8
-0.2
0.1
0.1
0.1
-2.8
0 - 5
79.9
-18.4
1.0
0.4
6.4
90.4
5-10
143.2
4.6
2.1
0.9
4.0
131.6
10 - 15
171.9
21.5
4.4
1.1
1.5
143.4
15 - 20
211.5
26.2
8.3
1.7
0.8
174.5
20 - 30
362.9
43.7
15.9
3.1
0.8
299.4
263.5
24.5
10.7
3.7
0.4
224.1
152.4
7.0
3.6
3.5
0.1
138.3
85.4
11.3
1.0
2.2
0.0
71.0
47.2
16.6
14.1
1,269.9
30 - 50
50 - 100
100 or more
Total
1,467.9
120.1
°fnrCe o f t h e Secretary of the Treasury
Office of Tax Analysis
- 156 -
Table 5 presents a cross-tabulation by economic income
and comprehensive income of the number of filing units
receiving pensions in excess of $500. While this
table indicates that pensioners in higher economic income
classes are in higher comprehensive income classes as well,
it also reveals that, in general, their comprehensive income
tends to be larger than their economic income. If taxes
were assessed on the basis of comprehensive income and
filing units were arrayed by economic income class, the tax
structure would appear less progressive. This is because
pensioners, who are generally in lower income classes, have
comprehensive income that exceeds economic income. During
their earning years, both economic and comprehensive income
are relatively high but economic exceeds comprehensive
income.
Both of these effects tend to tilt the structure of
effective tax rates as measured using economic income in the
direction of lower effective rates on higher economic income
and higher effective rates on lower economic income. What
appears to be a phenomenon of the aggregate distribution of
the tax burden is actually a matter of the timing of taxes
at different points in the life cycle of the same taxpayer.
A consequence of these lifetime effects, which are discussed
in more detail later in this chapter, is that comprehensive
income is a more meaningful classifier for analyzing a tax
system using a realization basis. Hence, in the tables that
follow, comprehensive rather than economic income is used to
identify the income classes of the taxpayers. Even more
desirable would be a comparison of lifetime tax burdens with
lifetime income.
Present Law Tax
Table 6 displays the progressivity of the present
income tax system, the total amount of revenue that it
raises, and the effective tax rates by comprehensive income
class. The individual income tax is only part of the
present tax structure. The proposals in this report also
would replace the corporation income tax and, by including
virtually all income in the tax base, would reduce implicit
taxes to near zero. Present tax burdens, however, include
all three forms of tax. As shown in table 6, effective tax
rates so derived rise continually with comprehensive income.
Table 5
Cross-Tabulation of the Number of Filing Units with Substantial
Pension Income by Economic Income and by Comprehensive Income 1/
(1976 levels)
Comprehens ive income ($000)
•
T^
Economic
income
($000)
:
U p
to o ;
0 - 5 ; 5 - 10
:
•
•
(..
•
10 - 15 ' 15 - 20 ; 20 - 30
•
, thou^^nd
:
100
• or more:
30 - 50 [ 50 - 100:
•
•
Total
)
49.
22.
7.
4.
0.
0.
0.
0.
0.
81.
4.
9,705.
3,221.
526.
88.
33.
3.
0.
0.
13,581.
5-10
4.
453.
2,839.
1,539.
318.
70.
6.
0.
0.
5,230.
10 - 15
1.
61.
170.
1,080.
472.
172.
22.
0.
0.
1,978.
15 - 20
0.
27.
17.
152.
640.
382.
55.
1.
0.
1,273.
20 - 30
1.
22.
4.
13.
185.
914.
208.
12.
0.
1,360.
30 - 50
0.
10.
2.
1.
4.
118.
681.
77.
0.
894.
50 - 100
0.
6.
0.
0.
0.
0.
26.
276.
22.
331.
100 or more
0.
4.
2.
0.
0.
0.
0.
6.
55-
68.
Total
60.
10,311.
6,262.
3,316.
1,707.
1,689.
1,001.
372.
77.
24,796.
Less than 0
0 -
5
Office of the Secretary of the Treasury
Office of Tax Analysis
1/ Pension income of $500 or more.
I
Ln
I
Table 6
Present Law Tax and Effective Tax Rates
(1976 levels)
Comprehens ive
income
class
($000)
Individual
income
tax
(
Corporation
Implicit
income
taxes
tax
$ billions
Total present
law
income tax
0.0
Effective
tax
rate 1/
) (.. percent ..)
-0.6
0.2
-0.6
0.4
5
1,.0
0.7
-0.3
1.4
1.7
5 -
10
9,.5
2.5
-1.1
10.9
6.4
10 -
15
17..8
3.6
-0.9
20.5
9.9
15 -
20
22 .9
4.3
-0.7
26.5
12.7
20 -
30
32,,6
7.3
-0.8
39.1
15.4
30 -
50
22,.8
10.1
0.5
33.4
19.8
50 - 100
16 .5
11.3
2.5
30.3
25.2
100 or more
13 .3
6.7
0.5
20.6
32.4
46.0
0.0
182.6
14.4
Less than 0
0 -
Total
136.6
Office of the Secretary of the Treasury
Office of Tax Analysis
1/ Tax as a percentage of comprehensive income.
- 159 -
A Proportional Comprehensive Income Tax
It would be possible to replace the present individual
and corporate income tax with a proportional or flat-rate
tax on individuals, choosing the rate in such a way as to
raise the same total revenue. A reasonable exemption could
be allowed for a taxpayer and dependent, or the exemption
could be eliminated altogether in favor of a lower rate.
Two versions of a proportional tax on comprehensive income,
raising the same revenue as the present income tax, are
shown in table 7. One has no exemption and a tax rate of
14.35 percent of the comprehensive income base, and the
other has an exemption of $1,500 per taxpayer and dependent
and a flat rate of 19.35 percent of comprehensive income in
excess of exemptions.
Table 7 shows comprehensive income
by income class, present law tax burdens, and the results of
the two proportional rate plans. As compared to present
law, both plans would result in a tax decrease for the
higher income taxpayers and an increase for those with lower
incomes. The plan that allows an exemption would come
somewhat closer to the present distribution of tax burdens,
but some form of graduated rates is required to achieve a
close approximation.
THE MODEL COMPREHENSIVE INCOME TAX
Table 8 shows the steps from comprehensive income to
the income subject to tax under the model comprehensive
income tax plan and compares that amount to present law
taxable income.
The first adjustment is for child care and secondary
workers and applies to joint and head-of-household returns.
Only 75 percent of the first $10,000 of earnings of workers
other than the primary wage earner is included in income
subject to tax. A deduction of one-half of child care
expenses, up to a maximum deduction of $5,000, is allowed
against wage earnings of unmarried heads of households and
against the included wages of secondary workers on joint
returns.
The combination of exemptions and structure of rates
is designed to yield about the same total revenue, with
about the same distribution by income class, as the present
tax. The model comprehensive income tax would allow exemptions
of $1,000 per taxpayer and dependent, plus $1,600 per return
(half for married persons filing separately). The value of
these exemptions is shown in table 8.
A deduction for
Table 7
Distribution of the Tax Burden under Present Law and Illustrative Proportional Rate Income Taxes
(1976 levels)
Comprehensive
income
class
($000)
Less than 0
0 - 5
Comprehensive
income
Present
law
(
0.0
0.0
1.4
11.6
5.7
-3.6 0.0
81.0
Amount of income tax under:
Proportional
Proportional
rate of
rate
19.35 percent
of
with exemption U
14.35 percent
$ billions
5-10
171.2
10.9
24.6
19.6
10 - 15
205.7
20.5
29.5
26.6
15 - 20
209.1
26.5
30.0
29.5
20 - 30
253.7
39.1
36.4
39.1
30 - 50
169.0
33.4
24.2
28.6
50 - 100
120.2
30.3
17.2
21.6
100 or more
63.5
20.6
9.1
11.9
Total
1,269.9
182.6
182.6
Office of the Secretary of the Treasury
Office of Tax Analysis
1/ Exemption of $1,500 per taxpayer and dependent.
182.6
o
I
Table 8
Tax Base for Comprehensive Income Tax Proposal
(1976 levels)
Comprehensive
income
class
($000)
Less than 0
0 - 5
Comprehens ive
income
Child care and
secondary
worker
provisions
(
Comprehensive
income
Exemptions 1/
subject
to tax 2/
$ billions ...
-3.6 0.0 0.0 0.0
81.0
-0.1
-68.0
12.9
Present
law
taxable
income
Change
in
taxable
income
0.8
-0.8
10.1
2.8
5-10
171.2
-1.5
-83.5
86.1
69.2
16.9
10 - 15
205.7
-4.4
-71.7
129.6
111.3
18.3
15 - 20
209.1
-6.6
-57.1
145.4
129.9
15.5
20 - 30
253.7
-8.2
-51.4
194.1
164.6
29.5
30 - 50
169.0
-3.1
-21.4
144.5
97.0
47.5
50 - 100
120.2
-1.0
-8.5
110.7
54.7
56.0
100 or more
63.5
-0.3
-2.0
61.2
31.7
29.5
Total
1,269.9
-25.3
-363.6
884.5
669.2
215.2
Office of the Secretary of the Treasury
Office of Tax Analysis
1/ The amounts shown do not include the value of exemptions that, if allowed, would reduce comprehensive income
subject to tax to below zero.
2/ Since comprehensive income subject to tax cannot be less than zero, it is greater than the sum of the first
three columns by the amount of the negative income in the first comprehensive income class.
- 162 -
these amounts yields "comprehensive income subject to tax,"
the amount to which the rate schedule is applied in the
model tax.
Table 8 also indicates the change in taxable income
from current law as a result of using the model comprehensive income tax. The increase in income subject to tax
is extremely large, approximately one-third of present
taxable income. Such a substantial broadening of the tax
base can permit a marked reduction in tax rates throughout
the entire income range.
The rate structure for joint returns would be as
follows:
Marginal Tax Rate
Income Bracket
$ 0 - $ 4,600
8 percent
$ 4,600 - $40,000
25 percent
Over $40,000
38 percent
For single returns, the rate structure would be as
follows:
Income Bracket
Marginal Tax Rate
$ 0 - $ 2,800
8 percent
$ 2,800 - $40,000
22.5 percent
Over $40,000
38 percent
"Heads of households," as under present law, would pay the
average of the amounts they would pay using the single and
joint schedules.
The tax revenues that would be raised by this plan, and
their distribution by income class, are shown in table 9,
along with the corresponding information for the present
tax. The agreement is quite close and the aggregate tax
change for each income class is small. Table 10 shows tax
liabilities by filing status under both the present law and
the comprehensive income tax proposal. Again, the changes
are small. The proposed tax plan would favor larger families
Table 9
Amount of Tax and Effective Tax Rates under the Present Law Income Tax
and Model Comprehensive Income Tax
(1976 levels)
Comprehensive
income
class
($000)
Less than 0
0 -
5
5-10
:
'
:
Present law
:
Effective
Tax
:
:
tax rate 1/
(.. $ billions ...) (..-. percent • • • • / \ • •
0.0
-0.6
•
Comprehens ive income tax
•
Effective
•
Tax
tax rate U
•
$ billions . . ) • (.... percent ....;
0.0
0.0
CO
1.4
1.7
1.0
1.3
10.9
6.4
10.4
6.1
10 -
15
20.5
9.9
20.5
10.0
15 -
20
26.5
12.7
27.0
12.9
20 -
30
39.1
15.4
40.1
15.8
30 -
50
33.4
19.8
32.6
19.3
50 - 100
30.3
25.2
31.2
26.0
100 or more
?n_6
32.4
20.8
32.7
Total
182.6
14.4
183.7
14.5
Office of the Secretary of the Treasury
Office of Tax Analysis
1/ Tax as a percentage of comprehensive income.
Table 10
Amount of Tax According to Filing Status under the Present Law Income Tax and Model Comprehensive Income Tax
(1976 levels)
Filing status
Single
Present law
income tax
32.3
Model comprehensive
income tax
$ billions
32.3
Married filing separately .........
2.5
3.0
Head of household
6.4
6.9
Joint and certain surviving spouses
141.4
141.5
No dependents
One dependent
Two dependents
Three dependents
Four dependents
Five or more dependents
54.3
28.2
29.0
17.5
7.8
4.6
57.3
All returns
182.6
183.7
Returns with one or more aged
21.6
25.8
Office of the Secretary of the Treasury
Office of Tax Analysis
)
I
27.8
27.9
16.8
7.4
4.3
- 165 -
slightly compared to present law. Filing units with one or
more aged members would pay somewhat higher taxes because
they would lose the extra age exemption and because social
security cash grants are included in the tax base.
Although tax liabilities by income class and filing
status do not change greatly on the average, the proposed
comprehensive income tax would alter significantly the tax
liabilities of many individual taxpaying units. Those
whose income is not fully taxed under current law would
pay more tax under this comprehensive plan, while others
would benefit from the generally lower rates. Also, many
would be relieved of the burden of double taxation on
corporate income.
Table 11 shows the number of filing units in various
categories that would have their tax liabilities either
increased or decreased by more than 5 percent of present law
tax or by more than $20. The average amount of decrease for
those returns with decreases is almost $380, while the
average amount of increase among the gainers is nearly 5650.
The average gains and losses are similarly large for virtually all the categories shown on the table.
This finding of large average amounts of gains and
losses should be interpreted with great care. It is inevitable that any such tax change will involve substantial
redistribution within income classes even if the total tax
collected within each class remains the same. Furthermore,
to some degree, the simulated comparisons are S P«"°"J . .
because it is not proposed to adopt the model plan overnight.
Indeed, the existence of a large number of gainers and
losers is in itself evidence that careful t " " 5 1 ^ ™ ™les
are needed to facilitate the movement toward a reformed tax
structure.
It should also be noted that the nature of the data
base biases the result in the direction of a f ^ i n 9 ° * i d u a l
extensive redistribution. This is so because the ^dividual
records in the file of taxpayers in the emulation were
constructed by matching information about different indi
viduals in the taxpayer and Current p ° P u l a t ^ h ? ? i Y ? e s for
samples. As a result, current and new tax l i a £ ^ i e s for
a given record in the data base may, in fact, be based on
information concerning different people.
Table 11
Filing Units with Gains and Losses under the Comprehensive Income Tax
as Compared to the Present Law Income Tax 1/
(1976 levels)
Tax decrease
Tax increase
Number of:Amount of:Average decrease:Number of Amount of:Average increase
filing :
tax
:for filing units: filing
tax
:for filing units
units : change : with decrease : units
change : with increase
(millions) ($ billions)
(dollars)
(millions) <$ billions)
(dollars)
All filing units with gains and losses
Filing units with $500 or more of pension
income
60.9
23.0
378
37.2
24.1
648
cr»
5.0
2.2
431
17.7
13.5
764
Filing units with less than $500 of pension
income
55.9
20.9
373
19.5
10.6
543
Single filers 27.7 4.1 148 3.6 1.2
Age less than 22
Age 22 to 61
Age 62 or over
13.7
13.0
1.0
0.6
3.2
0.3
46
245
293
1.0
2.4
0.2
0.1
1.0
0.1
331
107
427
254
Joint filers 24.2 15.8 654 12.9 8.4
Earning status:
One earner
Two or more earners
Dependency status:
No dependents
Two dependents
Four dependents
Filing units with means-tested cash grant
income
653
10.2
14.0
6.7
9.1
657
652
8.6
4.3
5.2
3.2
608
742
6.9
5.8
1.7
5.1
3.5
1.1
745
607
649
4.4
2.8
0.7
2.9
1.7
0.5
643
624
747
2^7
CK2
59
3^9
l^J.
270
Office of the Secretary of the Treasury, Office of Tax Analysis
1/ Filing units whose tax liabilities would change by more than 5 percent of present law tax or by more than $20.
- 167 -
Aside from such statistical details and the guestion of
transition rules, comparisons of gainers and losers may be
misleading on other grounds. The redistributions of income
indicated may reflect not only changes in tax burdens among
different taxpayers, but, perhaps more importantly, changes
between the taxpayer at one point in his life and the same
taxpayer at another point. For example, employee contributions to social security are excluded from taxable
income, but social security benefits are included. As a
result, the simulations show a decrease in tax for present
wage earners and an increase in tax for pensioners.
Indeed, table 11 shows that almost half of those with
tax increases are receiving $500 or more in pension income.
This gives a misleading impression of the distributional
consequences of the change, because present wage earners are
future retirees. A more satisfactory comparison would be
one that reflected the overall lifetime tax burden of
different individuals under various plans. It has not been
possible to perform simulations of such lifetime effects.
Thus, the simulations that are shown tend to be biased
toward a finding of greater redistribution than actually
would be implied by the model plan.
THE CASH FLOW TAX
Table 12 shows, for each comprehensive income class,
the derivation of gross consumption from comprehensive
income. "Imputed consumption from owner-occupied housing"
consists of the net rental value of owner-occupied dwellings,
and is included in gross consumption even though a cash
outlay may not be made for the rental services. "Corporate
retained earnings" are deducted because they represent
saving on behalf of households. Similar saving occurs in
the form of earnings on life insurance policies, contributions to and earnings of private pension plans, and employee
contributions to social security. "Direct saving" represents
household net purchases of real and financial assets. In
table 12, gross consumption is derived by subtracting the
sum of all forms of saving from the sum of comprehensive
income plus imputed consumption.
The term "gross consumption" is used because consumption is here considered to be gross of income taxes paid
under current law; in other words, gross consumption represents
before-tax consumption. Gross consumption is the starting
Point of the cash flow tax in the same way that comprehensive
income is the starting point of the comprehensive income
tax.
Table 12
Comprehensive Income and Gross Consumption
(1976 levels)
Comprehens ive
income
class
($000)
: Comprehensive
income
Imputed
consumption
from owneroccupied
housing
(
Saving
:Saving in life
Corporate
insurance,
retained
pension plans,
earnings
and
social security
$ billions
Direct
saving
[
Gross
consumption
)
-3.6
0.1
0.1
0.0
-5.9
2.3
5
81.0
1.3
0.3
0.4
3.0
78.6
5 -
10
171.2
3.6
0.9
2.1
8.1
163.7
10 -
15
205.7
7.0
1.1
3.3
14.0
194.4
15 -
20
209.1
8.3
1.3
4.0
18.3
193.8
20 -
30
253.7
9.7
2.4
5.6
26.7
228.7
30 -
50
169.0
4.9
3.5
3.2
18.9
148.3
50 - 100
120.2
2.1
4.0
- 1.3
16.8
100.2
63.5
0.7
6.0
0.5
6.8
51.0
1,269.9
37.8
19.6
20.5
106.7
1,160.9
Less than 0
0
100 or more
Total
Office of the Secretary of the Treasury
Office of Tax Analysis
Note: Gross consumption equals comprehensive income plus imputed consumption from owner-occupied housing minus all
the following forms of savings: corporate retained earnings, saving in life insurance plans, social security
contributions, and direct saving.
- 169 -
As was explained earlier in connection with the comprehensive income tax, taxpayers must be classified properly
before the distribution of tax burdens can be analyzed.
All tables dealing with the cash flow tax will use gross
consumption for classification purposes.
Table 13 shows the derivation of the cash flow tax
base. The provisions for child care and secondary workers
are the same for the cash flow tax as for the comprehensive
income tax. Exemptions under the cash flow tax are $1,500
per return and $800 per taxpayer and dependent. Adjusting
gross consumption for the child care and secondary worker
provisions and for exemptions yields the amount of cash
flow subject to tax. A comparison of the amounts subject to
tax in the two model plans, as shown in tables 8 and 13,
indicates that the amount of cash flow subject to tax is
about 7 percent less than the amount of comprehensive income
subject to tax. Nonetheless, the amount of cash flow
subject to tax is 23 percent more than present taxable
income, as shown in table 8. Thus, even though saving is
deducted, the model cash flow tax accomplishes a substantial
broadening of the tax base.
The rate structure for joint returns under the cash
flow tax would be as follows:
Income Bracket Marginal Tax Rate
$ 0 - 5,200 10 percent
5,200 - 30,000
28 percent
Over
30,000
40 percent
For single returns, the rate structure would be as
follows:
Income Bracket Marginal Tax Rate
$ 0 - 3,200 10 percent
3,200 - 30,000
Over
30,000
26 percent
40 percent
Heads of households, as under present law, would pay the
average of the amounts under the single and joint schedules.
Table 14 shows the distribution of tax liabilities and
effective rates of tax under the model cash flow tax and
Present law. The model cash flow tax nearly reproduces the
Table 13
Cash Flow Tax Base
(1976 levels)
Gross
consumption
class
($000)
Number of
: filing units 1/
(... millions
Gross
consumption
Child care and
secondary
worker
provisions
Exemptions 2/
Cash flow
subject
to
tax
...) (•
0.0
0.0
0.0
0.0
0.0
5
40.7
84.2
-0.1
-66.2
17.9
5 -
10
24.3
178.9
-1.8
-76.6
100.5
10 -
15
17.9
221.4
-5.7
-67.1
148.6
15 -
20
11.8
202.9
-7.3
-47.8
147.8
20 -
30
8.7
208.5
-6.8
-36.0
165.6
30 -
50
3.7
136.3
-2.6
-14.9
118.8
50 - 100
1.3
88.2
-0.8
-5.5
81.9
0.3
40.6
-0.2
-1.1
39.2
108.6
1,160.9
-25.3
-315.2
820.4
Less than 0
0
100 or more
Total
i
o
Office of the Secretary of the Treasury
Office of Tax Analysis
1/ Includes all filing units whether or not they actually file returns or pay tax under current law.
"2/ The amounts shown do not include the value of exemptions that, if allowed, would reduce cash flow
"" subject to tax to below zero.
1
Table 14
Amount of Tax and Effective Tax Rates under the Present Law Income Tax and under Model Cash Flow Tax
(1976 levels)
Gross
consumption
class
($000)
Prejsent law tax
4
1
Tax
(...
Less than 0
$ billions
•
«
..)
(...
:
Cash flow tax
•
Effective
:
Effective
Tax
•
tax rate l_l :
tax rate U
•
.. percent ...) (... $ billions .,.) (..
0.0
0.0
0.0
0.0
1.8
2.2
1.8
2.1
5-10
13.2
7.4
13.7
7.7
10 - 15
26.2
11.8
26.3
11.9
15 - 20
30.0
14.8
30.6
15.1
20 - 30
37.5
18.0
38.2
18.3
30 - 50
32.2
23.6
31.4
23.1
50 - 100
27.1
30.7
26.8
30.3
100 or more
14.6
36.0
14.5
35.7
Total
182.6
15.7
183.3
15.8
0 -
Office of the
5
SPCTPIh *» TTXT
n -F
Office of Tax Analysis
- Tax as a percentage of gross consumption.
.)
- 172 -
progressivity of the present tax structure. It is clear
that taxing consumption is perfectly consistent with a
progressive structure of tax liabilities.
Although the model cash flow tax preserves the average
progressivity of current law, it would extensively redistribute
tax burdens.
Table 15 tabulates filing units whose tax
change would be more than 5 percent of present law tax or
more than $20. This table yields essentially the same
results as those presented in table 11 for the comprehensive
income tax. The caveats in interpreting the results of
table 11 apply with equal force to table 15.
COMPARISONS OF TAX LIABILITIES UNDER THE DIFFERENT PLANS
Up to this point, this chapter has presented simulations
of the effects of the model tax plans on all taxpayers.
This section examines the tax liabilities of taxpayers in
particular situations. These materials illustrate the
differences among the present law income tax and the two
model pLans. Since the data are hypothetical, they do not
represent the situations for any particular taxpayer.
The Marriage Penalty
..,
<n.
•
A subject of continuing controversy and interest is the
division of the tax burden between married and unmarried
individuals. Table 16 shows, for current law, the additional
tax paid by a married couple filing a joint return over what
would be paid if both persons could file single returns.
The left-hand column shows the couple's total income. The
subsequent columns present different shares of the total
income earned by the lesser-earning spouse. For example,
in the first column, one spouse earns all of the income.
This column shows that a married couple would pay a lower
tax than would a single individual with the same income
because of the favorable rate structure of the joint return
schedule. In the last column, earnings are derived eaually
from the wages of both spouses. In this case, the married
couple would pay a higher tax than would two unmarried
individuals, with a marriage penalty of $4,815 on a joint
income of $100,000.
Table 17 shows the same data for the model comprehensive income tax plan. The area of marriage penalty has
increased somwehat as compared to current law. However, the
rate structure and exclusion of a portion of the earnings of
Table 15
Filing Units with Gains and Losses under the Cash Flow Tax Compared with Present Law Income Tax 1/
(1976 levels)
Tax increase
Tax decrease
Amount
of:Average increase
Number of Amount of:Average decrease:Number of
tax
:for filing units
tax
:for filing units: filing
filing
change
: with increase
change : with decrease : units
units
(trillions) <$ billions)(dollars)
(millions) <§ billions)
(dollars)
All filing units with gains and losses
Filing units with $500 or more of pension
income
«
53.6
31.0
577
44.7
31.7
708
5.1
3.5
700
17.9
13.7
765
CO
Filing units with less than $500 of pension
income
48.6
27.4
564
26.8
18.0
671
Single filers ....
Age less than 22
Age 22 to 61 ...
Age 62 or over .
24.5
12.6
11.0
0.9
4.9
0.5
3.9
0.4
199
43
360
410
6.6
2.0
4.3
0.3
2.0
0.3
1.7
0.1
309
130
392
313
Joint filers
•'....
Earning status:
One earner
Two or more earners
Dependency status:
No dependents
Two dependents ....
Four dependents •..
20.6
21.4
1,037
16.6
14.6
880
8.9
11.7
9.6
11.8
1,075
1,007
10.0
6.6
8.8
5.9
876
885
6.8
4.6
1.3
8.0
4.3
1.3
1,174
933
1,060
4.6
4.0
1.1
4.1
3.5
1.0
889
884
924
2.4
0.2
73
4.4
1.5
352
Filing units with means-tested cash grant
income
Office of the Secretary of the Treasury, Office of Tax Analysis
$20.
1/ Filing units whose tax liabilities would change by more than 5 percent of present law tax or than
by more
Table 16
Marriage Penalties in 1976 Law
The Marriage Penalty is the Excess of the Tax a Couple Pays with a Joint Return
Over What It Would Pay if Both Persons Could File Single Returns
Total
family
income
Dollar amount of marriage penalty when share of income earned by lesser-earning spouse is:
percent
40 percent
30nt
percent
None : 10 percent \ 20 percent | ™ — : ™ »««
* 50
Y~
No Marriage Penalty
0
0
87
0
0
130
101
191
162
201
216
237
212
221
263
56
29
13
189
235
320
258
319
497
243
365
565
149
334
605
661
1,188
2,819
1,034
1,743
4,275
1,188
1,910
4,815
0
0
-69
0
0
12
-137
-163
-187
-18
43
97
-762
-1,085
-1,406
-240
-324
-442
-2,013
-2,697
-6,810
-657
-799
-2,532
0
3,000
5,000
0
-42
-233
0
0
-149
7,000
10,000
15,000
-266
-383
-527
20,000
25,000
30,000
40,000
50,000
100,000
$
(
$
Marriage Penalty
Office of the Secretary of the Treasury
Office of Tax Analysis
Note: In all tax calculations, deductible expenses are assumed to be 16 percent
of income, and the maximum tax is not used.
)
Table 17
Marriage Penalties in the Model Comprehensive Income Tax
The Marriage Penalty is the Excess of the Tax a Couple Pays with a Joint Return
Over What It Would Pay if Both Persons Could File Single Returns
Total
family
income
$
0
3,000
5,000
Dollar amount of marriage penalty when share of income earned by lesser-earning spouse is:
None
:
10 percent ; 20 percent \ 30 percent ; 40 percent \ 50 percent
(
No Marriage Penalty
$
0
-32
-80
$
0
-8
-50
$
0
0
-20
7,000
10,000
15,000
-312
-441
-316
-169
-278
-72
-25
-116
140
20,000
25,000
30,000
-191
-66
59
134
340
515
347
555
675
40,000
50,000
100,000
309
244
244
/
847
1,477
1,835
Office of the Secretary of the Treasury
Office of Tax Analysis
0
0
10
$
46
0
0
40
$
72
0
0
62
$
58
15
263
97
300
122
206
425
456
488
300
300
425
175
300
425
675
800
1,432
1,432
4,935
3,385
Marriage Penalty
675
1,432
6,485
675
1,432
6,888
)
- 176 -
the secondary worker would result in some changes relative
to current law. This may be seen most clearly in the last
column. Although the marriage penalty paid by a couple
earning $100,000 would increase, for all other families in
which equal earners marry, the marriage penalty would be
reduced compared to current law. As the first column shows,
the differences between married couples and unmarried
individuals are, in general, reduced in the model comprehensive income tax plan compared to current lav/. This is
because the broader tax base permits a less steep progression
of marginal tax rates. Table 18 shows the marriage penalties
under the model cash flow tax.
Lifetime Comparisons
As suggested above, a desirable point of view from which
to assess the relative tax burdens among individuals is that
of the complete lifetime. The tables presented thus far
do not reflect this lifetime perspective. If either of the
model tax plans had been in effect as long as the present
tax, the income and tax situations of taxpayers would be
different from those shown in the simulated results.
This is particularly true of saving, which is subject
to considerably different treatment under the model plans.
For persons accumulating for their retirement years in
savings accounts, the present law would collect tax on the
income from which the saving is made and again on the
interest earned on the savings. Withdrawal of funds,
however, would have no tax consequence. Under the cash flow
tax, savings would not be subject to tax; rather, taxes would
be assessed when the proceeds are withdrawn for consumption.
The comprehensive income tax would be levied both on income
saved as well as on interest earned, but the broader base
would permit lower rates than under present law.
Since one objective of saving is the reallocation of
lifetime consumption, these three tax systems would be
expected to alter the timing of income, consumption, and tax
liabilities. Table 19 summarizes these effects. It shows
summary statistics for a family whose saving strategy is to
maintain a constant level of consumption throughout working
and retirement years. This table provides a very direct and
convenient way of comparinq the different systems, since tax
burdens may be determined directly from the level of consumption. The higher is the level of consumption attainable, the lower is the tax burden.
in this example, the
Table 18
Marriage Penalties in the Model Cash Flow Tax
The Marriage Penalty is the Excess of the Tax a Couple Pays with a Joint Return
Over What It Would Pay if Both Persons Could File Single Returns
Dollar amount of marriage penalty when share of income earned by lesser-earning spouse is:
Total
family
income
None
10 percent
20 percent
(
$
0
3,000
5,000
40 percent
30 percent
50 percent
No Marriage Penalty
$
o
$
0
-10
-5
0
0
32
0
0
70
0
0
88
-70
-80
0
-40
-42
7,000
10,000
15,000
-320
-494
-394
-156
-304
-109
9
-114
106
77
6
241
80
96
296
63
106
191
20,000
25,000
30,000
-294
-194
-94
86
261
406
296
486
596
396
391
386
256
216
316
116
216
316
40,000
50,000
100,000
-144
-144
-144
886
1,086
1,366
1,244
1,366
2,766
1,044
2,066
4,166
1,044
2,444
4 ,488
1,044
2 ,444
4 ,488
$
(
Office of the Secretary of the Treasury
Office of Tax Analysis
$
ty ..
....)
I
-J
I
Table 19
Lifetime Comparison of Present L a w Income T a x and M o d e l T a x Plans
(Married couple; o n e earner, wages $16,000 per year for 4 0 y e a r s ;
consumes at maximum possible steady rate over entire lifetime)
'TlHger:
Sa
lS8:0aCC°Unt
balanCC:
Present
law t a x
Comprehensive
income t a x
C a s h flow
tax
$ U.«6
* ".S*
*U > 7 1 3
-^1
60,114 53,759 58,764
A g e 6 0 '.'.'.'.'.'.'.'.'.'.'.'.'.'.'.
151,185
137,651
164,900
Taxes:
Working y e a r s :
A „ e 21
2
>1°
2
Age40*"!
2,272
Age60..1
2
Retirement years:
Age 61
Ale 75
>
582
845
505
2
3
> 1
„
>100
8
2
2,696
3
»
2,100
3i2
2
42
2
0
>1°°
>100
2,100
Office of the Secretary of the Treasury
Office of Tax Analysis
Note- This example assumes a 3-percent real rate of return (before taxes) on savings and that the
corporation income tax under present law is borne by the return from all savings at the rate
of 19.1 percent.
oo
- 179 -
present law tax burden is somewhat higher (consumption is
lower) than that implied by the model comprehensive income
tax which in turn is higher than that under the cash flow
tax.
- 181 -
Chapter 6
TRANSITION CONSIDERATIONS
INTRODUCTION
Major changes in the tax code such as would accompany a
switch to either the comprehensive income tax or the cash flow
tax may lead to substantial and sudden changes in current
wealth and future after-tax income flows for some individuals.
Transition rules need to be designed to minimize unfair
losses, or undeserved windfalls, to individuals whose
investment decisions were influenced by the provisions of
the existing code.
This chapter discusses the major issues in transition
and suggests possible solutions to problems arising from
transition to both the comprehensive income tax and the cash
flow tax. It outlines the major wealth changes that can be
expected under a switch to either of the two model taxes,
and discusses the relevant equity criteria to be applied in
the design of transition rules. Instruments for ameliorating
transition problems, including phasing in provisions of the
new law and grandfathering, or exempting, existing assets
from the new rules are discussed. The effects of applying
these transition instruments to different types of changes
in the tax law are outlined. Transition rules to be applied
to specific changes in the tax law included in the model
comprehensive income tax in chapter 3 are considered.
Special problems of transition to a cash flow tax are discussed
also, and a plan is suggested for transition to the cash
flow proposal described in chapter 4.
WEALTH CHANGES AND THEIR EQUITY ASPECTS
Two separate problems requiring special transition
rules can be identified: carryover and price changes.
Carryover problems would occur to the extent that changes in
the tax code affect the taxation of income earned in the
Past but not yet subject to tax or, conversely, income taxed
in the past that may be subject to a second tax. Price
changes would occur in those instances where changes in the
tax code altered the expected flow of after-tax income from
existing investments in the future.
- 182 Carryover Problems
Under the present tax system, income is not always
taxed at the time it accrues. For example, increases in net
worth in the form of capital gains are not taxed before
realization. A change in the tax rate on realized capital
gains, therefore, would alter the tax liability on gains
accrued but not realized before the effective date of the
tax reform. Application of the new rules to past capital
gains would either raise or lower the applicable tax on that
portion of past income, depending on whether the increase in
tax from including all capital gains in the income base
exceeded the reduction in tax caused by any allowance of a
basis adjustment for inflation.
The problem of changes in the timing of tax liability
would be especially severe if the current tax system were
changed to a consumption base. Under a consumption base,
purchases of assets would be deductible from tax and sales
of assets not reinvested would be fully taxable. Under the
current tax system, both the income used to purchase assets
and the capital gain are subject to tax, the latter, however,
at a reduced rate. Recovery of the original investment is
not taxed. An immediate change to a consumption base would
penalize individuals who saved in the past and who are
currently selling assets for consumption purposes. Having
already paid a tax on the income used to purchase the asset
under the old rules, they would also be required to pay an
additional tax on the entire proceeds from the sale of the
asset. On the other hand, if owners of assets were allowed
to treat those assets as tax-prepaid, they would receive a
gain to the extent they planned to use them for future .
consumption or bequest. Income on past accumulated wealth
would then be free from future taxes, and the government
would have to make up the difference by raising the tax rate
on the remaining consumption regarded as non-pretaxed.
Other carryover problems include excess deductions or
credits unused in previous years and similar special technical features of the tax law. In general, carryover can be
viewed as being conceptually different from changes in the
price of assets. In the case of capital gains tax, for
example, the change in an individual's tax liability for gains
that have arisen by reason of a past increase in asset values
does not affect the tax liability of another individual
purchasing an asset from him; in general, the asset price
depends only on future net-of-tax earnings. However, the
new tax law and the transition rules, by altering future
net-of-tax earnings, would change the price of assets.
- 183 In most cases, carryover problems could be handled by
special rules that define the amount of income attributable
to increases in asset values not realized before the effective
date of implementation of the new law. Changes in the
definition of an individual's past income would alter asset
prices only if they provided an incentive for pre-effective
date sales of existing assets. For example, if, under the
new system, past capital gains were taxed at a higher rate
than under the old system, an incentive might be created for
sales of assets prior to the effective date.
Price Changes
Adoption of a broadly based tax system would change
prices of some assets by changing the taxation of future
earnings. Under the comprehensive income tax, for example,
the following changes in the tax code would alter tax rates
on income from existing assets: integration of the corporate
and personal income taxes; taxation of all realized capital
gains at the full rate; adjustment of asset basis for
inflation (or deflation) ; inclusion of interest on State and
local government bonds in the tax base; elimination of
accelerated depreciation provisions that lower the effective
rate of tax on income arising in special sectors, including
minerals extraction, real estate, and some agricultural
activities; and elimination of the deductibility of property
taxes by homeowners. Adoption of these and other changes in
the tax code would alter both the average rate of taxation
on income from all assets and the relative rates imposed
among types of financial claims, legal entities, and investments
in different industries.
The effects of changes in taxation on asset values
would be different for changes in the average level of
taxation of the associated returns and changes in the
relative rates of taxation on different assets. A change in
the average rate of taxation on all income from investment,
while it would affect the future net return from wealth or
accumulated past earnings, would not be likely in itself to
change individual asset prices significantly. For any^
single asset, an increase in the average rate of taxation of
returns would reduce net after-tax earnings roughly in
proportion to the reduction in net after-tax earnings on
alternative assets. Thus, the market value of the asset,
which is equal to the ratio of returns net of depreciation
to the interest rate (after tax), would not tend to change.
°n the other hand, an increase in the relative rate o f
taxation on any single asset generally would lead to a tall
in the price of that asset, because net after-tax earnings
would
holds for
fallarelative
decrease to
inthe
theinterest
relative rate.
rate of
The
taxation.
opposite
- 184 -
The behavior of the price of any single asset in
response to a change in the relative rate of taxation of its
return depends on the characteristics of the asset and the
nature of the financial claim to it. For example, suppose
the asset is a share in an apartment project. In the long
run, the price of the asset will depend on the cost of
building apartments; if unit construction costs are independent of volume, they will not be altered by changes in
the tax rate on real estate profits.
Now, suppose the effective rate of taxation on profits
from real estate is increased. The increase in tax will
drive down the after-tax rents received by owners. Because
the value of the asset to buyers depends on the stream of
annual after-tax profits, the price a purchaser is willing
to pay also will fall. With the price of the structure now
lower than the cost of production, apartment construction
will decline, making rental housing more scarce and^driving
up the before-tax rentals charged to tenants. In final
equilibrium, the before-tax rentals will have risen sufficiently to restore after-tax profits to a level at which^
the price buyers are willing to offer for the asset is again
equal to its cost of production. However, for the interim
before supply changes restore equilibrium, after-tax returns
would be lowered by the price change.
Thus, the immediate effect of the change in the rate of
taxation would be to lower the price of equity claims to
real estate. The wealth loss to owners of those shares at
the time of the tax change would depend both on the time
required for adjustment to final equilibrium and the extent
to which future increases in the gross rentals (from the
decline in housing supply) were anticipated in the marketplace. The faster the adjustment to equilibrium and the
larger the percent of gross rentals change that is anticipated, the smaller the fall in asset price will be for any
given increase in the tax on the returns.
If the asset is a claim to a fixed stream of future
payments (e.g., a bond), a change in the rate of taxation
would alter its price by lowering the present value of the
future return flow. For example, if interest from municipal
bonds became subject to tax, the net after-tax earnings of
holders of municipal bonds would fall, lowering the value of
those claims. New purchasers of municipal bonds would
demand an after-tax rate of return on their investment
comparable to the after-tax return on other assets of
similar risk and liquidity. The proportional decline in
value
for time
a given
tax change would be greater for bonds with
a longer
to maturity.
- 185 -
The effect of corporate integration on the price of
assets is less certain. If the corporate income tax is
viewed as a tax on the earnings of corporate equity shareholders, integration would increase the rate of taxation on
income from investment of high-bracket shareholders and
lower the rate of taxation on such income of low-bracket
shareholders. 1/ In addition, many assets owned by corporations also can be used in the noncorporate sector. To
the extent that relative tax rates on income arising in the
two sectors were altered by integration, those assets could
easily move from one sector to the other, changing relative
before-tax earnings and output prices in the two sectors,
but keeping relative after-tax earnings and asset prices the
same.
In conclusion, raising the relative rate of taxation on
capital income in industries and for types of claims currently receiving relatively favorable tax treatment would
likely cause some changes in asset prices. Immediate asset
price changes generally would be greater for long-term fixed
claims, such as State and local bonds, than for equity
investments; greater for assets specific to a given industry
(e.g., apartment buildings) than for assets that can be
shifted among industries; and greater for assets the supply
of which can only be altered slowly (e.g., buildings and
some mineral investments) than for those the supply of which
can be changed quickly.
The net effect of integration on asset values may not
be large. On the other hand, changes in the special tax
treatment currently afforded in certain industries, for
example in real estate and mineral resources, and changes in
the treatment of State and local bond interest, would likely
cause significant changes in values of those assets.
The Equity Issues
Considerations of equity associated with changes in tax
laws are different from equity considerations associated
with the overall design of a tax system. Changes in the tax
code would create potential inequities to the extent that
individuals who made commitments in response to provisions
of the existing law suffer unanticipated losses (or receive
unanticipated gains) as a result of the change. .These gams
(and losses) can be of two types: (1) wealth changes to
individuals resulting from changes in tax liabilities on
income accrued in the past but not yet recognized for tax
purposes, and (2) changes in the price of assets or the
- 186 value of employment contracts brought about by changes in
future after-tax earnings. These two types of problems,
carryover and price change, pose somewhat different equity
issues.
Carryover poses the problem of how to tax equitably
income attributable to an earlier period, when a different
set of tax laws was in effect. For example, consider one
aspect of the proposed change in the tax treatment of
corporations under the comprehensive income tax. At present,
capital gains are subject to lower tax rates than dividends,
especially when realization is deferred for a long period of
time. Individuals owning shares of corporations paying high
dividend rates relative to total earnings pay more tax than
individuals owning shares of corporations with low dividends
relative to total earnings. As both types of investment are
available to everyone, individuals purchasing shares in
high-dividend corporations presumably are receiving something (possibly less risk or more liquidity) in exchange for
the higher tax liability they have to assume. To subject
shareholders of low-dividend corporations to the same rate
of taxation as they would have paid if income accumulated in
the form of capital gains before the effective date had been
distributed would be unfair.
Carryover poses another equity problem: some taxpayers
may be assessed at unusually high or low rates on past
income because of changes in the timing of accrual of tax
liability. The above example can be used to illustrate this
point too. Under current law, the special tax treatment of
capital gains in part compensates shareholders for the extra
tax on their income at the corporate level. Under the integration proposal presented in chapter 3, the separate corporate
income tax would be eliminated, but shareholders would be
required to pay a full tax on their attributed share of the
corporation's income, whether or not distributed.
Now, suppose integration is introduced and a shareholder
has to pay the full tax on the appreciation of his shares
that occurred before the effective date. 2/ The taxpayer
would, in effect, be taxed too heavily on that income,
because it was subject to taxation at the corporate level
before being taxed at the full individual income tax rate.
Before integration, he would, in effect, have paid the
corporate tax plus the reduced capital gains rate on the
gains attributable to that income; after integration, he
would be liable for the tax on ordinary income at the full
rate. Thus, in the absence of transition rules, he would be
- 187 -
subject to a higher tax on income in the form of capital
gains accrued before, but not recognized until after, the
effective date of the new law than on income earned in a
similar way under a consistent application of either present
law or the comprehensive income tax.
The most desirable solution to the problem of equity
posed by carryover is to design a set of transition rules
that insure that, to the maximum extent consistent with
other objectives, tax liabilities on income accrued before
the effective date are computed according to the old law and
tax liabilities on income accrued after the effective date
are computed according to the new law.
Changes in future after-tax income brought about by tax
reform raise a different set of equity issues. A complete
change in the tax system, if unexpected, would cause losses
in asset value to investors in previously tax-favored
sectors. Imposition of such losses may be viewed as unfair,
especially since past government policy explicitly encouraged
investment in those assets.
For example, as between individuals in a given tax
bracket one of whom held State and local bonds producing a
lower interest rate because such interest was tax-exempt and
the other of whom held taxable Treasury bonds producing
higher interest but the same after-tax return, it seems
reasonable to compensate the holder of the State and local
bonds for the loss suffered upon removal of the tax exemption
so that he ends up in the same position as the holder of
Treasury bonds. Note that this concept of distributive
justice does not imply that a third taxpayer, who earns
higher after-tax income from tax-free bonds than from
Treasury bonds because he is in a higher tax bracket than
the other two, should retain the privilege of earning taxfree interest. Equity does not require that the tax system
maintain loopholes; it does require some limitation on
wealth losses imposed on individuals because they took
advantage of legal tax incentives.
The counterargument to the view that justice requires
compensation for such wealth changes is that all changes in
public policy alter the relative incomes of individuals and,
frequently, asset values. For example, a government decision to reduce the defense budget will lower relative
asset prices in defense companies and their principal
supplying firms and also lower relative wages of individuals
with skills specialized to defense activities (e.g., many
engineers and physicists). Although some special adjustment
- 188 assistance programs exist, 3/ it is not common practice to
compensate individuals for changes in the value of physical
and human assets caused by changes in government policies.
In addition, it can be argued that, because investors in
tax-favored industries know the tax subsidy may end, the
risk of a public policy change is reflected in asset prices
and rates of return. If, for example, it is believed that
the continuing debate over ending remaining special tax
treatment of oil industry assets poses a real threat, it can
be argued that investors in oil are already receiving a risk
premium in the form of higher than normal net after-tax
returns, and further compensation for losses upon end of the
subsidy is unwarranted.
The discussion above suggests that a case can be made
both for and against compensation of individuals for losses
in asset values caused by radical changes in tax policy.
Because the asset value changes resulting from the tax change
alone are virtually impossible to measure precisely, designing a method to determine the appropriate amount of
compensation would be difficult on both theoretical and
practical grounds. However, it would be desirable to design
transition rules so that unanticipated losses and gains
resulting from adoption of a comprehensive tax base would be
moderated. Two possible design features, grandfathering
existing assets and phasing in the new rules slowly, are
discussed next.
INSTRUMENTS FOR AMELIORATING TRANSITION PROBLEMS
Objectives
The main criteria that transition rules should satisfy
are: (1) simplicity, (2) minimizing incentive problems, and
(3) minimizing undesirable wealth effects.
Simplicity. The transition rules in themselves should
not introduce any major new complexity in the tax law. To
the extent possible, transition rules should not require
that corporations or individuals supply additional data on
financial transactions or asset values.
Minimizing Incentive Problems. The transition rules
should be designed to minimize the probability of action in
response to special features of the change from one set of
tax rules to another. In particular, there should not be
special inducements either to buy or to sell particular
kinds of assets just before or after the effective date of
the new law.
- 189 -
Minimizing Undesirable Wealth Effects. Transition
rules should moderate wealth losses to individuals holding
assets that lose their tax advantages under basic tax reform
as well as gains to those whose assets are relatively
favored. At the same time, special transition rules to
protect assetholders from loss should not give them the
opportunity to earn windfall gains.
Alternatives
Two alternative methods of reducing capital value
changes are discussed here: grandfathering existing assets
and phasing in the new law.
Grandfathering. The grandfather clause was originally
used by some southern States as a method for disenfranchising
black voters following the Civil War. It exempted from the
high literacy and property qualifications only those voters
or their lineal descendants who had voted before 1867. More
recently, grandfather clauses have been used to exempt
present holders of positions from new laws applicable to
those positions, e.g., setting a mandatory age of retirement. In the context of tax reform, a grandfather clause
could be used either to exempt existing assets from the new
law as long as they are held by the current owner or to
exempt existing assets from the new law regardless of who
holds them. A grandfather clause also could be applied to
capital gains accrued but not yet realized at the time the
new law went into effect.
Consider, for example, the effect of eliminating the
special depreciation rules that result in a low rate of
taxation on income from real estate investments. A grandfather clause that exempts existing buildings only so long
as they are held by the current owner(s) would mean that
current owners could depreciate their buildings to zero
according to the old rules, but that new owners could not do
so. Grandfathering the buildings independently of their
owners would allow subsequent purchasers to depreciate
according to the old rules. 4/ This would have the effect
of raising the value of the buildings. Elimination of tax
incentives in real estate would discourage new construction,
reducing the supply of housing and raising gross rentals
before tax. Thus, grandfathering, by making existing
Property more valuable, would give a windfall gain to
investors in real estate tax shelters. On the other hand,
grandfathering the buildings only for current owners would
not prevent a wealth loss to real estate investors, because
- 190 the value to new buyers would decline. The loss would be
mitigated by the anticipated increase in after-tax profits
to current investors (because of the decline in housing
supply).
The effect of grandfathering on asset prices for fixedinterest securities is less certain. For example, if
existing municipal bonds were grandfathered, annual interest
received net of tax would be unchanged. However, the value
of the tax saving from owning municipal bonds would change
for two reasons. First, there would be no new tax-exempt
municipal bond issues under the new rules; with fewer
available tax-exempt bonds, the price of tax-exempt securities
will rise, as will the marginal tax bracket at which such
securities offer a net advantage. Second, the other changes
in the tax system which would enable marginal tax rates in
the highest brackets to fall, would reduce the gain from tax
exemptions, driving down the demand for, and the price of
tax-exempt securities. As demand and supply will both fall,
it is not clear in what direction the price of the grandfathered
securities would change, though the price change would be
smaller than if the new rules were adopted immediately for
all tax-exempt securities.
One problem of grandfathering is that it can provide an
unanticipated gain to current owners of assets subject to
favorable tax treatment. These owners would receive a gain
because the new tax law would reduce the supply of previously
favored assets, thus raising before-tax profits.
Grandfathering probably should be limited to cases
where gross returns are not likely to be altered significantly by the change in taxation. For example, changes in
the tax treatment of pensions would not be likely to affect
before-tax labor compensation significantly, assuming the
supply of labor to the economy is relatively fixed. While
grandfathering tax treatment of pensions in current employment contracts would not be likely to raise significantly
the value of those contracts relative to their value under
the old law, an immediate shift to the new law would reduce
the value of previously negotiated pension rights.
Phasing In. An alternative method of avoiding drastic
changes in asset values is to introduce the new rules
gradually. For example, taxation of interest on currently
tax-exempt State and local bonds could be introduced slowly
by including an additional 10 percent of interest in the tax
base every year for 10 years. Phasing in the new rules
would not alter the direction of asset value changes, but it
would reduce their magnitude by delaying tax liability
changes.
- 191 -
Assuming that the market incentives under the new law
are preferable to the incentives under the current law,
phasing in poses distinct disadvantages. Phasing in would
delay application of the new rules, thus reducing the
present value of the economic changes that would be encouraged and which are an important objective of the new
rules. Phasing in also may introduce substantial complexity.
The length of the phase-in period would depend on the
desired balance of the gains in efficiency and simplicity
from changing the tax system against the distributive
inequities resulting from imposition of asset value changes
on some investors.
Combination of Phasing In and Grandfathering. A
possible variant on the two approaches outlined above is to
adopt the new rules immediately for new assets while phasing
in the new rules for existing assets. In many cases, grandfathering existing assets when new assets would be taxed
more heavily under the new tax law would raise the market
price of the old assets. By phasing in the new rules for
the old assets, it would be possible to moderate the increase
in present value of future tax liabilities, while at the
same time reduced supply of new assets would raise beforetax returns on both new and existing assets. The two
effects may roughly cancel out, leaving asset prices almost
the same throughout the early transition period. For example,
a gradual introduction of new, and more appropriate, depreciation schedules for existing residential real estate, 5/
with a concurrent adoption of the new rules for new buildings, would have the same incentive effects on new building
as immediate adoption of the new law. Before-tax rentals on
existing real estate would rise gradually, as supply growth
is reduced, while tax liabilities on existing real estate
also would rise. It is likely that, for an appropriate
phase-in period, the asset value change to existing owners
would be small. However, tax shelters on new construction
would be totally eliminated immediately.
PROPOSED SOLUTIONS TO SELECTED PROBLEMS IN THE TRANSITION
TO THE COMPREHENSIVE INCOME TAX
Adoption of the comprehensive income tax would have
significant impact on the taxation of capital gains, corporate
income, business and investment income, and personal income.
The following discussion examines the problems that these
changes present for transition. In most cases, possible
solutions to these problems are suggested.
- 192 Capital Gains
Under the comprehensive income tax, no distinction will
be made between capital gains and ordinary income, and
losses will be fully deductible against income from other
sources. The transition mechanism proposed is to allow
capital gains (or losses) that have accrued as of the
general effective date of the proposal to continue to
qualify for capital gains treatment upon a sale or other
taxable disposition for 10 years following such date. This
"capital gain account11 inherent in each asset could be
determined in either of two ways:
1. By actual valuation on the general effective date of
enactment of the proposal (or on an elective alternative
valuation date to avoid temporary distortions in market
value), or
2. By regarding the gain (or loss) recognized on a
sale or exchange of the asset as having accrued ratably over
the period the seller held the asset. The portion of the
gain (or loss) thus regarded as having accrued prior to the
effective date would be taxed at capital gain rates (or be
subject to the limitation on capital losses) provided that
the asset continued to meet the current requirements for
such treatment. Recognition of capital gain (or loss) on
the asset after the effective date would extinguish the
capital gain (or loss) potential of the asset. Thus, gains
on sale or exchange of an asset purchased after the effective date would not receive any special tax treatment.
Both of these systems have been employed in the Tax
Reform Act of 1976 in connection with the so-called carryover basis provisions at death -- the former for securities
traded on established markets, and the latter for all other
assets.
A number of technical rules relating to transfers and
subsequent adjustments to basis would have to be provided.
In general, the account should carry over to the transferee
in certain tax-free transfers that reflect a change in the
transferor's form of ownership of, or interest in, the
asset, such as contributions to a controlled corporation
(under section 351) or partnership (section 721) or a
complete liquidation of certain controlled subsidiaries
(section 332). In the case of a transfer of an asset to a
controlled corporation or partnership, it may be appropriate
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to allow the shareholder or partner to elect to transfer the
capital gain account of the asset to his stock or partnership interest, and have the asset lose its capital gain
character in the hands of the corporation or partnership.
Also, in the case of a sale or exchange where the seller is
allowed nonrecognition of gain on the transaction because he
acquires an asset similar to the asset disposed of, the
capital gain account should attach to the newly acquired
asset. For example, if a taxpayer is to be allowed nonrecognition treatment on the sale of a personal residence
where another residence is acquired within a specified time,
the capital gain account would attach to the new residence.
Rules also would be needed to take into account an
increase or decrease in the basis of the property after the
effective date. An increase in the basis of the property
generally should not decrease the capital gain account,
since the increase in basis generally will be accompanied by
an increase in the fair market value of the asset (for
example, where a shareholder contributes cash to a corporation)^ the increased fair market value due to the increase
in basis would, when recognized, represent a return of the
investment increasing the basis. On the other hand, a
decrease in basis resulting from a deduction against ordinary income should reduce the capital gain account (i.e.,
code sections 1245, 1250, and other recapture provisions
currently in the code that prevent the conversion of ordinary income into capital gain because of excess depreciation deductions or other means should continue to apply).
In general, if the taxpayer's basis in an asset is required
to be allocated among several assets (such as is required
with respect to a nontaxable stock dividend) the capital
gain account should be allocated in a similar manner.
Special rules also would be needed for section 1231
property, since net gains from the sale of such assets
qualify for capital gains treatment. 6/ A workable rule
would be to apply section 1231 to assets that qualify as
section 1231 assets in the hands of the taxpayer on the
general effective date, and continue to so qualify as of the
date of sale or other taxable disposition. Such property
would have a "section 1231 account" similar to the capital
gain account attaching to each asset. Similar rules relating to transfers, basis adjustments, etc., also would
apply.
Since an asset may be held for an indefinite period, a
cutoff date for capital gains treatment is needed; otherwise,
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the complexity of the capital gains provisions in the code
would continue for at least a generation. (Under the
proposal, donors and decedents would be required to recognize
gain or loss on the assets transferred, subject to certain
exceptions and, thus, the capital gain account would not
carry over to a donee or heir.) Accordingly, at the end of
a specified period (say, 10 years), the capital gains
deduction and the alternative tax treatment would expire.
Admittedly, some of the equity problems resulting from
immediate repeal of the capital gains provisions would
remain even if complete repeal were delayed 10 years. The
10-year phase-out period, however, would allow gradual
market adjustments and help protect the interests of investors who purchased assets in reliance on the current
capital gains provisions.
An alternative to the capital gain account (and section
1231 account) procedure would be to phase out the deduction
for capital gains (and the alternative tax) ratably over a
specified number of years. For example, the 50-percent
deduction for capital gains could be reduced five percentage
points a year, so that at the end of 10 years the deduction
would be eliminated. The simplicity of this alternative is
the best argument for its adoption, since no valuation as of
a particular date would be required.
Corporate Integration
Under the comprehensive income tax, corporations would
not be subject to tax. Instead, shareholders would be
taxable on their prorata share of corporate income, or would
be allowed to deduct their prorata share of corporate loss.
(See the discussion in chapter 3.)
The most significant transitional problems involve the
question of timing and the treatment of income, deductions,
credits, and accumulated earnings and profits that are
earned or accrued before the effective date of the changeover to integration but that would be taken into account for
tax purposes after such date. Other transition problems
related to the foreign area are discussed in chapter 3.
Pre-effective Date Retained Earnings. Perhaps the most
difficult transition problem posed by corporate integration
is the treatment of corporate earnings and profits that are
undistributed as of the effective date of integration. Such
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earnings would have been taxed to the shareholders as
dividends if distributed before the effective date, or taxed
at capital gains rates if recognized by means of sale or
exchange of the stock.
Under corporate integration,
distributions made by a corporation to its shareholders
would be tax-free to the extent of the shareholder's basis;
distributions in excess of the shareholder's basis in his
stock would be taxable. However, corporate earnings and
profits accumulated before the effective date but distributed
afterward should not be accorded tax-free treatment; to do
so would discriminate against corporations that distributed
(rather than accumulated) their earnings and profits in preintegration taxable years. (In the case of shareholders who
are content to leave the accumulated earnings and profits in
corporate solution, however, the effect of corporate integration
on the income generated by such accumulated earnings may
give the same result as if such earnings had been distributed
tax-free, since such income would be taxed directly to the
shareholders, without the interposition of corporate tax,
and would then be available to the shareholders as a taxfree dividend.)
The problem of accumulated earnings can be addressed by
continuing to apply current law to corporate distributions
that are made within 10 years after the effective date of
integration and that (1) are made to persons who held the
shares on such effective date with respect to which the
distribution is made, and (2) are made out of earnings and
profits accumulated before such date. Thus, a distribution
to such shareholders out of earnings and profits accumulated
by the corporation before the first taxable year to which
corporate integration applies would be a dividend, taxable
as ordinary income, unless the distribution would qualify
for different treatment under current law. For example, a
distribution received pursuant to a redemption of stock that
is not essentially equivalent to a dividend under current
law would continue to be treated as a distribution in part
or full payment in exchange for the stock. On the other^
hand, an attempt to bail out the pre-effective date earnings
and profits by means of a partial redemption of stock that
would be treated as a dividend distribution under current
law would continue to be so treated. The provisions of
current law relating to electing small business (subchapter
S) corporations would be helpful as a model in draf ting ^ this
particular transition proposal. For purposes of determining
how much of a distribution that is treated as a sale or #
exchange under current law would qualify for special capital
gains treatment, the transition rules outlined above for
changes in taxation of capital gains would apply.
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In general, distributions with respect to stock acquired in a taxable transaction after the effective date
would be subject to the new rules, and wouldreduce basis
and not constitute income (unless such distributions exceeded the shareholder's basis). However, in those cases
where the transferee acquired the stock after the effective
date without recognition of gain by the transferor, current
law would continue to apply to distributions from preeffective date accumulated earnings and profits.
Distributions after the effective date would be deemed
to be made first from the shareholder's distributable share
of the corporation's post-effective date income and then
from pre-effective date earnings and profits (similar to the
subchapter S rules). Distributions in excess of these
amounts would be applied against and reduce the shareholder's
basis in his stock. Amounts in excess of the shareholder's
basis generally would be considered income.
In order to avoid indefinite retention of such a dual
system of taxation, the special treatment of pre-effective
date earnings and profits would cease after a specified
number of years following the effective date of integration.
Distributions received after such date, regardless of
source, first would be applied against basis and would be
income to the shareholder to the extent they exceed basis.
As previously indicated, pre-integration accumulated earnings and profits remaining after this date will not escape
taxation completely at the shareholder level, since such
earnings will be reflected in the gain recognized on a
subsequent taxable transfer of the stock (such as a sale or
a transfer by gift or at death), or may be taxed as a distribution
in excess of basis. Before fixing the cutoff date for this
provision, an effort should be made to determine quantitatively
the extent of the benefit to the shareholders of the deferral
of such taxation.
An alternative proposal was considered in an attempt to
preserve the ordinary income character of distributions from
pre-effective date earnings. This proposal would treat a
shareholder as receiving a "deemed dividend" (spread ratably
over a 10-year or longer period) in an amount equal to the
lesser of the excess of the fair market value of the share
of stock as of the effective date over its adjusted basis,
or the share's prorata portion of undistributed earnings and
profits as of such date. This proposal was rejected because
of its complexity and because of the likelihood of substantial liquidity problems for certain shareholders.
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Carryovers and Carrybacks. The carryover or carryback
of items ot income, deduction, and credit between taxable
years to which the corporate income tax applies, and taxable
years to which it does not, must be considered for purposes
of the transition rules. To the extent practicable, an
attempt should be made to treat such items in a manner that
reflects the impact of the corporate income tax as in effect
when such items were earned or incurred. In following this
approach, however, no attempt should be made to depart from
the general rules requiring that an item of income or loss
be recognized before it is taken into account in computing
gross income. Accordingly, unrecognized appreciation or
decline in value of corporate assets (or stock of the
corporation) attributable to the pre-effective date period
should not be "triggered" or recognized solely because of
the shift to full integration.
In general, certain deductions and credits may carry
back to a preceding taxable year or carry over to a subsequent taxable year because of a limitation on the amount of
such deduction or credit that the taxpayer may claim for the
taxable year in which the deduction is incurred or the
credit earned. Thus, for example, a net operating loss
carryback or carryover arises because the taxpayer's deductions exceed his gross income. Capital loss deductions
are limited to capital gains, deductions for charitable
contributions are limited to a certain percentage of income,
and the investment tax credit is limited to a percentage of
the tax due. Also, the recapture as ordinary income, after
the effective date, of deductions allowed and other amounts
of income upon which tax has previously been deferred in
pre-effective date years, has the effect of shifting that
income to post-effective date years.
If income sheltered by a deduction (or income that
would have been sheltered had the deduction been utilized in
an earlier year) had been distributed as a taxable dividend,
the net after-tax effect on the shareholder of the deferral
or acceleration of a deduction would depend on his marginal
tax bracket. In general, if the shareholder is in a lower
bracket, he may realize more total after-tax income if the
deduction is utilized in a pre-effective date year in which
the corporate tax applies and in which the tax savings at
the corporate level are distributed as a dividend. If the
taxpayer is in a higher bracket, he may realize more total
after-tax income if the deduction is utilized in computing
his distributable share of taxable income after integration.
To best approximate the net result that would occur if such
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items could be used in the year incurred or earned, unused
deductions and credits incurred or earned in pre-effective
date years should be given an unlimited carryback to earlier
years of the corporation. In many cases this would benefit
the taxpayer because he would receive a tax refund from such
carryback earlier than he would tinder current law. Such
benefits could be avoided to a large extent by charging the
taxpayer an appropriate amount of interest for advancement
of the refund
Deductions that could not be absorbed in pre-effective
date years would be allowed to be carried in full to posteffective date years, subject to the limits established on
the number of succeeding taxable years to which the item may
be carried. In general, however, deductions carried over
from a pre-effective date year should not flow through to
the shareholders, either directly or indirectly, for use in
offsetting the shareholder's income from other sources, but
should be available only as deductions at the corporate
level in order to determine the shareholder's prorata share
of corporate income. This would avoid retroactive integration
with respect to such deductions, since the deduction would
not flow through when incurred; it also would avoid possible
abuses by means of trafficking in loss corporations. Ordinary
income upon which tax was deferred in pre-effective years
should continue to be subject to recapture as ordinary
income.
Generally, the carryover to a post-integration year of
a tax credit earned in a pre-effective date taxable year
would result in a windfall for the shareholder. If the
credit had been used to offset corporate income tax in the
year in which it was earned, the amount representing the tax
at the corporate level offset by the credit would have been
taxable to the shareholder, either when distributed as a
dividend or when realized by means of sale of the stock.
Accordingly, a rule should be devised by which the tax
benefit of a credit carryover approximates the benefit that
would result if the amount of the credit first offset a
hypothetical corporate tax and then was distributed to the
shareholder as a taxable dividend (or, perhaps, realized as
capital gain).
In general, no losses incurred or available credits
earned in post-effective date years would carry back to preeffective date years, since such items would flow through to
the shareholders after the effective date of integration.
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Under present law, certain taxpayers, such as regulated
investment companies, real estate investment trusts, and
personal holding companies, receive a dividends-paid deduction for a taxable year even though the distribution is
actually made in a subsequent year. Such distributions in
post-effective date years should be allowed to relate back
to the extent provided by current law for the purpose of
determining the corporate tax liability for the appropriate
pre-effective date year. The distribution would be considered to be out of pre-effective date earnings and profits
(whether or not it exceeds the amount in such account) and
taxable to the shareholders as a dividend from that source.
Rules will have to be provided to insure that, if an
investment tax credit earned by a corporation in a preeffective date taxable year is subject to recapture because
of an early disposition of the property, the credit also is
recaptured, either from the corporation or the shareholders.
This could be accomplished at the corporate level by imposing an excise tax on the transfer or other recapture
event in an amount equal to the appropriate income tax
recapture.
Flow-Through of Corporate Capital Gains. During the
phase-out period for capital gains, the net capital gain or
net capital loss for taxable years after the effective date
of corporate integration should be computed at the corporate
level with respect to sales or exchanges of capital assets
or section 1231 property by the corporation. The character
of such net capital gain or net capital loss should flow
through to the shareholders.
Flow-Through of Tax-Exempt Interest. If the character
of capital gains is to flow through to shareholders, consistency would require that the character of any remaining
tax-exempt interest received or accrued by a corporation
after the effective date of corporate integration from any
State or municipal bonds that are grandfathered also should
flow through as tax-exempt interest to the shareholders.
The tax-free character of the interest to shareholders would
be preserved by increasing reducing the shareholder's basis
by the amount of the interest attributable to him, but not
including such interest in taxable income. Distribution
would be treated as under the new law -- as a reduction of
basis, but not included in income. Thus, such interest, if
distributed, would leave both taxable income and basis
unchanged.
- 200 Generally, under present law, State and municipal bond
interest is received tax-free by the corporation, but is
taxable as a dividend when distributed to shareholders. The
1976 Tax Reform Act, however, provides that, in certain
cases, the character of tax-exempt interest distributed by a
regulated investment company flow through as tax-exempt
interest to its shareholders. 7/ If it is determined that
the tax-exempt character of State and municipal bond interest
received by all corporations should not flow through to
shareholders, an exception should be made for regulated
investment companies that have relied on the flow-through
provisions of the 1976 Tax Reform Act.
Unique Corporate Taxpayers. The provisions of the tax
code relating to taxation of insurance companies and other
unique corporate taxpayers will have to be examined to
determine what adjustments, if any, are required to take
into account the effect of corporate integration on the
special rules applying to such taxpayers. The determination
of appropriate transition
rules will depend on the nature
of any changes made to the basic provisions.
Business and Investment Income, Individual and Corporate
In general, the repeal of code provisions that provide
an incentive for certain business-related expenditures or
investments in specific assets should be developed to minimize
the losses to persons who made such expenditures or investments
prior to the effective date of the new law. The principal
technique to effectuate this policy would be to grandfather
actions taken under current law. For example, any repeal of
a tax credit (such as the investment tax credit) and any
requirement that an expenditure that is currently deductible
(such as soil and water conservation expenditures) must be
capitalized should be prospective only. 8/ Subject to the
rules prescribed above for corporations, unused tax credits
earned in pre-effective date years should be available as a
carryover to taxable years after the effective date to the
extent allowed under current law. The repeal of special
provisions allowing accelerated amortization or depreciation
of certain assets generally should apply only with respect
to expenditures made or assets placed in service after a
specific cutoff date. The revised general depreciation and
depletion rules should apply to property placed in service
or expenditures made after an effective date. Thus, for
example, buildings would continue to be depreciable in the
manner prescribed by current law only in the hands of their
current owners. A taxpayer who acquires a building and
places it in service after the effective date would be
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subject to the new rules. Although this could result in
losses in asset value for the current owners, grandfathering
the asset itself could, particularly in the case of buildings,
delay the effect of the new rules for an unacceptable period.
The deduction for local property taxes on personal
residences should be phased out by allowing deduction of a
declining percentage of such taxes.
The exclusion from gross income of interest on State
and municipal bonds and certain earnings on life insurance
policies should continue to apply to such interest and
earnings on bonds and insurance policies that are outstanding
as of the effective date.
When adoption of the comprehensive income tax results
in ending those provisions of current law that allow the
nonrecognition of gain (or loss) on sales or exchanges of
particular assets, such changes should be effective immediately,
with no grandfather clause. It is unlikely that the original
deQision to invest in such assets depended on an opportunity
to make a subsequent tax-free change in investment. An
exception may be appropriate, however, with respect to a
repeal of the provision that excludes from gross income the
value of a building constructed by a lessee that becomes the
property of the lessor upon a termination of the lease. A
grandfather clause should apply current law to the termination
of a lease entered into before the effective date.
The proposal would allow an adjustment to the basis of
an asset to prevent the taxation of "gain" that is attributable to inflation and that does not reflect an increase in
real value of the asset sold by the taxpayer. The inflation
adjustment should be applied with respect to inflation
occurring in taxable years after the effective date. Making
such an adjustment retroactive would result in a substantial
unanticipated gain for many asset holders.
Other Individual Income
Under the comprehensive income tax, several kinds of
compensation and other items previously excluded would be
included in gross income, and deductions for a number of
expenditures that can be considered personal in nature would
be disallowed.
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Employee Compensation. Such items as earnings on
pension plan reserves allocable to the employee, certain
health and life insurance premiums paid by the employer,
certain disability benefits, unemployment benefits, and
subsidized compensation would be included in gross income.
It may be presumed that existing employment contracts
were negotiated on the basis that such items (other than
unemployment compensation) would be excluded from the
employee's gross income, particularly in those cases where
the exclusion reflects a policy of encouraging that particular type of compensation. In the absence of special
transition rules, the inclusion of such items in income
could create cash flow problems or other hardships for
employees under such contracts. For example, a worker who
is required to include in income the amount of his employer's
health insurance plan contribution may have to pay the tax
on this amount from what was previously "take home" pay if
he cannot renegotiate his contract.
This problem can best be solved by an effective date
provision that would apply the new rules to compensation
paid in taxable years beginning after a period of time to
allow employers and employees to adjust to the new rules.
Thus, the tax-free status of items paid by employers on the
date of enactment would continue for a specified period,
such as 3 years. Alternatively, the inclusion of these
items of income could be phased in over such a period,
including one-third after 1 year, two-thirds after 2 years,
and the full amount after the third year. Special rules for
military personnel could be devised to grandfather servicemen
through their current enlistment or term of service. Earnings
of a qualified pension plan allocable to the employee that
are attributable to periods before this delayed effective
date would not be included in the gross income of the employee.
However, earnings attributable to periods after that date
(as extended with respect to binding contracts) would be
included in gross income as accrued.
Generally, unemployment compensation, which would be
included in taxable income under the proposal, would not
represent a return of a tax-paid basis to the recipient,
since the "premiums," or employer contributions, with respect
to such compensation were not included in his gross income.
Thus, the full amount of such compensation should be included
in taxable income immediately after the general effective
date.
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Medical and Casualty Loss Deductions. Under the
comprehensive income tax, certain nonbusiness expenditures,
such as casualty losses, and medical and dental expenses,
would cease being deductible. Generally, the repeal of the
deductibility of these expenses could be effective immediately.
If the medical expense deduction is replaced by a catastrophic
insurance program, or some other program to achieve the
same ends, repeal of the deduction should coincide with the
effective date of the substitute program.
Charitable Deductions. This provision should be phased
in if the deductibility of charitable contributions is
eliminated under the model comprehensive income tax. To the
extent that direct public subsidies to the affected institutions
do not replace the loss in private gifts from removal of the
tax incentive for contributions, both employment in and
services to beneficiaries of such institutions would decline
greatly. A gradual phase-in would increase the extent to
which employment losses occur through gradual attrition
rather than layoffs and would aid in identifying the types
of charitable recipients who might require greater direct
public assistance when the deduction is completely ended.
One possible method of phase-in would be to allow a declining
fraction of contribution to be deductible in the first few
years of the effective date.
Other Items Previously Excluded. The inclusion in gross
income of scholarships, fellowships, and means-tested cash
and in-kind government grants would not appear to present
any transition problems because, generally, the amounts of
these items were not bargained for by the recipient and do
not represent a return of a tax-paid basis.
Treatment of Retirement Benefits. Under the comprehensive
income tax, retirement benefits, including social security
benefits and private pensions, will be included in the tax
base, while contributions to private pension funds and to
social security by both employees and employers will be
exempted from any concurrent tax liability. A significant
transition problem arises from this feature of the comprehensive
income tax. In the absence of special transition rules,
currently retired persons would be required to pay tax on
the return of private pension contributions that had
already been taxed. While the link between contributions
and benefits is not so direct for social security, it still
would be unfair to include social security benefits in the
taxable income of persons who have been retired as of the
effective date, again, because these taxpayers have paid tax
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on the part of income represented by employee social security
contributions throughout their working years. Thus, persons
retired as of the effective date should not have to pay tax
on private retirement benefits which represent a return of
contribution or on social security benefits. On the other
hand, benefits paid by qualified pension plans that allowed
deductibility of post contributions, should remain fully
taxable, as under present law.
More complex provisions are required for retirement
income of taxpayers who are in the middle of their working
years as of the effective date. Such taxpayers will have
been taxed on the employee portion of retirement contributions
up to the effective date, but not afterwards. Thus, it
seems fair that they should pay tax on a fraction of the
retirement benefits which represent return of contribution,
the fraction bearing some relation to the portion of the
contributions that were excluded from taxable income. The
general rule proposed is to include in the tax base a fraction
of retirement income that represents return of contribution
to an employee-funded pension plan. The fraction would
depend on age at the effective date, ranging from 0 for
taxpayers age 60 or over to 1 for taxpayers age 20 or under.
A table could be provided in the tax form relating date of
birth to the fraction of such income that is taxable. A
similar treatment is proposed for social security benefits.
Treatment of Gifts and Transfers at Death as Recognition
Events. Under the proposal, gifts and transfers at death
would be treated as recognition events. Thus, in general,
the excess of the fair market value of the asset transferred
over its adjusted basis in the hands of the donor or decedent
would be included in the gross income of the donor or decedent.
The portion of such gains attributable to the period
before the effective date of any such recognition rule
should be exempted. Provisions for such an exemption were
made in the Tax Reform Act of 1976 in connection with the
carryover basis at death rule. The gains deemed to have
accrued after the effective date would be taxable on transfer
at the same rates applying to other sources of income.
TRANSITION TO A CASH FLOW TAX SYSTEM
This section presents a proposal for transition from
the current system to the model cash fXow tax proposed in
chapter 4. The problems involved in a transition to the
cash flow tax would be considerable, and all of the alternative
methods considered have major shortcomings. Presentation of
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this proposal includes discussion of administrative difficulties
and some possible distributive inequities, and an explanation
of why certain alternative plans were rejected.
In summary, the proposed transition plan would maintain
the present tax alongside the cash flovz tax for 10 years
before total conversion to the cash flow tax. During the
transition period, individuals would compute their tax
liability under both systems and would be required to pay
the higher of the two taxes. The corporate income tax would
be retained for the interim and would be discontinued
immediately at the end of the 10-year period. At that time,
unrealized capital gains earned prior to full adoption of
the cash flow tax would be "flushed" out of the system
through a recognition date, at which point they would be
taxed at the current capital gains rates. Payment of taxes
on past capital gains could be deferred, at a low interest
charge, to prevent forced liquidation of small businesses.
The transition program outlined here would not fully
realize the goals of transition presented below. It would,
however, mitigate the redistribution of wealth that would
result from immediate adoption of a cash flow tax and would
simplify the tax system by eliminating, within a reasonable
period of time, the need to keep the personal and business
income tax records currently required.
Goals of Transition
The main objectives to be realized by the transition
rules for the cash flow tax are: (1) prevention of immediate
or long-term redistribution of economic welfare, and (2)
simplicity and administrative ease. Although some changes
in consumption opportunities would be inevitable in a tax
change as major as the one proposed, the proper transition
program should be able to minimize large redistributions
among taxpayers in ability to consume immediately and in the
future. In particular, this program should prevent heavy
additional tax liabilities (in present-value terms) for any
clearly identifiable group of taxpayers. For purposes of
simplicity, transition rules should eliminate the present
tax system and its recordkeeping requirements promptly and,
to the extent possible, avoid measuring current accumulated
wealth and any annual changes in individuals' total wealth
Positions in the transition period, as well as afterward.
After transition, the principal records for tax purposes
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would consist only of cash flow transactions for business
activities, net deposits and withdrawals in qualified
accounts, the usual wage and salary data, and transfer
payments.
Distribution Issues
Two distribution issues are important in a transition
to the cash flow tax: (1) treatment of untaxed income before
the effective date and (2) changes in the distribution of
after-tax consumption.
Equitable treatment of income untaxed before the
effective date would require that an individual who had
unrealized capital gains at the time of adoption of the new
system be treated in the same way as the individual who
realized the capital gains before the effective date. The
practical problems involved in achieving this goal influence
the specifics of the transition proposal discussed below.
The treatment of past accumulated income that has been
taxed poses a more difficult problem of equity. Because the
cash flow tax is, in an important sense, equivalent to
exempting income from capital from tax, as outlined in
chapter 4, a higher tax rate on current wages not saved
would be required to maintain the same tax revenue. Thus,
the short-term effect of a cash flow tax wcruld be a higher
after-tax rate of return from ownership of monetary or
physical assets regarded as tax prepaid and a lower aftertax wage rate. The distributive consequences of this change
could be modified if some or all of accumulated wealth were
to be treated as if already held in qualified accounts;
i.e., subject to tax upon withdrawal for consumption.
If existing wealth were to be regarded as tax-prepaid
under the new system, all future returns from such assets,
as well as return of principal, would not be subject to tax.
On the other hand, if existing wealth were to be regarded as
receipts in the first year of the cash flow tax, an equally
logical approach, consumption of principal would be taxed,
though the present value of tax liability would not increase
as assets earned accrued interest, as it would under an
income tax.
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Table 1 illustrates the tax treatment, under a comprehensive
income tax and under the two alternative methods of transition to the cash flow tax, of consumption out of $100 of
past accumulated assets for different times at which wealth
is withdrawn for consumption. A tax rate of 50 percent is
assumed, assessed on annual interest earnings in the case of
an income tax.
Table 1
Potential Consumption Out of Accumulated
Wealth Under Different Tax Rules
Initial Wealth = $100
Assets Accumulate at 10 Percent Per Year If Untaxed;
5 Percent Per Year If Taxed
Cash Flow Tax;
Years After
Effective Date Income Tax
Cash Flow Tax;
Asset Tax-Prepaid
Asset in Initial
Receipts
0 $100 $100 $ 50
10 $163 $259 $130
20 $265 $673 $336
Under a comprehensive income tax, the asset could be
withdrawn and consumed tax-free, but future accumulation
would be taxed. 9/ Under the cash flow tax, with the asset
defined as tax-prepaid, returns from the asset would be
allowed to accumulate tax-free and could also be withdrawn
and consumed tax-free. Under the cash flow tax, with the
asset value initially included in the tax base, consumption
from the asset would be taxed upon withdrawal, but the rate
of accumulation of the asset would not be affected by the
tax.
A transition to a cash flow tax with assets initially
defined as tax prepaid would increase the welfare of owners
of assets.
The after-tax consumption of these taxpayers
would increase under the new system unless they consumed all
of their wealth within the first year after the effective
date, in which case consumption would be unchanged. If
assets were initially included in the tax base, however, the
a
fter-tax consumption of owners of assets would decrease if
they chose to consume a large portion of their wealth m the
early years after the effective date. Inclusion of assets
- 208 -
in the base would increase after-tax consumption relative to
an income tax for asset-holders who deferred consumption out
of accumulated wealth for a long period. 10/
. As Table 1 illustrates, how past wealth is viewed would
make a big difference in the present value of tax liabilities.
Inclusion of accumulated assets in the tax base would
be unfair to older persons who are about to consume out of
accumulated wealth during the retirement period, if the
income from which this wealth was accumulated had been
subject to tax during their working years. On the other
hand, tax-prepaid designation would greatly benefit all
owners of monetary and physical assets by redistributing
after-tax dollars from labor to capital. Although returns
from assets would in effect be nontaxable under a fully
operational cash flow tax, past accumulation of wealth would
have occurred under a different tax system, where individuals
did not anticipate a sharp rise in the after-tax return to
capital. Thus, tax-prepaid treatment of capital assets for
transition purposes may be viewed as inequitable.
The distribution problem caused by defining existing
capital assets as prepaid would be reduced over time. The
increased incentive to savings provided by the cash flow tax
should raise the rate of capital formation, increasing the
amount of investment and eventually lowering before-tax
returns to capital and raising before-tax wages. However,
in the first few years after transition, higher tax rates on
current wages would not be matched by a corresponding increase
in before-tax wages.
For certain types of assets, the appropriate rule for
transition definition is clear. Under the present system,
investments in owner-occupied houses and other consumer
durables are treated very similarly to tax-prepaid investments,
and they should be defined as prepaid assets for purposes of
transition to a cash flow tax. The accrued value of employerfunded pension plans should be treated in the same manner as
qualified accounts, because the contributions were exempt
from tax under the old system and the receipts were fully
taxable.
Designation of past accumulated assets as tax-prepaid
assets would be the easier transition to administer. There
would be no need to measure existing wealth. Tax-prepaid
assets could be freely converted to qualified assets to
- 209 -
enable the individual to average his tax base over time. An
individual converting a tax-prepaid asset to a qualified
asset would be able to take an immediate tax deduction, but
would become liable for taxes upon withdrawal of principal
and subsequent earnings from the qualified account. U 7 If
assets were defined initially to be part of an individual's
tax base, it would be necessary to valuate them on the
effective date. Individuals would have an incentive to
understate their initial wealth holdings. Assets not
initially accounted for could be deposited in qualified
accounts in subsequent years, enabling an individual to take
a deduction against other receipts.
A Preliminary Transition Proposal
Considering the objectives of basic reform (equity,
simplicity, efficiency), it seems best to define all assets
initially in transition to the cash flow tax as prepaid
assets. For a period of 10 years, the existing tax code
would be maintained, with taxpayers filing returns for both
tax systems and paying the higher of the two computed taxes. 12/
For most taxpayers, the cash flow tax would be higher.
However, for persons with large amounts of income from
assets relative to wages, the current tax would be probably
higher.
The corporate income tax would be retained throughout
the transition period. Theoretically, stockholders paying
the cash flow tax should receive their corporate earnings
gro&s of corporate tax during the interim period. However,
without full corporate integration, whereby all earnings
would be attributed to individual stockholders, it would be
practically impossible to determine what part of a corporation's earnings should be attributed to individuals paying
the consumption tax and what part, to individuals paying tax
under the old law. It is likely that ownership of corporate
shares would be concentrated among individuals who would be
subject to the current tax during the interim period. For
reasons of simplicity, therefore, the corporate tax would be
retained for the transition period and would be eliminated
immediately afterward.
All sales of corporate stock purchased before the
beginning of the transition period by individuals paying
under either tax base would be subject to a capital gains
tax at the existing favorable rates. The reason for this
- 210 -
provision is that capital gains which were accrued but not
realized before the interim period should be taxed as if
they were income realized at the effective date. 13/
This
is not administratively attractive, so for 10 years all
capital gains would be taxed on realization, whichever tax
base the individual was using.
A recognition date would be required at the end of the
transition period to account for all remaining untaxed
capital gains. Under the cash flow tax, with assets defined
as prepaid and no records of current and past corporate
earnings and profits kept, it would be impossible to distinguish
between distributions that were dividends out of current
income and distributions that were return of accumulated
capital. The dividends would not be subject to tax under
the new law. Distributing past earnings would be a way of
returning to the individual tax-free, the capital gains
which had arisen prior to the adoption of the cash flow tax.
To eliminate the need for permanent corporate records to
capture this past income, it would be necessary to have a
single day of recognition for past gains at the end of the
transition period.
However, it would be possible to develop a method of
allowing the final capital gains tax assessed on the recognition
date to be paid over a long period at a low interest rate,
to avoid forced liquidation of small firms with few owners.
The advantages of the transition proposal outlined here
are the following:
1. It would enable all of the simplifying features of
a cash flow tax to be in full operation after 10
years, including elimination of tax records
required under the present code, but not under the
cash flow tax.
2. It would allow consumption out of past accumulated
earnings to be exactly the same as it would have
been under the current tax during the first years
after the effective date.
3. It would provide for appropriate and consistent
taxation of income earned before the effective
date.
- 211 -
4.
By eliminating taxes on returns earned after the
effective date from past accumulated assets only
on a gradual basis, it would mitigate the redistribution
of wealth to current asset owners that would occur
after immediate full adoption the cash flow tax.
The major disadvantages of this transition program are
that it would require a recognition date that would impose a
large, one-time administrative cost on the system, and it
would require some taxpayers to fill out two sets of tax
forms for a period of 10 years, a temporary departure from
the long-term goal of simplicity.
Alternative Transition Plans
One alternative plan would be to adopt the new tax
system immediately, designating all assets as prepaid,
without a recognition date to flush out past capital gains.
Although this plan would be the simplest one, it would give
too great an economic advantage to individuals with unrealized asset appreciation and would cause too large a
transfer of future after-tax consumption to present asset
owners.
Another transition plan would be to adopt the cash flow
tax immediately and designate all assets as receipts in the
first year.
This would require valuating all wealth on the
effective date and imposing a one-time wealth tax. Such an
approach would be harsh on older persons planning to live
off accumulated wealth in the early years after the effective
date.
A complicated variation on tax-prepaid treatment of
assets would be one under which, in exchange for the
elimination of taxes on consumption of assets defined as ^
tax-prepaid, an initial wealth tax related to an individual s
personal circumstances would be imposed.
For example, the
initial tax could be based on age and wealth, with higher
rates for persons with more wealth and lower rates for older
persons. 14/ Although it might provide a transition program
that A
approximates
distributive
a plan would
third option
would allowneutrality,
three typessuch
of assets:
taxbe
a
significant
departure
from
the
goal
of
simplicity.
Prepai
id, as defined above; qualified, as defined above; and
- 212 -
a third type, which would treat assets as defined under the
current system. In principle, it would be desirable for
persons to be able to consume out of the third type of
assets tax-free and to invest in prepaid and qualified
assets only out of savings from current income. In effect,
this plan would initiate cash flow taxation on current
earnings only and would treat pre-effective date earnings
exactly as they are treated under the current system,
including the same treatment of post-effective date capital
accumulation from pre-effective date wealth. This plan
would be extremely difficult to administer. Not only would
individuals have to keep books for three types of assets,
but total annual wealth changes also would have to be
computed, in order to arrive at a measure of annual consumption. (Valuation of unsold assets would not be a
problem because even if too high a value were imputed,
raising both measured wealth and saving, consumption would
remain unchanged.) Treatment of corporate income under this
system also would be complicated, because some investments
in corporate stock would come from all three types of
assets.
Under this transition alternative, assets of the third
type would be subject to a transfer tax and converted to
prepaid assets at death. Eventually, these assets would
disappear from the system, and the complete cash flow tax
would be in operation. Alternatively, all assets of the
third type could be designated prepaid after a fixed number
of years.
Although the three-asset plan has the advantage of
treating owners of capital exactly as they would have been
treated under the income tax, and would change the rules
only for new wealth, 15/ its administrative complexity
raises very severe problems.
- 213 -
Footnotes
The exact change in the rate of taxation on income
earned in corporations for different taxpayers will
depend on the fraction of corporate income currently
paid out in dividends, the current average holding
period of assets before realizing capital gains, and
the taxpayer's rate bracket. While the current corporate
income tax does not distinguish among owners in different
tax brackets, integration, which would attribute all
corporate earnings to the separate owners, would tax
all earnings from corporate capital at each owner's
marginal tax rate.
The taxpayer could avoid this problem by selling his
shares before the effective date at the current lower
capital gains rate and then buying them back. However,
one other objective of transition rules, discussed in
the next section, should be to avoid encouraging market
transactions just prior to the effective date.
For example, workers damaged by employment reductions
in industries with increasing imports due to liberalized trade policies are eligible for trade adjustment
assistance.
Note that is is not clear just what is meant by an
"existing asset" in this context. For example, a
building is greatly affected by maintenance and improvement expenditures over time.
Appropriate depreciation schedules are those that
conform most closely to the actual rate of decline in
asset values.
Section 1231 property is generally certain property
used in the taxpayer's trade or business. If gains
exceed losses for a taxable year, the net gains from
section 1231 property are taxed at capital gains rates;
if losses from section 1231 property exceed gains, the
net
losses
treated
as ordinary
losses. the charact
In the
character
caseare
of a
subchapter
S corporation,
of net capital gains flows through to the shareholder.
The character
Lracter of tax-exemp
tax-exempt interest does not.
Expenditures made pursuant to binding contracts entered
into before the effective date also should be grandtatnere
- 214 -
The income tax computation assumes that all returns to
investment would be taxed as accrued at full rates. Thus,
the annual percentage rate of after-tax interest under
the income tax would be cut in half. Under the present
law, taxation of capital gains is deferred until realization and then taxed at only one-half the regular rate.
For example, if the asset is sold after 20 years,
potential after-tax consumption would be $530, which is
computed by multiplying the long-term capital gain of
$573 by .75 (the taxpayer is assumed to be in the 50
percent bracket) and adding the return of basis. It
should be noted, however, that, if the asset is corporate
stock, profits are also subject to an annual corporate
tax. Combining the effects of corporate and personal
taxes, the income of the asset holders may be taxed
under current law at either a higher or lower rate than
the rate on wage and salary income, depending on assumptions
about the incidence of taxes.
For example, if the before-tax interest rate were 10
percent, wealth would quadruple in 15 years. With the
50-percent tax rate used in Table 1, wealth holders
would be better off under the consumption tax, even if
their assets were initially included in receipts if
they deferred consumption out of wealth for at least 15
years, obtaining a deduction against receipts in the
first year by placing the asset in a qualified account.
A wealthy person could appear to "shelter" his current
consumption by converting prepaid assets into qualified
assets, deducting the deposits in qualified assets from
current wage and other receipts.
However, this
practice would not reduce the present value of his tax
base, because he would have to pay a tax on the principal
and accumulated interest whenever the qualified asset
It is
possible for
thatconsumption.
only wealthy persons should be
was
withdrawn
required to fill out a return for the current personal
income tax. The main reason for retaining the current
tax would be to tax returns from past accumulated
wealth for an interim period of time to mitigate the
inequitable distribution effects of a transition to
- 215 -
tax-prepaid treatment of assets. It is likely that
only people with significant amounts of wealth would
have a higher liability under the current tax. The
requirement to file two income tax returns might be
limited to taxpayers reporting an adjusted gross income
above a certain minimum level (for example, $20,000 or
more) in any of several years before the effective
date.
13/ Technically speaking, individuals paying the cash flow
tax during the interim period should not have to pay
capital gains tax between the first day of the interim
period and the time as asset is sold. One way to avoid
this would be to adjust the basis upward to conform to
interest that would have been earned on a typical
investment after the beginning of the interim period.
By doing this, the present value of capital gains tax
paid for assets growing at that interest rate would be
the same as if the gain were realized on the effective
date.
14/ Because the wealth of older persons might be subject to
the accessions tax sooner, it might not be necessary
for reasons of equity to tax it on the effective date.
15/ The three-asset plan can be viewed as a sophisticated
form of "grandfathering."
- 217 -
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•fr U.S. GOVERNMENT PRINTING OFFICE : 1977—O227-320
D E P A R T M E N T OF T H E TREASURY
WASHINGTON, D.C. 20220
P O S T A G E A N D FEES PAID
DEPARTMENT OF THE TREASURY
OFFICIAL BUSINESS
P E N A L T Y F O R PRIVATE USE $300
TREAS-551
FIRST CLASS
FOR RELEASE AT 4:00 P.M.
January 18, 1977
TREASURY'S WEEKLY BILL OFFERING
The Department of the Treasury, by this public notice, invites tenders for
two series of Treasury bills to the aggregate amount of $6,100 million, or
thereabouts, to be issued January 27, 1977,
as follows:
91-day bills (to maturity date) in the amount of $2,500 million, or
thereabouts, representing an additional amount of bills dated October 28, 1976,
and to mature April 28, 1977
(CUSIP No. 912793 F8 4), originally issued in
the amount of $ 3,501 million, the additional and original bills to be freely
interchangeable.
182-day bills, for $3,600 million, or thereabouts, to be dated January 27, 1977
and to mature July 28, 1977
(CUSIP No. 912793 J3 1).
The bills will be issued for cash and in exchange for Treasury bills maturing
January 27, 1977,
outstanding in the amount of $6,110 million, of which
Government accounts and Federal Reserve Banks, for themselves and as agents of
foreign and international monetary authorities, presently hold $2,378 million.
These accounts may exchange bills they hold for the bills now being offered at
the average prices of accepted tenders.
The bills will be issued on a discount basis under competitive and noncompetitive bidding, and at maturity their face amount will be payable without
interest.
They will be issued in bearer form in denominations of $10,000,
$15,000, $50,000, $100,000, $500,000 and $1,000,000 (maturity value), and in
book-entry form to designated bidders.
Tenders will be received at Federal Reserve Banks and Branches and from
individuals at the Bureau of the Public Debt, Washington, D. C. 20226, up to
1:30 p.m., Eastern Standard time, Monday, January 24, 1977.
Each tender must be for a minimum of $10,000.
in multiples of $5,000.
Tenders over $10,000 must be
In the case of competitive tenders the price offered
must be expressed on the basis of 100, with not more than three decimals, e.g.,
99.925. Fractions may not be used.
Banking institutions and dealers who make primary markets in Government
WS-1267 (OVER)
-2securities and report daily to the Federal Reserve Bank of New York their positions
with respect to Government securities and borrowings thereon may submit tenders
for account of customers provided the names of the customers are set forth in
such tenders.
Others will not be permitted to submit tenders except for their
own account.
Tenders will be received without deposit from incorporated banks
and trust companies and from responsible and recognized dealers in investment
securities.
Tenders from others must be accompanied by payment of 2 percent of
the face amount of bills applied for, unless the tenders are accompanied by an
express guaranty of payment by an incorporated bank or trust company.
Public announcement will be made by the Department of the Treasury of the
amount and price range of accepted bids.
Those submitting competitive tenders
will be advised of the acceptance or rejection thereof.
The Secretary of the
Treasury expressly reserves the right to accept or reject any or all tenders,
in whole or in part, and his action in any such respect shall be final.
Subject
to these reservations, noncompetitive tenders for each issue for $500,000 or less
without stated price from any one bidder will be accepted in full at the average
price (in three decimals) of accepted competitive bids for the respective issues.
Settlement for accepted tenders in accordance with the bids must be made or
completed at the Federal Reserve Bank or Branch or at the Bureau of the Public Debt
on January 27, 1977,
in cash or other immediately available funds or in a like
face amount of Treasury bills maturing January 27, 1977.
tenders will receive equal treatment.
Cash and exchange
Cash adjustments will be made for differences
between the par value of maturing bills accepted in exchange and the issue price
of the new bills.
Under Sections 454(b) and 1221(5) of the Internal Revenue Code of 1954 the
amount of discount at which bills issued hereunder are sold is considered to accrue
when the bills are sold, redeemed or otherwise disposed of, and the bills are
excluded from consideration as capital assets.
Accordingly, the owner of bills
(other than life insurance companies) issued hereunder must include in his Federal
income tax return, as ordinary gain or loss, the difference between the price paid
for the bills, whether on original issue or on subsequent purchase, and the amount
actually received either upon sale or redemption at maturity during the taxable
year for which the return is made.
Department of the Treasury Circular No. 418 (current revision) and this notice,
prescribe the terms of the Treasury bills and govern the conditions of their issue.
Copies of the circular may be obtained from any Federal Reserve Bank or Branch, or
from the Bureau of the Public Debt.
FOR IMMEDIATE RELEASE
Contact: J.C. Davenport
Extension 29 51
January 18, 19 77
TREASURY ANNOUNCES TENTATIVE REVOCATION OF
DUMPING FINDING ON TUNERS (OF THE TYPE
USED IN CONSUMER ELECTRONIC PRODUCTS)
FROM JAPAN
Under Secretary of the Treasury Jerry Thomas announced
today a tentative determination under the Antidumping Act to
revoke a finding of dumping in the case of tuners (of the
type used in consumer electronic products) from Japan.
Notice of this decision will appear in the Federal Register
of January 19, 19 77. A finding of dumping with respect to
tuners from Japan was published in the Federal Register of
December 12, 19 70. The finding had previously been modified
to exclude therefrom five Japanese companies.
The Federal Register notice of January 17, 19 77 will
state in part that all of the firms for which the finding has
been modified, together with Alps Electric Co., Ltd., and
Waller Japan K.K., accounted for approximately 9 6.4 percent
of all the subject tuners sold to the United States during
the years 19 70 through 19 75 and that only de minimis dumping
duties have been assessed on shipments of tuners from
Japanese firms as a whole during a two-year period since the
finding of dumping. In addition, written assurances have
been received from all of the firms indicated above that
future sales of tuners to the United States will not be made
at less than fair value.
Imports of tuners from Japan during calendar year 19 75
were valued at roughly $4 million.
* * *
WS-1268
Contact:
Stephen Dicke
202-566-8277
Gabriel Rudney
202-566-5911
FOR IMMEDIATE RELEASE January 18, 1977
TREASURY SECRETARY SIMON SENDS PRIVATE PHILANTHROPY PROPOSALS
TO CONGRESS TO IMPROVE PUBLIC ACCOUNTABILITY AND PREVENT ABUSES
Secretary of the Treasury William E. Simon On January 14,
1977 sent proposals for legislation on private philanthropy to
the Chairmen and ranking minority members of the Congressional
tax committees.
The Treasury proposals are intended to assure public
confidence and support of philanthropic institutions and
thereby sustain the vital role of private philanthropy in our
society. The proposals would increase the public accountability of philanthropic institutions and improve the Federal
tax treatment of charitable contributions. In transmitting
the proposals to the Congress, the Secretary stated:
"I know that you share my concern for improving
public accountability and prevention of abuse
in private philanthropy through sound legislation
and I respectfully urge consideration of the proposals at the earliest possible date."
The Treasury proposals were stimulated by recommendations
of the well-known privately-established Filer Commission (The
Commission on Private Philanthropy and Public Needs) which were
submitted to the Congress and the Ford Administration in
December 1975. The Treasury studied these recommendations as
well as recommendations of other groups and individuals.
WS-1269
-2Also, in response to a Filer Commission recommendation,
Secretary Simon announced on January 6 the appointment of
the Treasury Advisory Committee on Private Philanthropy and
Public Needs. The 25 members are concerned citizens with
knowledge and interest in the vitality of the philanthropic
sector. The Chairman is C. Douglas Dillon, former Treasury
Secretary. The Advisory Committee met on January 6 to organize.
ana has not had the opportunity to examine the Treasury
proposals. The Committee will however consider the proposals
in its work with the next Administration.
A summary of the Treasury proposals and a technical
explanation of each proposal are attached.
oOo
Attachment
TREASURY PROPOSALS
TO IMPROVE PRIVATE PHILANTHROPY
INTRODUCTION
Private philanthropy plays an important role in our society today,
complementing the efforts of government to meet our social and individual
needs. Private philanthropy is uniquely capable of responding quickly
and flexibly to fill new needs as they arise and of experimenting with new
and untested methods in meeting existing needs.
However, the lack of adequate accountability to the public and evidence
of abuse has created a growing public concern about the effectiveness
of philanthropic institutions. Government officials are accountable at
the polls and businessmen are accountable in the marketplace, but
philanthropic organizations face no such test of their efforts, and their
accountability to State officials burdened with other responsibilities
has often been criticized as inadequate. The result has been the gradual
erosion of public confidence in some private philanthropic institutions
and of the public's willingness to contribute money, time and effort
to them.
This erosion of confidence and support, when coupled with
financial difficulties that these institutions have been facing in recent
years as a result of spiraling inflation, could lead to a severe crisis
for private philanthropy generally and threaten its important role in
our society.
To avoid this crisis and to restore public confidence and support to
these institutions, proposals have been made to increase their public
accountability, to minimize abuses, and to improve the Federal tax
treatment of charitable contributions. During the past year the
Treasury Department has studied the proposals of the privately-est.bli^ed
-2Commission on Private Philanthropy and Pdblic Needs (the Filer
Commission), as well as proposals of other groups and commentators.
As a result of this study, the Treasury D3partment is recommending to the Congress that it consider the following legislative
proposals at the earliest feasible date.
SUMMARY OF PROPOSALS
L Improving the Philanthropic Process
A. Accountability
1. Annual Report to the Public
In general, every private foundation, every public charity*
that makes grants, and every public charity or social welfare
organization with annual gross receipts of at least $100,000 would
be required to make available to the public an annual report on
its finances, programs and priorities.
In addition, a business organization making annual charitable
contributions of at least $100, 000 would be required to make available
to the public an annual report on its charitable giving programs.
2. Regulation of Interstate Solicitation
Interstate solicitation would be subject to Federal legislation
that would be administered by the Treasury Department. Disclosure
would have to be made with respect to certain financial information
about the soliciting organization, particularly with respect to its
fund-raising and administrative costs.
*For purposes of these proposals a public charity is a philanthropic
organization (an organization exempt under section 501(c)(3)) that is not a
private foundation.
-3 B. Extending Private Foundation Restrictions to Public Charities
1. Self-Dealing
The prohibitions and excise taxes on self-dealing transactions
with private foundations would be extended to public charities. *
However* the Secretary of the Treasury would be provided with
regulatory authority to provide exceptions to strict prohibitions
for classes of transactions, provided that they meet an arms-length
standard.
2. Minimum Payout
Public charities* and private operating foundations would be
required to spend or distribute annually for charitable purposes
at least 3-1/3 percent of their noncharitable assets.
3. Jeopardy Investments
The prohibitions and excise taxes on investments that jeopardize
the carrying out of the exempt purposes of a private foundation would
be extended to public charities.* In addition, the tax would be imposed
on any public charity (or private foundation) that retained an investment
after it knew or should have known that it had become a jeopardy
investment.
4. Taxable Expenditures
The prohibitions and excise taxes on proscribed expenditures
made by private foundations would be extended to public charities.*
However, these provisions would not apply in the case of lobbying
expenditures by public charities that elect under current law to
be subject to certain limits on those expenditures. In addition, public
Consideration should be given to exempting very small public chanties
from these four restrictions.
-4 charities would not be required to obtain prior approval of the
Internal Revenue Service for certain grants to individuals, as
private foundations must do.
C. Enforcement Procedures
1. Alternative Sanctions
United States District Courts would be invested with equity
powers sufficient to remedy any violation of the substantive rules
concerning philanthropic organizations in such a way as to minimize
any financial detriment to the organization and to preserve its asset
for its philanthropic purposes.
2. Audit Tax
The rate of tax on the net investment income of private
foundations would be no more than 2 percent.
If many of the restrictions on private foundations are
extended to public charities, consideration should be given
to repealing the tax altogether.
Changes Affecting the Charitable Deduction
A. Minimum Tax
The charitable income tax deduction would be deleted as a tax
preference item for minimum tax purposes.
B. Contributions for Foreign Philanthropic Purposes
The charitable deduction for income, estate and gift tax purposes
would be made uniform in that no deduction would be allowed unless
the contribution was made to an organization which was subject to
the laws of the United States and which had full control and discreti
as to where the contribution was to be distributed or spent.
- 5C. Profiting from the Charitable Deduction
The charitable income tax deduction would be reduced to the
extent necessary to prevent a high-bracket taxpayer with greatly
appreciated property from obtaining a financial gain by contributing
such property (as opposed to selling it).
TECHNICAL EXPLANATION
I. Improving the Philanthropic Process
A. Accountability
1. Annual Reports
a. Present law
Under present law, the only philanthropic organizations
required to file annual reports for public inspection are private
foundations having at least $5, 000 worth of assets. The only
source of information regarding a public charity available
for public inspection is its annual return, and that lacks much
of the information contained in the annual reports required of
private foundations.
b. Treasury proposal
(1) General description. Every private foundation with at
least $5, 000 worth of assets, and every public charity (other than
a church* or an integrated auxiliary thereof) or social welfare
organization which has annual gross receiptsof at least $100,000
or which makes grants annually of more than a specified minimal
amount, would be required to make available to the public, and
*For purposes of these proposals, the term "church" includes a
convention or association of churches.
-6 file with the Internal Revenue Service, an annual report regarding
its finances, programs and priorities. In addition, any business
organization that makes annual charitable contributions of at least
$100, 000 would be required to make available and file an annual
report on its charitable giving programs. This report would be
supplied by the organization upon request, at or below cost, during
the year following the date it is filed with the Service.
(2) Detailed description.
(a) Organizations Affected.
The new reporting requirements
would replace the current requirements for private foundations with
at least $5,000 worth of assets. In addition, they would apply to
every public charity and social welfare organization (exempt under
section 501(c)(3) or section 501(c)(4), other than a church or an
integrated auxiliary thereof), if it makes total grants of more than
a specified minimal amount or it has gross receipts of at least
$100,000 for the immediately preceding year (or as an annual
average for the five preceding years). The reporting requirements
would also apply to business corporations, partnerships and trusts
whose annual contributions, together with the amount of direct and
indirect expenses attributable to those contributions, totaled at
least $100, 000 for the preceding year (or as an annual average for
the five preceding years).
In determining the amount of gross receipts of a philanthropic
organization for any year, the principles in the regulations which
now apply in computing gross receipts for purposes of the exempttion from the current annual return filing requirement (section 6033)
- 7would apply. In determining the $100, 000 contribution figure for a
taxable corporation, amounts contributed by such a corporation to
its company foundation would not be included if the company
foundation files an annual report under these provisions.
(b) Contents of report. The Secretary of the Treasury would
be provided with regulatory authority to prescribe the contents of
the annual report. It is expected that the regulations would require
that the report be written in language clearly understandable to a
layman and include the following information: a description of
the organization's program and priorities; an explanation of the
criteria that are taken into account in accepting or rejecting requests
for funds, products or services; and financial information, including
a statement of income, a statement of expenditures (including fundraising and administrative expenditures), and a balance sheet.
It is also expected that the regulations would require that,
in discussing the criteria which are applied in awarding and rejecting grants, the report would be specific enough so that a
prospective applicant could determine the general policies and
circumstances under which grants are awarded or rejected. However,
the annual report would not be required to disclose the internal
decision-making processes of the organization, particularly with
respect to individual grant applications.
In the case of a business organization, the information
required would be limited to the pertinent aspects of its charitable
giving program.
-8 (c) S u m m a r y Annual Report. In addition to an annual report,
organizations with annual gross receipts of $100,000 or more would
be required to make available to the public a s u m m a r y annual report
that is in shorter form and in less detail than the annual report.
The Secretary of the Treasury would also be provided with
regulatory authority to allow grant-making public charities with
annual gross receipts of less than $100, 000 to prepare a summary
annual report in place of, rather than in addition to, the basic
annual report.
(d) Availability of the Annual Report. Each organization required
to file an annual report (or s u m m a r y report) with the Service would
be required to supply the report, or any portion thereof, at or
below reproduction cost to any person within 60 days after a request
for such report is made, if the request is made within one year
from the date such report is filed with the Service.
If the organization does not respond to a request for information
within 60 days, or if the request is made after one year from the filing
date, the person requesting the information m a y then seek it from
the Service. The Service would not be required to respond to a request
within any definite period of time.
(e) Sanctions. Penalties similar to those imposed for failure
to file information returns (section 6652(d)) would be imposed on an
organization for failure to file an annual report with the Service
or to provide the report promptly to a person requesting it, unless
any such failure is due to reasonable cause. Since the Service m a y
not be made aware of a failure to provide information in response
- 9 to a request from the public, consideration should be given to the
type of remedy that should be afforded to a person requesting the
report when it is not provided on time.
2. Regulation of Interstate Solicitation
a. Present Law
There is no supervision or monitoring of interstate solicitation
by the Federal Government, and the State laws affecting it vary
considerably, making it easy, particularly for large fund-raising
drives, to circumvent tough enforcement by any one State.
b. Treasury proposal
Interstate solicitation would be subject to Federal legislation
administered by the Treasury Department. Disclosure would
have to be made with respect to certain financial information
about the soliciting organization, particularly with respect to its
fund-raising and administrative costs. The annual reports filed
with the Internal Revenue Service would allow it to check such
disclosures readily.
The Treasury Department recommends that Congress conduct
hearings on the appropriate methods for regulating such solicitation,
with emphasis on the following issues:
1. The extent of financial data concerning
the soliciting organization that must be
supplied with the solicitation material;
2. The need for administrative review of
solicitation material prior to dissemination
(as opposed to relying solely on criminal
and equitable sanctions for misleading or
incomplete material);
-10 3. The appropriate method for regulating oral
solicitations (e. g., by telephone or television)
and the extent of disclosure required for them;
4. The need for limitations on fund-raising and
administrative costs; and
5. The pre-emption of varying State reporting
requirements for interstate solicitations,
with a uniform Federal report to be filed
with all requesting States.
Extending Private Foundation Restrictions to Public Charities
1. Self-Dealing
a. Present law
Certain "self-dealing" transactions between a private foundation
and any of its "disqualified persons" (basically substantial contribu
tors, foundation managers and related persons) are subject to a twotier Federal excise tax. Some of these transactions are subject
to such a tax whether or not they meet an arms-length standard,
and others are subject to tax only if they violate such a standard.
The initial tax imposed on the disqualified person is 5 percent
per annum of the amount involved (until corrected). He is also subjec
to an additional tax of 200 percent of the amount involved, if the tr
action is not corrected within a specified period . There are
similar, but smaller, excise taxes imposed on a foundation manager
who knowingly participates in such a self-dealing transaction (withou
reasonable cause) or refuses to agree to any part of the necessary
correction.
No similar sanctions are imposed in the case of a self-dealing
transaction with a public charity, although it may lose its tax-exemp
status for failing to operate exclusively for charitable purposes.
-11 Under State law there are limited restrictions on such transactions,
generally requiring them to meet an arms-length standard.
b. Treasury proposal
Since violations of an arms-length standard are often difficult
to prove, and the revocation of an organization's exempt status is
usually too severe a sanction for non-repetitative violations, the
Treasury Department proposes to extend the self-dealing prohibitions
and excise taxes to transactions involving public charities (other than
churches and their integrated auxiliaries). As in the case of private
foundations, the general rule would be a flat prohibition against
the proscribed transactions, with certain transactions being allowed
if they meet an arms-length standard.
However, because of the greater variety in the types of
organizations, disqualified persons and transactions that would be
affected by such an extension of the flat prohibitions, and the greater
potential need for administrative flexibility in providing relief from
the unforeseen consequences of such an extension, the Secretary of
the Treasury would be provided with regulatory authority to provide
additional arms-length exceptions to the statutory prohibitions.
Such authority should not be authority to promulgate individual
exemptions, but merely regulatory authority to provide exceptions
for various classes of transactions. Such exceptions would have to
be found to be both administratively feasible and beneficial to, as
well as protective of, the interests of the public charity. *
*Jn addition, as a technical point, consideration should be given to
changing the amount involved for a prohibited loan from the amoun
of interest to the full amount of the loan, since the latter is a measure
of the loss that the organization m a y face if the disqualified person has
difficulty repaying the loan.
- 12 -
2. Minimum Payout
a.
Present law
Under present law, a private nonoperating foundation is subject
to a two-tier excise tax if it does not distribute for philanthropic
purposes at least 5 percent of its noncharitable assets (generally
investment assets), or its adjusted net income, whichever is greater,
in the year following the close of its accounting period. For new
foundations, there are special liberal rules that allow a set-aside
for up to 5 years to qualify as a current distribution under certain
circumstances.
Private operating foundations are not subject to this minimum
payout requirement, but to qualify for operating status, the foundation
must expend at least 85 percent of its adjusted net income directly
in the active conduct of its exempt purposes, and must satisfy one
of three alternative tests. The alternative tests require the foundation to expend annually 3-1/3 percent of its noncharitable assets
directly in such exempt activities, to devote at least 65 percent
of its assets directly to such exempt activities, or to receive at
least 85 percent of its support from the general public and five or more
exempt organizations.
Public charities are not subject to any similar requirements.
b.
Treasury Proposal
Every public charity (other than churches and their integrated
auxiliaries) and every private operating foundation would be required
to make qualifying distributions of an amount that is not less than
-13 3-1/3 percent of its noncharitable assets, in the year following the
close of its accounting period. Any excess of its adjusted net income
over such minimum amount would not be subject to the payout
requirement.
Generally, the rules applicable to private nonoperating foundations for determining the minimum amount of noncharitable assets,
the sources of distribution, and what constitutes a qualifying distribution would be applied to public charities and private operating
foundations. For example, qualifying distributions would include
administrative expenses incurred in the direct conduct of the
organization's exempt activities and the cost of acquiring and repairing
buildings and other facilities used in such activities. However, to
prevent public charities and private operating foundations from avoiding
the payout rules by distributing assets back and forth among one
another, the distribution by any such organization to another from
which it received (directly or indirectly) a contribution in the
5 preceding years would not count as a qualifying distribution. Such
a distribution would also increase the recipient's minimum distributable amount* for the year of receipt, to the extent that it effectively
repaid a qualifying distribution made by the recipient during the
preceding 5-year period.
•Current law treats the repayment of any part of a qualifying distribution of a private nonoperating foundation as merely an increase in
its adjusted net income. This rule would be ?h.anSed "£^
repayment would increase the foundation's m i n i m u m distributable
amount.
-14 The minimum payout for new organizations or organizations
whose endowment suddenly increased many times over should be
graduated to 3-1/3 percent (or 5 percent for private nonoperating
foundations) over a number of years, e.g., five. Alternatively,
there could be liberal set-aside rules that would allow, for example,
grants to be paid out over several years to allow the granting
organization to monitor how they are used.
3.
Jeopardy Investments
a.
Present law
Private foundations and their managers are subject to a two-
tier excise tax when they make investments (other than programrelated investments) that jeopardize the carrying out of a foundation^ exempt purposes. No such tax is imposed if the investment
is not initially a jeopardy investment, but later becomes one and
is retained by the private foundation. Nor is an excise tax imposed
in the case of a jeopardy investment made or retained by a public
charity. However, in both of these latter cases, the trustees or
managers of the charity m a y be subject to fiduciary liability for
such investment under State law.
b.
Treasury proposal
The tax for making a jeopardy investment would be ex-
tended to public charities (other than churches and their integrated
auxiliaries).
In addition, the tax would be imposed on any public charity
or private foundation (and its managers) which did not dispose of
a non-program-related investment within a reasonable period of
- 15 time after it learned, or should have known, that the investment had
become a jeopardy investment, or was in fact a jeopardy investment
at the time of its receipt by the organization, e.g., as a charitable
contribution.
4C Taxable Expenditures
a. Present law
Under present law, private foundations and their managers who
make certain proscribed expenditures or distributions are subject
to a two-tier excise tax on the amount of such expenditures or
distributions. These "taxable expenditure" provisions do not apply
to public charitiesc Thus, the only sanction generally available
for similar expenditures by these organizations, e.g., for noncharitable purposes, is loss of their tax-exempt status. Certain
public charities, however, may elect to become subject to specified
limits on their lobbying expenditures. An excise tax is imposed on
minor violations of these limits, while loss of exemption is reserved
for sustained excessive violations.
In addition, a private foundation is required to take certain
steps to ensure that the recipient of any of its grants is spending
the grant properly if the recipient is not a public charitye This
expenditure oversight requirement applies to a grant from one
private foundation to another, even though the.latter is also subject
to the taxable expenditure provisions.
-16 b. Treasur}^ proposal
In general, the taxable expenditure rules for private foundations
would be extended to all public charities (other than churches and
their integrated auxiliaries). A public charity, however, would not
be required to obtain prior Service approval of grants to individuals
for travel, study or similar purposes, as private foundations must
do. In addition, in the case of a public charity electing to be subjec
to the specific limits on lobbying expenditures, sanctions for violations of those limits would be limited to those imposed under
present law.
At the same time, the expenditure oversight rules for
both private foundations and public charities would be limited
to cases where the recipient of a grant is not itself subject to the
taxable expenditure rules. This would eliminate the present
administrative burden that discourages grants from one private
foundation to another (in favor of grants to public charities).
- 17 Enforcement Procedures
1. Alternative Sanctions
a. Present law
Under present law, the only sanction for violation of any of the
statutory requirements imposed upon public charities is loss of
exemption. The consequences of such a loss are severe; the
charity will be unable to receive charitable contributions and
its net income (if any) will be subject to tax. Private foundations
on the other hand, are subject to two-tier excise taxes for certain
violations, as described above,. Even these sanctions may be severe,
particularly the second-tier tax for failure to correct. The
foundation and its charitable beneficiaries may be deprived not only
of the funds expended in furtherance of the violation, but also of
the funds used to pay the excise tax.
b. Treasury proposal
(1) General description. In addition to having the authority to
impose excise taxes on public and private charities as described abo
the United States District Courts would be invested with a set of eq
powers sufficient to remedy any violation of the substantive rules
concerning philanthropic organizations in such a way as to minimize
any financial detriment to the organization and to preserve its
assets for its philanthropic purposes.
- 18 (2) Detailed description.
(a) Equity powers. United States District Courts would
be invested with (1) equity powers (including, but not limited to,
power to rescind transactions, surcharge trustees and order
accountings) to remedy any detriment to a philanthropic organization
resulting from any violation of the substantive rules, and (2) equity
powers (including, but not limited to, power to substitute trustees,
divest assets, enjoin activities and appoint receivers) to ensure
that the organization^ assets are preserved for philanthropic
purposes and that violations of the substantive rules will not occur
in the futuree For example^ the purchase of securities owned by
a public charity in a self-dealing transaction could be rescinded
if the market value of the assets had increased. If the securities
had first increased and then declined, the trustees could be surcharged for depriving the charity of the opportunity to dispose of
the assets at a higher price. If the value of the securities declined
immediately after the self-dealing transaction, the appropriate remedy
might be to do nothing under the equity power.
The mandatory specific sanctions would apply regardless
of the action or non-action under the equity powers. Thus, even if
no remedies were necessary to protect the charity or preserve its
assets for charitable purposes, the imposition of the applicable firsttier excise taxes would be mandatory. However, the Secretary
of the Treasury could be given authority to waive the first-tier taxunder extenuating circumstances.
- 19(b) Judicial proceedings. Upon institution of an equity action
by the Government, power to review excise taxes would be vested
exclusively in the District Court. Thus, any action to review excise
taxes pending in the Tax Court or Court of Claims would be terminated
and be made part of the District Court equity action.
If equity action is necessary, the philanthropic organization
and all persons against whom remedies or sanctions are sought would
be named as defendants. The extent to which the organization and
private persons could all be joined in one suit would depend upon
the general rules of venue under the Judicial Code of the United State
The equity action would spell out the particular specific
sanctions and equitable remedies sought against each defendant.
Any party's right to a jury trial would be determined under existing
law, but the determination of the specific sanctions and appropriate
equitable remedies would be determined exclusively by the Court.
Thus, for example, any questions of fact concerning the persons
who knowingly authorized the organization to engage in a selfdealing transaction could be determined by a jury, in the discretion
of the Court; however, the review of the excise taxes and appropriate
equitable relief would be determined exclusively by the Court.
(c) Correlation with State authorities. In the event that
appropriate State authorities institute action against a philanthropic
organization or individuals based upon acts which constitute a violati
of substantive rules of law applicable to such an organization, the
- 20 "
United States District Court before w h o m the federal civil action is
instituted or was pending would be required to defer action on any
equitable relief for protection of the organization or preservation
of its assets for its philanthropic purposes until conclusion of the
State court action. At the conclusion of the State court action, the
District Court could consider the State action adequate or provide
further equitable relief, consistent with the State action, as the
case warrants. However, no action by a State court would defer
or abate the imposition of the initial Federal excise taxes for the
violations.1 Thus, for example, the institution of a State court action
based upon a self-dealing transaction would result in a deferral
of an}' action by the federal court to rescind the transaction.
However, the review of the first-tier Federal excise taxes imposed
for the specific violation would not be deferred.
In any case where the appropriate sanction or equitable remedy
requires one or more distributions to other philanthropic organizations,
the governing body of the distributing organization would be given
the opportunity to select the appropriate recipients. If the governing body failed to select any such recipients, the appropriate State
authorities for supervision of charitable trusts and corporations
would be asked to make the choice, with final authority in the District
Court in the absence of selection by the distributing organization
or State authorities,.
- 21 Upon loss of exemption by a charity for any reason, the invocatior
of equity powers to insure that the charity's assets are preserved
for charitable purposes would be mandatory. Tne specific form of
the remedy to provide such insurance would be up to the District
Court.
2. Audit Tax
a. Present law
Under present law, private foundations are subject to an excise
tax of 4 percent on their net investment income. This tax is
designed in part to cover the costs of auditing all exempt
organizations, but it produces more than twice the revenue needed
to cover such costs.
Other exempt organizations are not subject to any such tax.
b. Treasury proposal
The rate of tax imposed on the net investment income of
private foundations would be no more than 2 percent.
In addition, if many of the private foundation restrictions were
extended to public charities, consideration should be given to
repealing the tax altogether. * There would be little justification
for imposing this tax only on private foundations, and not on
other philanthropic organizations, or other exempt organizations,
as well. Extending this tax to such other organizations, however,
*Such a repeal should not, however, result in a reduction of amounts
appropriated under section 1052 of the Employee Retirement Income
Security Act of 1974 to support the operation of the Office of Employee
Plans and Exempt Organizations of the Internal Revenue Service.
- 22 would raise serious questions as to (1) whether the net investment
income of such organizations is the appropriate tax base for such
a tax (and if not, what should it be), (2) what the rate of tax shou
and (3) whether the small amount of revenue collected warrants the
imposition of such a tax.
Changes Affecting the Charitable Deduction
A. Minimum Tax
1. Present law
Under the Tax Reform Act of 1976, the charitable deduction
is made an item of tax preference subject to the minimum tax to
the extent that it, along with the individual taxpayers other
itemized deductions (except medical and casualty loss deductions),
exceeds 60 percent of the taxpayer's adjusted gross income. This
will have the effect of reducing contributions to many philanthropic
organizations that already face financial difficulties.
2. Treasury proposal
The charitable deduction would be eliminated as an item of
tax preference.
B. Contributions for Foreign Philanthropic Purposes
1. Present law
Under present law, the criteria for the allowance of a deduction
in the case of contributions made for foreign philanthropic purposes
vary considerably, depending on whether the deduction is for Federal
income, estate or gift tax purposes and, particularly in the case of
income tax, on whether the donor is an individual, corporation, trus
or estate. For example, courts have allowed a charitable deduction
- 23 for estate tax purposes even in the case of contributions made to
a foreign government or organization, so long as the contribution
is to be used only for philanthropic purposes. On the other hand,
for income tax purposes a charitable deduction is never allowable
to a corporation for a contribution made for foreign philanthropic
purposes, unless the recipient is a corporation (not some other
entity) created under the laws of the United States.
2.
Treasury proposal
To minimize circumvention of the requirements placed on
philanthropic organizations to receive and distribute tax-deductible
contributions, no charitable deduction would be allowed for income,
estate or gift tax purposes unless the contribution is made to an
organization which is created under the laws of the United States
and which has full control and discretion as to where the contribution is to be distributed or spent. This will subject the
expenditure or initial distribution of such contribution to the
scrutiny and jurisdiction of the Internal Revenue Service and the
Federal courts.
C. Profiting from the Charitable Deduction
1. Present law
Under present law, a taxpayer in the high income tax brackets
can, with certain largely appreciated capital assets, obtain a greater
after-tax benefit from contributing the property to charity than
from selling the property. This anomaly results from the fact
that, with respect to a charitable contribution of such an asset,
a Federal income tax deduction is allowable for the appreciation
-24 in such asset (as well as for its basis), even though such appreciation
is never taken into income and subject to tax. Because of the taxpayer's high bracket, his tax savings from the charitable deduction
is greater than the after-tax proceeds that he could obtain from
selling the property.
For example, assume that a taxpayer in the 70 percent
bracket has stock with a basis of $1. 000 but a fair market value of
$15, 000.
Assume further that if he sells the stock, the effective
tax rate on his capital gain will be 35 percent (this assumes that
he takes the 5 0 % deduction for capital gains and is not subject to
the minimum tax). His after-tax proceeds from such a sale would be
$10,100 ($15,000 - 3 5 % (14,000)). On the other hand, if he contributes
the stock to a public charity, he would be entitled to a charitable
deduction for the full $15, 000, even though none of the $14, 000
appreciation is ever included in his income and subject to the capital
gains tax. Since he is in the 70 percent backet, such a deduction
would save him $10, 500 in Federal income tax (70% of $15, 000),
which is $400 more than he would have left over (after taxes)
if he had sold the property.
This $400 can be viewed as his
"tax profit'1 from contributing the property.
2.
Treasury proposal
While the Federal income tax law should continue to encourage
taxpayers to contribute appreciated capital assets to charity, it should
not allow high bracket taxpayers to "profit" from such a contribution
more than if they had sold the property outright.
-25 Accordingly, the Treasury Department proposes that the Federal
income tax deduction for such a charitable contribution be reduced
by a sufficient amount to'eliminate such a "tax profit.
ff
To avoid
changing the statutory provisions every time the tax rates change,
the Secretary of the Treasury would be given regulatory authority to
compute the amount of this reduction.
The proposal would not apply to minimal amounts of untaxed
appreciation, e.g., $5, 000 or less.
FOR RELEASE AT 6 P.M.
January 18, 1977
CARTER ANNOUNCES THREE
APPOINTMENTS IN TREASURY DEPARTMENT
President-elect Jimmy Carter and Secretary-designate of
the Treasury Mike Blumenthal today announced that the
President-elect is nominating three sub-cabinet officials
for appointment in the Treasury Department.
Nominated as Deputy Secretary of the Treasury is Kenneth
S. Axelson, now Senior Vice President and Director of J.C.
Penney Company, Inc. Mr. Axelson will become the second ranking
official of the Treasury Department. He was previously Deputy
Mayor for Finance of the City of New York on loan from J.C.
Penney Company for one year.
Mr. Anthony M. Solomon is nominated to be Under Secretary
for Monetary Affairs. Mr. Solomon was previously Assistant
Secretary of State for Economic Affairs and was Deputy
Assistant Secretary of State for Latin America. He also was
a special consultant to the House Ways and Means Committee.
Mr. C. Fred Bergsten is nominated to be Assistant Secretary
for International Affairs. Mr. Bergsten was recently a Senior
Fellow at the Brookings Institution and previously served as
Assistant to the President for National Security Affairs. He
received his Doctorate Degree from the Fletcher School of Law
and Diplomacy.
oOo
WS-1270
TAX POLICY RESEARCH STUDY T U D __?__?
NUMBER i nnjLCi
CONTENTS
Page
FOREWORD ii
DEDICATION
lv
U.S. TAXATION OF THE UNDISTRIBUTED INCOME OF
CONTROLLED FOREIGN CORPORATIONS
1
Gary Hufbauer and David Foster
TAX TREATMENT OF INCOME FROM INTERNATIONAL
SHIPPING
64
Marcia Field and Richard Gordon
U.S. TAXATION OF FOREIGN EARNED INCOME OF
PRIVATE EMPLOYEES
99
Marcia Field and Brian Gregg
U.S. TAXATION OF ALLOWANCES PAID TO U.S.
GOVERNMENT EMPLOYEES
128
Marcia Field and Brian Gregg
TAX TREATMENT OF INCOME OF FOREIGN GOVERNMENTS
AND INTERNATIONAL ORGANIZATIONS
151
Jon Taylor
STATE TAXATION OF INDIVIDUAL INCOME FROM FOREIGN
SOURCES
180
Roy Blough
STATE TAXATION OF CORPORATE INCOME FROM FOREIGN
SOURCES
George Carlson
For sale by the Superintendent of Documents, U. S. Government Printing Office
Washington, D. C. 20402
231
- 11 -
FOREWORD
This is the third volume in a continuing series of Treasury
tax policy research studies analyzing the interactions between tax
law and economic policy. The publication of Treasury tax policy
studies is part of an ongoing effort by the Office of Tax Policy
to clarify tax issues which are sometimes debated with more feeling
than understanding.
The first two volumes in this series were
published in 1968 when Stanley S. Surrey was Assistant Secretary
for Tax Policy.
This collection of essays is addressed to international tax
issues.
M a n y of the essays represent the cooperative work of
economists and lawyers. Both disciplines are applied in an attempt
to explain current law and policy considerations, and to evaluate
possible changes.
For the most part the essays included in this volume were
initially prepared in the spring of 1976 by the Office of International
Tax Affairs for consideration by the House W a y s and Means Committee Task Force on the Taxation of Foreign Income. The policy
analyses contained in these essays evaluate changes which presuppose the foreign tax credit mechanism, the separate taxation of
corporations and
their shareholders, and other basic elements
in U.S. taxation of foreign income. Thus, the changes analyzed
for the most part would not require radical departures in the
structure of international taxation. The views reflected in these
essays are, of course, the opinions of the authors, and do not
necessarily reflect the position of the Treasury Department.
The essays cover a range of topics. The essay by Hufbauer
and Foster, "U.S. Taxation of Undistributed Income of Controlled
Foreign Corporations", provides a broad outline of the manner in
which the United States taxes foreign source income. It specifically
deals with "deferral" of U. S. taxation of the earnings of foreign
subsidiaries until those earnings are distributed to the United States
as dividends. The "Tax Treatment of Income from International
Shipping", by Field and Gordon, deals with "deferral", the reciprocal
exemption, and other issues in the taxation of shipping income. The
"U.S. Taxation of Foreign Earned Income of Private Employees"
and "U.S. Taxation of Allowances Paid to U.S. Government
Employees", both essays by Field and Gregg, are concerned with
exceptions to the general principle that U. S. citizens are taxed by
the United States on their worldwide income regardless of residence.
The essay by Taylor,
"Tax Treatment of Income of Foreign
Governments and International Organizations", was prompted by the
increased volume and changing nature of foreign governmental
investment in the United States. The final two essays by Blough
and Carlson deal with the complex and often inconsistent approaches
taken by states in the taxation of foreign source income.
- iii While these essays by no means exhaust the list of current
issues in the field of international tax policy, they are designed
to illuminate selected topics which have attracted Congressional
interest in recent years.
This volume is affectionately dedicated to the memory of
Nathan Norton Gordon who devoted a long and productive career,
with the U. S. Treasury Department, to the international harmonization of national tax systems.
Washington, D. C.
Charles M. Walker
Assistant Secretary of the Treasury
for Tax Policy
December 31, 1976
- iv -
DEDICATION
These papers are dedicated to the m e m o r y of Nathan Nortoi
Gordon who, for m a n y years, played a leading role in the formulatioi
of international
tax policy for the United States Treasun
Department.
As Assistant Director of the Treasury Department's Office
of Tax Analysis, then Director for International Tax Affairs, and
finally Deputy to the Assistant Secretary for Tax Policy, Mr. Gordorj
was responsible for advising several Assistant Secretaries for Tax
Policy on international tax questions. At the same time, he waq
the principal U.S. negotiator of tax treaties with other countriei
to avoid double taxation. In more than 35 years of service, he won
the respect and friendship of each of the Assistant Secretaries he
served, his colleagues at the Fiscal Committee of the OECD, the
Inter-American Center for Tax Administrators, and the Ad Hoc
Group of Experts on Tax Treaties between Developed and Developing
Countries, sponsored by the United Nations.
Nathan Gordon was a man of broad vision, who brought an
analytical mind, an appreciation of practicality, a sensitivity to
the concerns of others, and a delightful sense of humor to the complex world of international taxation. These papers touch on a few
of the topics which were among his m a n y professional concerns,
They are dedicated to his m e m o r y by the m a n y Treasury colleague^
who benefitted from association with Nathan Gordon.
- v-
Nathan Norton Gordon, 1915-1976
-1 -
U. S. TAXATION OF THE UNDISTRIBUTED INCOME
OF CONTROLLED FOREIGN CORPORATIONS
Gary Hufbauer
and
David Foster
- 2-
TABLE OF CONTENTS
page
I. Issue 5
II. Present Law 7
1. Classical system of taxation 7
2. Exceptions to recognize economic unity and to
avoid double taxation
7
(a) Consolidated return
7
(b) Dividends received deduction
7
(c) Subchapter S
•
8
3. Exceptions to discourage tax abuse by individuals
8
(a) Accumulated earnings tax
8
(b) Personal holding company tax
8
(c) Foreign personal holding company
8
4. Exceptions to discourage tax abuse by corporations .... 9
(a) Section 367
. .
:".
9
(b) Subpart F and its exclusions .
•
10
(i) M i n i m u m distribution
11
(ii) Less developed country corporations
11
(iii) 30-70 rule
12
(iv) Shipping income
12
(v) Agricultural sales
12
III. Analysis 13
1. International tax neutrality 13
2. Constitutional problems
3. Foreign reaction
(a) Tax treaties
(b) Foreign statutory change
(c) Average foreign tax rates
4. Administrative aspects
5. Investment impact
6. Financial impact
7. Revenue impact
(a) Policy options
(b) Behavioral change
(i) Change in distribution rates
(ii) Foreign vs. domestic investment
(iii) Minority participation and "decontrol"
(iv) Higher foreign taxes
8. S u m m a r y of the analysis
(a) Tax neutrality
(b) Tax avoidance
(c) Tax simplification
(d) Investment and financial impact
(e) U. S. tax revenue
19
21
21
23
24
30
31
34
37
37
42
43
43
48
52
52
52
52
53
53
54
- 3TABLE OF CONTENTS
Options
55
1. Retain present system 55
2. Broaden Subpart F
55
(a) The substantial reduction test
55
(b) 50 percent subsidiaries
56
(c) Shipping income
56
(d) "Runaway plants" and tax holiday manufacturing
56
(e) Simplification
56
3. Partial or complete termination of deferral
57
(a) Required m i n i m u m percentage distribution
58
(b) Allocation of the deemed distribution between C F C s ... 58
(c) The extent of consolidation
58
(i) Individual foreign corporation approach
58
(aa) Hop-scotch method
58
(bb) Link-by-link method
59
(ii) Consolidation of foreign operations
60
(iii) Consolidation of worldwide operations
61
(d) The problem of decontrol
61
4. Terminate deferral in the context of a special statutory
deduction or the repeal of domestic tax preferences
62
- 4 -
LIST O F T A B L E S
Table 1
Table 2
Table 3
Table 4
Table 5
Estimated Tax Revenue Consequences in 1976 of
Achieving Alternative Standards of International
Tax Neutrality with Respect to U. S. Corporations
in Non-extractive Industries
18
Comparison Between Foreign Tax Relief and
Foreign Input Subsidies
25
Statutory and Realized Corporate Income Tax
Rates on Manufacturing Firms, 1974
27
Estimated Impact of Terminating Deferral on
Selected Economic Variables for Multinational
Manufacturing Firms
33
The Effect of Deferral on the Use of Local
Debt by a Hypothetical Foreign Subsidiary
36
Table 6
Financing of Foreign Affiliates, 1972 38
Table 7
Actual Revenue from Subpart F and Potential
Revenue from Termination of Deferral, with
Overall Limitation on Foreign Tax Credit
39
Revenue Changes from Alternative Proposals
to End Deferral
40
Table 8
Table 9
Termination of Deferral with Alternative Consolidation Requirements and with Current Dividend
Distribution Rate
41
Table 10
Revenue Effect of 100 Percent Dividend Distribution
Rate
44
Table 11
Termination of Deferral with Assumed Changes
in Investment Location and Means of Finance
45
Termination of Deferral with Assumed Adverse
Impact on Competitive Position of U. S. C F C s
46
Net Earnings by Extent of U. S. Ownership in
Foreign Affiliates
49
Table 12
Table 13
Table 14
Estimated Revenue from Subpart F and Termination
of Deferral with Increase of N o n - C F C Earnings
51
- 5I.
ISSUE
Since the introduction of the Federal income tax in 1913, the United
States has employed a "classical" system of taxing corporations and
their shareholders. Under a classical system, corporations and their
shareholders are separately taxed. A corporation's tax liability is not
affected by the amount of dividends it distributes to its shareholders,
and conversely (with limited exceptions) a shareholder's tax liability
depends on dividends received, and is not affected by either the amount
of tax paid by the corporation or by the corporation's retained earnings
and profits.
These principles extend to a U.S. shareholder in a foreign
corporation. N o U.S. tax is imposed on the U.S. shareholder until
(and unless) the shareholder receives dividends from the foreign corporation. This consequence of a classical system of taxation is called
deferral, because the U.S. tax on the income of a foreign corporation
is deferred until dividends are paid.
The bulk of U.S. investment in foreign corporations is undertaken,
not by individual shareholders, but by U.S. based multinational enterprises.
So long as earnings are retained abroad by foreign corporate
subsidiaries, the U.S. parent corporation pays no U.S. tax on the
foreign income. 1/ If taxable corporate earnings are defined the same
way abroad as iri~the United States, and if the host government applies
a tax rate lower than the U.S. corporate tax rate of 48 percent, the
difference in rates represents a temporary tax saving to the parent
corporation.
Multinational firms based in the United States argue that deferral
is necessary to allow them to compete on even terms with foreign firms.
In their view, tax neutrality requires the same rate of taxation on all
firms operating in the same country. The U. S. multinational firms
suggest that the termination of deferral would bring about changes in
foreign tax practices and dividend distribution rates that would erode
or eliminate U. S. tax revenue gains, and that, without deferral, the
foreign expansion of U.S. firms would be curbed, profits and U.S.
tax revenues might decline, and U.S. exports to foreign markets might
fall.
Others object that deferral enables foreign investors to enjoy tax
advantages not available to domestic investors.
In this view, tax
neutrality requires the same taxation of investment at h o m e and investment abroad. Expressing concern for the impact of foreign investment on American jobs, and the loss of potential tax revenue, labor
1/ The foreign subsidiary m a y pay dividends, interest, royalties, and
management fees to the U.S. parent corporation, and these types of
income would, of course, be taxed currently by the United States.
- 6-
groups in particular have questioned the continuance of deferral. This
concern was expressed most strongly in the late 1960s and'early
1970s.
Since 1972, a system of flexible exchange rates and the DISC
legislation have, to some extent, answered the concern over foreign
tax advantages. 1/
1/ The tax preference provided by the Domestic International Sales
Corporation (DISC) was substantially reduced in the Tax Reform
Act of 1976.
-7IL
PRESENT L A W
1. Classical system of taxation. Under present law, a corporation
and its shareholders are taxed separately. The corporation is taxed on
its earnings; the shareholders are taxed on distributed dividends.
This
is known as a "classical" or separate entity system of taxation. By contrast, under an "integrated" system of taxation, either the taxes imposed
on the corporation are claimed (in whole or part) as a tax credit by the
shareholder, or the corporation is allowed a reduced tax rate on dividends
paid. Britain, France, Germany, Canada, Japan, and other industrial
countries have adopted various types of integrated tax systems. The
Ford Administration proposed an integrated tax system for the United
States, and the proposal is receiving Congressional consideration.
Over the years, the United States has made limited exceptions to
its separate entity system of taxation. Certain exceptions are intended
to recognize the economic unity of an affiliated group of corporations within
the United States, to avoid double taxation when dividends are distributed
from one corporation to another, or to encourage small business. Other
exceptions are intended to discourage tax abuse by individuals investing
in domestic or foreign corporations. Subpart F of the Internal Revenue
Code is principally designed to discourage tax abuse by U. S. corporations
which control foreign corporations.
2. Exceptions to recognize economic unity and to avoid double
taxation.
— —
(a) Consolidated return. Under specified circumstances (Section
1501 of the Internal Revenue Code), related domestic corporations are
permitted to file a consolidated return. The consolidated return recognizes the economic unity of a corporate group. Through the mechanism
of a consolidated return, the profits of one domestic corporation m a y be
used to offset the losses of another. In this way, related corporations
can share their investment risks. 1/ A foreign corporation cannot, however, join a consolidated return. 2/~
(b) Dividends received deduction. Dividends distributed from one
domestic corporation to another are entitled to an 85 percent or 100 percent dividends received deduction, depending on the extent of affiliation
between the two corporations (Section 243). The purpose of the dividends
received deduction is to avoid double taxation at the corporate level.
Dividends received by a domestic corporation from a foreign corporation
are not eligible for the deduction. 3/
1/ Only one surtax exemption can be claimed on the consolidated return.
2/ Certain contiguous country corporations, defined under Section 1504(d),
are allowed to join a consolidated return.
3/ The dividends received deduction is available for dividends paid by
"" a foreign corporation which earns at least 50 percent of its gross
income from a U. S. trade or business (Section 24 5).
- 8-
(c) Subchapter S. Under Subchapter S (Sections 1371-1379), certain
small corporations can elect to be treated for tax purposes much like
a partnership. If an election is made, there is no corporate tax, and
all earnings (whether or not distributed) are taxed to the shareholders.
The purpose of Subchapter S is to encourage small business.
3. Exceptions to discourage tax abuse by individuals.
(a) Accumulated earnings tax. The Revenue Act of 1913 contained
the antecedents of today's accumulated earnings tax (Section 531). This
is a penalty tax imposed on a corporation when it unreasonably accumulates earnings for the purpose of shielding shareholders from personal
income taxation.
(b) Personal holding company tax. In 1934, Congress enacted the
personal holding company tax (Sections 541-547). This is a penalty tax
on the undistributed personal holding company income of a corporation
that receives at least 60 percent of its adjusted ordinary gross income
from passive investment sources and certain types of personal services, and is owned to the extent of more than 50 percent in value
by five or fewer individuals. The tax applies to the corporation and
not to the shareholders. The tax can be mitigated if the corporation
declares a "deficiency dividend".
(c) Foreign personal holding company. In 1937, Congressional
investigation brought to light the formation of "incorporated pocketbooks" abroad by United States citizens. These corporations, designed
to collect and retain passive investment income, were domiciled in
countries, such as the Bahamas and Panama with little or no corporate
income tax.
As foreign corporations, they could not be effectively
taxed either on their accumulated earnings or as personal holding
companies.
The Congressional remedy was to enact the foreign personal
holding company legislation (Sections 551-558) which taxes each U. S.
shareholder on his pro-rata share of the foreign corporation's undistributed income. Certain tests must be met before the foreign corporation is characterized as a foreign personal holding company. At least
60 percent of its gross income must be derived from passive sources
(dividends, interest, rents, royalties, capital gains, income from an
estate or trust, personal service income and certain other items),
and more than 50 percent in value of the stock must be owned by
five or
fewer
U. S. individuals.
When these and other tests
are met, each shareholder is deemed to receive a distribution from
the foreign personal holding company, and deferral of U. S. tax liability
on the foreign income is effectively precluded. 1/
1/ The individual shareholders are not permitted to claim a credit for
~~ any foreign corporate income tax paid. The deemed paid credit
(Section 902) is only available to U. S. corporations.
-9The foreign personal holding company legislation did not reach
foreign investment companies that sold shares widely among U. S.
individuals.
Such companies, domiciled in low-tax jurisdictions,
could thus retain their dividend and interest income free from U. S.
tax.
The shareholders could later realize the income in the form
of capital gains, if and when the shares were sold.
The Revenue Act of 1972 abolished this device in one of two ways.
Either the gains realized by the shareholder on disposition of the stock
would be taxed as ordinary income to the extent of accumulated earnings (Section 1246), or the foreign investment company could enter
a binding election to distribute at least 90 percent of its income
annually (Section 1247).
4. Exceptions to discourage tax abuse by corporations.
(a) Section 367. The Internal Revenue Code permits numerous
types of tax-free corporate reorganizations. One corporation m a y
acquire another, a subsidiary m a y merge into a parent, or a corporation m a y divide into several parts, all without creating a taxable
event. The underlying philosophy is that, so long as assets remain
in "corporate solution", and are not distributed to individual shareholders, reorganization is a matter of economic convenience for the
firm and need not provide an occasion for taxation.
Reorganizations that involve foreign corporations create an
exception to this basic philosophy. The concern arose very early
that domestic or foreign corporate income that had not previously
been taxed by the United States could forever leave its tax jurisdiction
through corporate reorganization. In 1932, the predecessor of Section
367 was enacted. It prevents a tax-free exchange involving a foreign
corporation unless "it has been established to the satisfaction of
the Secretary or his delegate that such exchange is not in pursuance
of a plan having as one of its principal purposes the avoidance of
Federal income taxes. "
In any reorganization involving a foreign corporation, the U. S.
taxpayer must obtain a Section 367 ruling from the Internal Revenue
Service that the exchange is not in pursuance of a tax avoidance
plan; otherwise, the transaction will be treated as a taxable event. 1/
Often the taxpayer must pay a "toll charge", involving partial recognition of the gain, in order to receive a favorable Section 367 ruling.
The ruling might also be accompanied by a closing agreement which
preserves the U. S. tax base (Revenue Procedures 68-23 and 75-29).
1/ The Tax Reform Act of 1976 eliminated the necessity for
"~ obtaining a Section 367 ruling in certain circumstances.
- 10 -
(b) Subpart F and its exclusions. The early anti-abuse provisions
were addressed to situations where an individual U. S. shareholder took
advantage of lower U. S. or foreign corporate tax rates, or where a U. S.
corporation took advantage of the tax-free reorganization provisions.
The Revenue Act of 1962 partially terminated deferral in answer to
the tax abuse which can arise when a U. S. parent corporation takes
advantage of lower foreign corporate tax rates on ordinary income
in tax-haven countries.
The Kennedy Administration originally sought the complete termination of deferral, but Congress adopted a m o r e focused approach.
The history and drafting of Subpart F (Section 951-964) indicate that
it represents a compromise between the complete termination of deferral and the classical system of taxing foreign corporate income. The
purpose of Subpart F is to terminate deferral in tax abuse situations,
yet otherwise retain the separate taxation of a foreign corporation
and its U. S. shareholders.
Subpart F, as enacted in 1962, taxes U. S. shareholders currently
on the income of a controlled foreign corporation when the nature of
the corporation and its sources of income combine to exhibit tax haven
characteristics. The foreign corporation is potentially subject to Subpart F if it is a controlled foreign corporation (CFC), that is to say,
if the voting stock is m o r e than 50 percent owned by U.S. "shareholders", defined as individuals or corporations each controlling at
least 10 percent of the voting stock. 1/
If the foreign corporation can establish that it did not have as one
of its purposes a substantial reduction in taxes (Section 954(b)(4)), it
will not fall within Subpart F. The substantial reduction test is not
defined with reference to U.S. tajxes. Rather the test is whether
taxes have been reduced by comparison with the taxes that would have
been imposed by the buying or selling country, or the paying or receiving country, if a third country corporation had not been interposed
in the transaction (Regulations 1. 954-l(b)(4), example (1)). A company
which was not organized with tax reduction as one of its significant
purposes can, however, still have Subpart F income on individual
transactions undertaken for the purpose of tax avoidance.
A controlled foreign corporation's income is subject to Subpart F
if it is derived from the insurance of U. S. risks, or if it is characterized as foreign base company income. Foreign base company income
includes: (i) foreign personal holding company income (interest,
dividends, rents, and similar categories of passive income); (ii) foreign
base company sales income (income derived by the C F C from selling
V In the case of a controlled foreign corporation that insures U. S.
risks, the test is whether more than 25 percent of the voting stock
is owned by U. S. shareholders. (Section 957(b)).
-11 -
or buying personal property to or from a related person, if the
property is both produced and sold for use outside the country in
which the C F C is incorporated); and (iii) foreign base company services income (income derived from the performance of technical,
managerial, or similar services or on behalf of a related person
outside the country of C F C incorporation).
When the foreign corporation and the composition of income
meet these statutory tests, the U. S. shareholders are generally
deemed to receive a distribution of retained earnings and are taxed
accordingly, with provisions for a foreign tax credit (Sections 960
and 962).
A s a backstop to Subpart F, the Revenue Act of 1962
required that when a U.S. shareholder disposes of shares in a
controlled foreign corporation, the gains must be reported as ordinary income to the extent of earnings and profits accumulated after
1962 (Section 1248)._l/ This provision forestalls the accumulation
of earnings in a C F C not subject to Subpart F, and the taxation
of that income at more favorable capital gains rates.
The Revenue Act of 1962 provided several exclusions to the
general rule of current U.S. taxation of Subpart F income. The
Tax Reduction Act of 1975 repealed or modified four of the exclusions and added one new exclusion. 27
(i) Minimum distribution. The parent corporation could elect
a so-called "minimum distribution". The m i n i m u m distribution was
a constructive distribution of earnings from C F C s with and without
Subpart F income. If the m i n i m u m distribution showed that average
foreign taxes were equal to a certain percentage or within a certain
percentage point range of the U.S. tax rate, the deemed distributions under Subpart F were reduced or eliminated. The m i n i m u m
distribution election was repealed by the Tax Reduction Act of
1975.
(ii) Less developed country corporations. The Subpart F
income of a C F C derived from and reinvested in "qualified investments" in less developed countries was excluded from the definition
of foreign base company income. Less developed countries were
broadly defined to include all nations outside of industrial Europe,
Canada, Japan, Eastern Europe, and the Sino-Soviet Bloc. This
exclusion was repealed by the Tax Reduction Act of 1975.
1/ A n exception was made for the disposition of shares in a less
~~ developed country corporation (Section 1248 (d)(3)).
2/ The Tax Reform Act of 1976 made further minor changes in
"" Subpart F.
- 12 -
(iii) 30-70 rule. If less than 30 percent of C F C income was
characterized as foreign base company income, then a special rule
provided that none of the income would retain that character and no
deemed distribution was required. If between 30 and 70 percent of
the income was characterized as foreign base company income,
then the actual percentage would have that character and that percentage would be subject to a deemed distribution. Above 70 percent,
the entire C F C income would be characterized as foreign base company income and would be deemed distributed. The Tax Reduction
Act of 1975 changed the 30 percent rule to a 10 percent rule.
(iv) Shipping income. As originally enacted, Subpart F provided
an exclusion from foreign base company income for income derived
from, or in connection with, the use of any aircraft or vessel in
foreign commerce. The Tax Reduction Act of 1975 required that
shipping income be reinvested in shipping operations to qualify for
this exclusion.1/
(v) Agricultural sales. The Tax Reduction Act of 1975 modified
the definition of foreign base company sales income to exclude income
from sales of agricultural commodities which are not grown in the
United States in commercially marketable quantities.
1/ The Tax Reform Act of 1976 provides that income from coastal
~~ shipping operations within one country is not base company shipping income if the ships are registered within that country and the
company is incorporated locally.
- 13 -
IIL
ANALYSIS
!• International tax neutrality. Tax neutrality is a broad concept
which is often defined in conflicting ways. Whether foreign corporate
income is taxed by the United States currently or only when dividends
are distributed is one element in a definition of international tax neutrality, but it is not the only element. The relationship between deferral
and international tax neutrality must be viewed in the overall context
of U. S. and foreign tax rules.
Tax neutrality at the corporate level 1/for foreign investment can
be defined either with reference to the taxation of domestic profits, or
with reference to the taxation of the profits of competing foreign firms.
These alternative standards are usually designated as "capital-export
neutrality" and " capital-import neutrality". In their pure forms, the
concepts of capital-export neutrality and capital-import neutrality say
nothing about the division of tax revenue between home and host country
tax authorities. In principle, either type of neutrality could be reached
consistent with various revenue sharing arrangements between the taxing authorities. In practice, under present international rules, each
type of neutrality tends to be associated with a certain division of
revenue.
Capital-export neutrality is achieved when the total rate of
corporate tax onforeign profits is the same as on comparable domestic
profits. For example, if the French subsidiary of an American firm
pays 40 percent of its profits in tax to France, and if the United
States corporate tax rate was a uniform 48 percent, capital-export
neutrality would be served by a current U. S. corporate tax of 8 percent
on the French subsidiary's profits.
In order to achieve capital-export neutrality under existing
domestic tax law, several underlying conditions would have to be met.
First, host country taxes paid should be credited against
the home country tax liability, with a refund of excess foreign
taxes; alternatively, home country taxes should be credited
against the host country tax liability;
Second, foreign income, including undistributed subsidiary
earnings, should be taxed currently to the parent corporation
by the home country;
Third, the home country should employ the same accounting practices in calculating domestic and foreign profits (in particular, the same depreciation conventions should be used);
1/ This paper does not analyze tax neutrality at the individual level.
- 14 -
Fourth, any capital subsidies provided for investment
in the home country (for example, an investment tax credit)
should be available for investment abroad.
Similarly, preferential taxation of export earnings, such as through the DISC,
should be extended to foreign production for export markets;
Fifth, the same treatment should apply to sub-Federal income taxes levied at home and abroad. If state and local taxes
are deductible at home, then to the same extent they should
be deductible in computing taxable foreign source income;
Sixth, losses of foreign subsidiaries should be deductible
to the same extent as the losses of the parent companies.
Capital-export neutrality could alternatively be achieved under a
reformed domestic tax law which was free of all corporate tax preferences, and instead taxed corporate income at a uniformly lower rate.
In order to achieve capital-export neutrality under such a neutral
domestic tax law, several conditions would have to be met, many
the same as before.
First, (and this is the main difference), tax preferences
for domestic corporate income must be repealed, and nominal corporate tax rates must then be lowered so that there
is no net revenue change from the taxation of domestic income;
Second, host country taxes paid should be credited against
the home country tax liability, with a refund of excess
foreign taxes; alternatively, home country taxes should be
credited against the host country tax liability;
Third, foreign income should be taxed currently by the
home country;
Fourth, the home country should employ the same accounting practices in calculating domestic and foreign profits;
Fifth, the same treatment should apply to sub-Federal
income taxes levied at home and abroad;
Sixth, losses of foreign subsidiaries should be deductible
to the same extent as the losses of the parent companies.
A regime of capital-export neutrality, whether achieved under
existing domestic tax law or under a neutral domestic tax law, would-unlike present law--encourage U. S. firms to locate their productive
facilities wherever pre-tax returns promised to be greater. A firm
would be indifferent between a 20 percent pre-tax rate of return on
investment in Canada, in Brazil, or in the United States, for it
would receive the same after-tax return in all cases. Tax considerations would play no role in investment decisions, pre-tax returns
- 15 on U. S. investments of equivalent risk would ultimately be equalized
around the world, and the United States capital stock would be allocated in a manner designed to maximize world production. 1/'
Capital-import neutrality for corporate investment would be
achieved if firms of all nationalities operating in one industry--for
example, the Italian office equipment industry--paid the same total
tax rate on profits earned in the country where the industry islocated-inthis case Italy. 2/ Pure capital-import neutrality in this situation
would emerge if Italian tax law m a d e no differentiation among enterprises of diverse national origin. For example, Italy could not withhold tax on dividends, interest, and royalties paid to foreign
corporations unless it also withheld tax on such payments to Italian
corporations. Furthermore, foreign nations should m a k e no attempt
to impose an additional tax on corporate earnings arising in Italy.
Indeed,
one way home countries can promote capital-import
neutrality is through the unilateral exemption of corporate foreign
source income from domestic taxation, as is virtually done by France
and the Netherlands. 3/ Under territorial taxation, as this approach
is called, the home government relinquishes all tax claims, and the
host government collects all the tax revenues arising from the enterprise. However, a revenue sharing arrangement between the host and
home countries
would equally be consistent with capital-import
neutrality.
Capital-import neutrality is sometimes called "competitive"
neutrality because firms of diverse national origin compete on an
equal tax basis in any particular country and industry. Because tax
considerations do not distort competition, capital-import neutrality
promotes the most efficient use of resources between firms in that
country and industry.
Both in legislation and in bilateral tax treaties, the United
States has attempted. to ensure the type of tax neutrality appropriate
to different situations, while at the same time protecting U. S. tax
revenue. Thus, United States taxation of the foreign income of U. S.
owned firms embodies a mixture of capital-export neutrality, capitalimport neutrality, and revenue protection clauses.
1/ This statement ignores the misallocation caused by tariffs,
quotas, and other impediments to free international trade.
2] When a host country has an integrated system of taxing corporations and their shareholders, the analysis of capital-import
neutrality can become more complicated. This discussion
envisages a host country with a classical separate entity system
of taxation.
3_/ France arid the Netherlands do tax a small portion of corporate
foreign source income.
- 16 The keystone of U.S. taxation of American enterprise abroad is
the foreign tax credit. Subject to certain limits, U.S. firms m a y take
a credit against their tentative U.S. tax for the foreign income tax
levied on the repatriated earnings of foreign corporate subsidiaries^/,
on the total earnings of foreign branches, and on interest, rents,
royalties and fees paid from foreign sources. The foreign taix credit
essentially cedes to the host country the first slice of tax jurisdiction,
and hence most of the revenue. To the extent that a U. S. firm repatriates dividends, interest, rents, royalties or fees from its foreign
corporate subsidiary, or operates abroad through foreign branches,
the foreign tax credit system m a y c o m e close to ensuring capitalexport neutrality.
There are several reasons, however, why existing United States
law does not entirely achieve capital-export neutrality. The U. S.
foreign tax credit limitation rules operate so that when foreign taxes
exceed the tentative U.S. tax on foreign source income, the excess
foreign tax credit cannot be claimed currently (but it can be carried
forward or carried back to other taxable years). If the excess credit
could be claimed without limit, foreign governments could erode U. S.
tax revenues on domestic source income. But because the excess
foreign tax credit cannot be claimed, capital-export neutrality disappears whenever the foreign tax rate exceeds the U.S. rate. Foreign
investment offering a given pre-tax return then becomes less attractive than domestic investment offering the same return.
In addition to the foreign tax credit limit, other features of the
law reduce the extent of capital-export neutrality. U.S. parent corporations cannot offset the losses of foreign subsidiaries against
domestic income (the losses of foreign branches of U.S. corporations
can, however, be offset against domestic income). The investment
tax credit is not available for capital expenditures abroad, 2/ and
the asset depreciation range (ADR) cannot be used for computing earnings and profits of a foreign subsidiary. 3^/ DISC is not available
for exports by foreign subsidiaries. Like the limit on applying the
foreign tax credit, these measures shield the U. S. Treasury and
promote domestic investment, at the expense of capital-export
neutrality. T w o asymmetries, however, favor foreign over domestic
investment: U.S. taxation of foreign subsidiary earnings is deferred
until dividends are declared, and foreign sub-Federal taxes m a y be
credited against the tentative U.S. tax, whereas U.S. state and local
taxes can only be deducted from earnings.
1/ There is both a direct credit (Section 901) for foreign withholding
taxes ondividends, and an indirect credit (Section 902) for foreign
taxes paid on the underlying corporate earnings.
2/ Section 48(a)(2).
3/ The tax rules provide that guideline periods, but not the asset
depreciation range, m a y be applied to property predominately
used outside
the
United
States (Revenue Procedure 72-10;
Regulation 1. 964-l(c) (i)(iii)).
- 17 -
To the extent that the earnings of a foreign corporate subsidiary
are not remitted as dividends, United States tax practice comes close
to achieving capital-import neutrality. No current U. S. tax is levied
on those earnings; instead U. S. taxation is deferred until repatriation.
(Under the foreign personal holding company legislation and Subpart F,
certain kinds of tax haven income m a y be taxed currently, whether or
not repatriated. ) When earnings are retained abroad, deferral places
the American-owned foreign subsidiary on m u c h the same tax footing
as its local competitors.
Pure capital-import neutrality cannot be
achieved, however, unless the United States (and other countries) abandon
their claim to tax foreign source income (although home countries could
seek revenue sharing arrangements with host countries) and host countries pursue a strict policy of non-discrimination.
In essence, an American multinational enterprise can elect to have
its foreign ventures taxed either under a modified form of capital-export
neutrality (by operating through a foreign branch or by distributing the
earnings of a foreign subsidiary), or under a modified form of capitalimport neutrality (by ope rating through a foreign subsidiary and retaining
the earnings abroad). In neither case is the neutrality pure, and the
level of purity partly depends on the host country.
The 1976 revenue consequences of present law, and of possible
changes , are summarized in Table 1 for the non-extractive industries. 1/
Corporate pre-tax foreign earnings were about $24.9 billion, foreign
taxes were about $10. 3 billion (41 percent of earnings) and U. S. tax
collections were about $2. 0 billion (8 percent of earnings).
A standard of pure capital-import neutrality at the corporate level
would require zero U. S. tax collections on corporate foreign source
income. The adoption of a territorial system would thus involve a 1976
revenue loss of nearly $2. 0 billion by comparison with present collections. This revenue loss could be unilaterally absorbed by the United
States, or it could be shared between the United States and various
host countries. Capital-import neutrality, in whatever manner achieved,
would not of course answer those critics of deferral who wish to increase
U. S. tax revenues and promote domestic investment.
A standard of capital-export neutrality under existing domestic tax
law would also reduce the revenue collections of U. S. and foreign tax
authorities (assuming the revenue loss is shared). In 1976, the net
revenue loss from a system of pure capital-export neutrality would
have been about $1. 2 billion. The net loss represents a combination of
revenue effects. If the law were changed to end deferral, to provide
a deduction rather than a credit for that portion of foreign taxes which
1/ The taxation of petroleum and hard minerals involves special considerations which do not easily fit into the concepts of capital-export
neutrality and capital-import neutrality. For this reason, Table 1
is confined to the non-extractive industries.
Table 1
Estimated Tax Revenue Consequences in 1976 of Achieving Alternative Standards of
International Tax Neutrality with Respect to U.S. Corporations in Non-Extractive Industries
(Millions of Dollars)
Foreign source income of U.S. corporations, before taxes
Capital-export neutrality
With extension of :
U.S. domestic tax : With removal of
preferences to
: U.S. tax preferences
foreign investment : for domestic investment
24,900
24,900
Capital-import
neutrality
24,900
Present total taxes on the foreign source income of
U.S. corporations under current law
Net U.S. taxes
Foreign taxes
12,270
1,970
10,300
12 270
1 970
10 300
12,270
1,970
10,300
Change in total taxes on the foreign source income of
U.S. corporations in non-extractive industries
•1,220
-2 ,990
1,970
Remove U.S. tax preferences for foreign investment
Western Hemisphere Trade Corporation deduction __/
Non gross-up of dividends from LDC corporations 1/
Deferral of tax on retained profits of foreign
subsidiaries
Allowance of credit for foreign taxes comparable to
state income taxes
Allow credit (or refund) for foreign taxes in excess
of overall limitation
890
ZU
55
365
365
450
450
-180
-180
Remove U.S. tax preferences for domestic investment
and reduce U.S. corporate tax rate on domestic
and foreign source income to 33 percent 2/
Extend U.S. domestic investment tax preference to
foreign investment
Investment tax credit
Asset depreciation range
.
Domestic International Sales Corporation (DISC) 1'
890
20
55
_ 3,700
-1,930
•1,000
-300
-630
-1,970
Adopt territorial income tax
Hypothetical total taxes on the foreign source income
of U.S. corporations in non-extractive industries
11,050
9,280
10,300
Office of the Secretary of the Treasury
Office of Tax Analysis
1/ These features were repealed, with transition rules, by the Tax Reform Act of 1976.
2/ After the hypothetical repeal of all U.S. tax preferences for domestic investment by the non-extractive industries,
~~ the U.S. corporate tax rate could be reduced from 48 percent to about 33 percent (on a broader base) with no change in
tax revenue on domestic source income. However, there would be revenue loss on foreign source income, since the
applicable tax rate on that income would also drop from 48 percent to 33 percent.
3/ This estimate represents the effect of extending DISC treatment, as modified by the Tax Reform Act of 1976, to export
—
sales of foreign subsidiaries of U.S. corporations.
-19correspondstoU.S. state and local taxes, and to eliminate certain minor
non-neutralities, there would be revenue gains. But these gains would
be m o r e than offset if the law were also changed to compensate for
foreign taxes in excess of the tentative U. S. tax, and to extend the
mvestment tax credit, the asset depreciation range, and DISC to investment abroad.
A standard of capital-export neutrality under a neutral domestic
tax law would likewise reduce the revenue collections of U.S. and foreign
tax authorities on U.S. investments abroad. After the repeal of domestic tax preferences, and a compensating reduction in rates so that the
corporate tax on domestic income remained unchanged, the nominal
U.S. corporate tax rate could be reduced from 48 percent to about 33
percent. A s a result, however, current U.S. revenues from foreign
source income would decline by $3. 7 billion. This would be partly offset by higher revenues from the termination of deferral, from the rerepeal of the Western Hemisphere Trade Corporation deduction, from
the gross-up of dividends from less developed country corporations,
and from other changes. But a net revenue loss of $3. 0 billion on foreign source income would remain after all adjustments.
Few would argue that the United States should unilaterally
implement a standard of capital-export neutrality and incur all the
associated revenue costs. Such a standard would require tax cooperation
between the United States and foreign governments. O n the other hand,
legislation by the United States to end deferral would not, by itself,
move the international tax system closer to a standard of capital-export
neutrality. Rather, it would reinforce the existing preferential taxation
of corporate profits earned within the United States. 1/
2
» Constitutional problems. The taxation of a shareholder on the
constructive receipt of a corporation's undistributed earnings raises constitutional issues. Can such earnings properly be viewed as "income"
under the terms of the Sixteenth A m e n d m e n t ? This issue has recently
been litigated in connection with Subpart F. The court decisions upholding Subpart F provide some indication of the potential reach of U.S.
tax law if a wider termination of deferral is sought. 2/
1/ It should be emphasized that the investment tax credit or DISC can
exert a very different impact on investment per dollar of revenue
cost than, for example, deferral or the foreign tax credit. Therefore,
an examination of total revenue gains and losses under alternative tax
systems provides only a rough guide to their impact on the location of
investment.
2/ Subpart F has withstood legal attacks based on the due process clause
of the Fifth Amendment, the principles of international law, and the
Sixteenth Amendment.
The Sixteenth Amendment issues are most
important, and they are the only onesdiscussed here. The discussion
draws on an unpublished paper by Howard Liebman, "The Tax
Treatment of Joint Venture Income Under Subpart F: Some Issues
and Alternatives", April 1976.
- 20 -
The Sixteenth A m e n d m e n t gives Congress the power to impose
income taxes. Ifatax is not levied on "income", it would be considered
a "direct tax" under the ruling in Pollock v. Farmer's Loan Trust (157
U.S. 429, 158 U.S. 601, 1895), and would require apportionment among
the states according to population. The opponents of Subpart F have
relied on the Pollock opinion to argue that the current taxation of
each C F C shareholder's portion of undistributed earnings and profits
cannot possibly constitute a tax on "income" and must, therefore, be
apportioned among the states as a "direct tax". The basis for this
reasoning lies in the decision of Eisner v. Macomber (252 U.S. 189,
1920) holding that a stock dividend on accumulated profits is not
"income" under the Sixteenth Amendment. But Macomber was a close
decision and has since been undercut by numerous judicial exceptions.
Thus, in 1961, the Treasury Department's General Counsel concluded
that, "enactment of [Subpart F] is appropriately within the constitutional powers of the Congress both to lay and collect taxes and to
regulate commerce with foreign nations. "\l
This view has been upheld by the Tax Court:
The Supreme Court's pronouncements
have been to the effect that taxation
of undistributed current corporate
income at the stockholder level is
within the Congressional power. 2_/
Although the Supreme Court has not ruled on Subpart F, other
courts have endorsed the Tax Court's position. There appears to be no
constitutional barrier to the termination of deferral for a wider class of
income than that presently defined in Subpart F.
A more general termination of deferral would,however, provide
an incentive for U.S. shareholders to "decontrol" their existing controlled foreign corporations and to take minority positions in new
ventures rather than establish new controlled foreign corporations.
The incentive to escape current taxation might be mitigated
if the ownership threshold used to define a controlled foreign
corporation were reduced to 50 percent or less. However, a
lower threshold might conflict with the "constructive receipt'
doctrine underlying both Subpart F and the foreign personal holding
_1/ M e m o r a n d u m from Robert H. Knight to Treasury Secretary Dillon,
June 12, 1961, in President's 1961 Tax Recommendations, Hearings
before the House Committee on W a y s and Means, 87th Congress, 1st
Session (1961), Volume 1, p. 322.
2/ Estate of Leonard E. Whitlock, (59T.C. 490, 507, 1972; affirmed
494 F.2nd 1297, 10th Circuit, 1974).
- 21 company legislation. If the U. S. shareholders are not a closeknit,
controlling group that can force the declaration of a dividend, the
constitutionality of a lower threshold under the Sixteenth Amendment
and the due process clause of the Fifth Amendment must once again
be assessed.
How can the United States tax a shareholder on an
undistributed gain when the shareholder lacks the degree of control
required to realize the imputed gain? It m a y seem "patently unfair
and unjust to tax anyone on income which he has not received and
which is not within his control, "l I
The most recent cases dealing with Subpart F have indicated that
actual control rather than numerical control is the key issue. In Garlock
(58 T. C. 423, 1972) "actual control"by U. S. shareholders in a reorganlzed Panamian subsidiary was found where the U. S. shareholders only
owned 50 percent of the subsidiary, and foreign investors, chosen for
their sympathy towards the management, owned callable cumulative
preferred stock. Hans P. Kraus (59 T. C. 681, 1973; affirmed, 490
F. 2nd 898, 2nd Circuit 1974) presented similar facts. The court
looked to substance rather than form and concluded that divestment
in order to avoid the impact of Subpart F must result in actual decontrol.
These cases suggest that Subpart F might be extended to
situations where U. S. shareholders own less than 50 percent of the
foreign corporation, provided that U. S. shareholders exercise actual
control. 2/
3
' Foreign reaction. Any significant change in the U. S. approach
to deferral would raise tax treaty questions and might prompt offsetting
foreign tax legislation.
(a) Tax treaties. The United States has in force tax treaties
with some 37 countries (including extensions to former colonies). Five
treaties have been signed and await ratification by the U. S. Senate
and foreign parliamentary bodies.
Ten tax treaties are in various
states of active negotiation.
The deferral of U. S. tax on the income of controlled foreign
corporations is not specifically addressed in these treaties. 3/ The
V
Statement
of
Randolph W .
Thrower, Hearings before the
Senate Committee on Finance, 87th Congress, 2nd Session (1962)
part 6, p. 2251.
2' For a contrary case see CCA, Inc. (64 T. C. 137, 1974). Note
that income from the insurance of U. S. risks earned by a foreign
corporation which is owned more than 25 percent by U.S. shareholders is presently taxed under Subpart F (Section 953 and 957
(b)). The 25 percent test has not been litigated, and it is not
clear whether it furnishes a precedent for a less than 50 percent
ownership test in the absence of actual control.
3/ The pending treaty with Egypt takes note of U. S. deferral provisions and their interaction with Egyptian tax incentives.
- 22 -
United States has made no treaty commitments which would preclude
partial or total elimination of deferral. However, the classical U. S.
system of taxation and the consequent deferral of U. S. taxation of
retained foreign corporate earnings are well understood by foreign tax
officials, and these elements of U. S. law play an important role in
treaty negotiations.
Less developed countries frequently raise the issue of a tax
sparing credit. The tax sparing credit is a home country foreign tax
credit for taxes waived by the host country, usually through a tax
holiday or preferential tax rates designed to encourage a particular
industry. The United Kingdom, France, Germany, Japan, Canada
and most other industrialized countries grant a tax sparing credit
in their bilateral tax treaties with less developed countries. During
the 1950's and 1960's, the United States negotiated seven treaties
with either a tax sparing credit (Pakistan, India, Israel and the UAR)
or, as a substitute, an investment tax credit (Brazil, Thailand,
Israel). In none of the seven cases did the credit provisions receive
Senate approval. The United States Treasury no longer negotiates
treaties with either a tax sparing credit or an investment tax credit.
However, in negotiations with less developed countries, the
United States has emphasized that existing U. S. tax law does not
frustrate local tax incentives. If the host country chooses to reduce
its corporate
tax rates as an investment incentive measure, the
United States will not absorb the incentive through offsetting taxation
so long as the
foreign subsidiary reinvests its earnings abroad.
Moreover, the U. S. ordering rule for associating dividends with
earnings and profits ensures that U. S. taxes need never erode the
foreign tax relief, even if earnings are distributed during the
post-tax relief period.
The United States follows a last-in-firstout rule in tracing dividends to the underlying earnings and profits.
Thus, suppose Country X grants a five year tax holiday, and in
the sixth year imposes a 45 percent tax on current earnings. During
the tax holiday period, the controlled foreign corporation accumulates
earnings and profits of $12 million, but distributes no dividends.
In the sixth year, the corporation earns $3. 63 million (before tax),
pays foreign taxes of $1.63 million, and therefore has after-foreigntax earnings of $2. 0 million. A dividend of $2. 0 million is distributed
to the U. S. parent. The entire dividend is deemed to be paid out
of current earnings, and none of the dividend is deemed to be paid
out of accumulated earnings.
The grossed-up dividend for U. S.
tax purposes will be $3.63 million. 1'
The net U.S. tax on the
V
Under prior law, dividends from a less developed country corporation were not grossed-up, and a different formula was used
to calculate the foreign tax credit. The Tax Reform Act of 1976
requires the gross-up of such dividends.
- 23 dividend, after allowance for the foreign tax credit of $1.63 million
would be $0.11 million. 1/
The combination of deferral and the dividend inventory rule has
proven satisfactory to m a n y of our tax treaty partners. On the one
hand, developed countries have not had to negotiate the issue of U. S.
tax treatment of their own tax relief provisions for particular regions
or industries. On the other hand, less developed countries have often
dropped their initial demands for a tax sparing credit or similar provisions. If the United States were to terminate deferral, some treaty
countries would no longer be satisfied with existing arrangements. They
might seek new negotiations with a view toward provision of deferral
by treaty. Alternatively, they might take unilateral statutory steps along
the lines in the following discussion.
. <b> Foreign statutory change. If the United States limits the extent
of deferral, countries which provide tax relief as an incentive measure
might narrow the scope of that relief to exclude companies which would
be subject to current U. S. taxation. The result could be heavier foreign
taxation of U. S. controlled foreign corporations, by comparison with
competing firms either owned locally or by third country parent firms.
In selected instances, heavier foreign taxation might serve to equalize
the taxation of U. S. investment at home and abroad, but it would erode
the potential gains in U. S. tax revenue from the termination of deferral,
and it might put U. S. firms at a severe competitive disadvantage.
There are several ways foreign taxes on U. S. controlled foreign
corporations could be selectively increased. Subsidiaries of U. S. corporations might no longer be eligible for special tax holidays and investment tax credits. For example, under present law Egypt provides tax
relief for foreign investors only if the home country does not tax the
income either when earned or distributed. Alternatively, foreign countries could m a k e withholding taxes payable on deemed dividend distributions, as well as on actual dividend distributions, and withholding tax
rates could be increased.
V
In this case, the deemed paid foreign tax credit is calculated as:
Dividend x Foreign corporation income tax
Earnings after foreign tax
= $2. 0 x $1. 63 = $1.63
The tentative U. S. tax before the credit would be 48 percent of $3. 63
million, or $1.74 million.
After the foreign tax credit of $1.63
million, the net U. S. tax would be $0.11 million.
- 24 -
In cases where the foreign country wished to encourage U.S.
firms, methods could be found which would circumvent the U.S. termination of deferral. The foreign country could provide tax relief for
joint ventures in which the U.S. corporation held a minority interest,
and therefore was not subject to current U.S. taxation. Alternatively,
the foreign country could provide U. S. controlled corporations with
input subsidies--for example wage or energy subsidies--while taxing
the C F C s at rates close to the U.S. corporate rate. This possibility
is., illustrated- in Table 2.
In both situations, the firm has sales of 1, 000, raw material costs
of 400, and wage costs of 500. In Case A , with U.S. deferral, a tax
holiday in the foreign country ensures that the firm realizes after-tax
income of 100. In Case B, without U. S. deferral, a wage subsidy of
100 coupled with a foreign corporate tax of 50 percent ensures that
the firm still realizes after-tax income of 100._1/ In the eyes of the firm,
little has changed._/
In the first case, the foreign government collects no tax, in the second case, the wage subsidy just offsets the tax,
and in both cases the United States collects no tax. It is not clear what
the United States would gain by encouraging foreign countries to undertake this sort of fiscal subterfuge._/
(c) Average foreign tax rates. With the termination of deferral,
many foreign countries would be concerned about the U. S. tax status
of subsidiaries engaged in particular industries and regions. Reliable
foreign tax rate figures for particular industries and regions within individual countries are not available, but national average tax rate figures
can be estimated. Although national average tax rates often conceal the
situation for individual industries and regions, they do perhaps indicate
the nations which would be most seriously affected by the termination of
deferral.
Table 3 shows 1974 statutory and realized corporate tax rates,
the withholding rate applied to dividends payments to the United States,
and the total (corporate and withholding) realized tax rate on grossed-up
dividends for more than 60 countries. Realized corporate tax rates are
1/ The wage subsidy cannot be conditioned on the payment of tax, or
it would be regarded as a tax refund for purposes of calculating the
U.S. foreign tax credit.
_/ In the long run,however, the firm may respond differently to a wage
subsidy than a tax holiday.
For example, a wage subsidy might
induce the firm to use more labor and less capital to produce a given
level of output.
_l It should be noted that the foreign tax credit mechanism generally
encourages foreign governments to tax the aggregate of dividends,
interest, rents, royalties, and other foreign income paid to U.S.
corporations at a rate near 48 percent.
- 25 -
Table 2
Comparison Between Foreign Tax Relief and Foreign Input Subsidies
Case A
U.S. taxation with
deferral
Foreign tax holiday
Sales
1,000
Raw materials
400
Wages
500
Less: wage subsidy
100
Income before tax
Foreign tax
100
Income after foreign tax
Deemed or actual
dividend distribution
U.S. tax after foreign
100
tax credit
Office
theall
Secretary
Income ot
after
taxes or the Treasury
Office of Tax Analysis
Case B
U.S.taxation without
deferral
Foreign corporate tax
of 50% plus wage subsidy
1,000
400
500
(100)
200
100
100
100
100
February 3, 1976
- 26 -
computed as the ratio of taxes paid to the U.S. definition of pretax earnings and profits, which is the base from which the deemed paid
foreign tax credit is computed.J./
The realized rates are estimated
from 1968 data, adjusted for changes in statutory rates between 1968
and 1974.
The figures in Table 3 are confined to the manufacturing sector.
Termination of deferral would have its greatest impact on manufacturing. Realized foreign tax rates on mineral income frequently exceed
the U.S. tax rate, so deferred U.S. taxation makes no difference.
Undistributed corporate earnings arising in the trade, finance, and
insurance sectors are to some extent taxed currently under Subpart F
(as amended by the Tax Reduction Act of 1975). Thus, low foreign
tax rates applied to those sectors are already partly offset by current
U.S. taxation.
Table 3 reveals that realized corporate tax rates on manufacturing
are generally well below the statutory rate. The median ratio of
realized to statutory tax rates in 1974 was approximately 80 percent;
in only 11 of the 63 countries did the realized rate exceed the statutory
rate.
For purposes of evaluating the consequences of terminating deferral on a country-by-country basis, the correct procedure is to compare
foreign total realized tax rates on grossed-up dividends with the U.S.
statutory corporate rate of 48 percent. 2/ The U.S. foreign tax credit
is so designed that the termination of "Heferral would usually result in
higher U.S. taxation of retained corporate income in those countries
with realized tax rates below the U.S. statutory rate. 3/ Table 3 reveals
that, in 1974, 26 countries imposed a total realized tax rate on grossedup dividends above the U.S. statutory rate of 48 percent, while
37 countries imposed total realized rates below the U.S. statutory rate. The partial or complete termination of deferral would
1/ The term "realized tax rate" indicates the ratio between taxes paid
and earnings and profits, as reported for U.S. tax purposes. By
contrast, the term "effective tax rate" often refers to the ratio
between taxes paid and book income, as reported for financial
purposes.
Foreign effective rates for selected countries are
reported in Survey of Current Business, M a y 1974 (Part I).
2] The realized U.S. corporate tax rate on domestic source income was
about 41 percent in 1974, but the U.S. statutory rate--not the U.S.
realized rate--applies to foreign source income.
3/ This generalization does not apply to U.S. firms which use the overal
limitation in reporting the foreign tax credit ( as they must under the
Tax Reform Act of 1976) and also have excess foreign tax credits.
Table 3
Statutory and Realized Corporate Income Tax Rates on Manufacturing Firms, 1974
Country
Canada
Statutory T a x Rates
Distributed
Corporate
profits tax
2/
Tax Rate 1/
rate, if different
48.0
Withholding tax rates
on dividends distributed
to U.S.
Total real
Statutory
: Realized
tax rate
or Treaty
: Rate on
grossed
Rate
: grossed-up
dividen
:dividends
Local
Income
taxes
Realized
Corporate
tax rate 3/
13.0
41.1
15.0
15.0
53.4
37.5
32.5
48.0
43.0
11.9
12.7
41.9
17.1
36.0
40. 5
30.3
43.1
27.1
44.6
5.0
15.0
5.0
5 0
15.0
30.0
5.0
5.0
5.0
10.0
15.0
15.0
5.0
5.0
15.0
2.3
9.4
3.4
2.6
8.5
26.4
4.4
2.9
4.1
6.4
8.9
10.5
2.8
3.6
8.3
55.7
46.9
35.9
50.6
51.5
38.3
17 .1
44.8
21.2
42.4
49.4
40.8
45.9
30.7
52.9
49.9
Europe:
27.5
0
Austria
Belgium
Denmark
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Norway
Spain
Sweden
Switzerland
United Kingdom
Oceania:
55.0
42.0
36.0
50.0
51.0
38.2
50.0
43.8
40.0
48.0
26.5
32.8
40.0
8.8
52.0
Australia
New Zealand
47.5
45.0
42.9
51.7
15.0
5.0
8.6
2.4
51.5
54.1
42.0
42.9
42. 2
28.2
20.0
12.0
11.6
8.6
53.8
36.8
25.0
15.0
0
27.0
4/
13.0
4/
5/
14.0
0
4/
21 .3
25.0
28.0
26. 2
Latin America:
Mexico
Argentina
Table 3 - continued
Statutory tax rate!
Country
Corporate
tax rate 1/
Brazil
Chile
Columbia
Ecuador
Peru
Uruguay
Venezuela
Costa Rica
El Salvador
Guatemala
Honduras
Nicaragua
Panama
Africa:
Algeria
Mo roc co
Liberia
Ethiopia
Kenya
Nigeria
Rhodes ia
South Africa
Zambia
30.0
41.7
36.0
20.0
55.0
37.5
50.0
40.0
15.0
52.8
40.0
30.0
50.0
Distributed
: Local
profits tax
_ , : income
rate, if different— : taxes
33.5
40.0
50.0
48.0
45.0
40.0
40.0
45.0
40.0
43.0
45.0
Withholding tax rates
on dividends distributed
to U.S.
Realized
Realized
Statutory
rate on
corporate
or treaty
grossed-up
3/
tax rate
rate
dividends
Total realized
tax rate on
grossed-up
dividends
30,
39.
47,
18,
47,
25,
30.0
33.7
7.6
21.0
25.2
1.8
15.4
25.0
40.0
20.0
40.0
30.0
25.0
15.0
15.0
38.0
10.0
5.0
0.0
10.0
17.4
24.2
10.5
32.5
15.7
18.7
10.5
9.9
35.1
7.9
3.7
0.0
8.5
47.
63.
57.
51.
63.
43,
40.
43,
42.
28.
28,
1,
23,
0.0
54.5
5.7 6/
38.6
19.0
4.7
30.9
41.9
28.0
18.0
25.0
15.0
0.0
12.5
15.0
15.0
15.0
15.0
18.0
11.4
14.1
0.0
10, 1
14 3
10 4
8. 7
10.8
18.0
65.9
19.8
38
29
19
41
50
38.8
10.5
44.7
15.1
60.0
30.0
10.0
53.7
16.6
8.5
64.2
61.3
23.6
21. 2
57.0
39.3
25. 7
31.0
11.1
52.2
68.1
Middle East
Iran
Israel
Lebanon
10.0
56.5
42.0
55.0
42.0
60.0
60.0
33.3
3.4
15.0
Asia:
Sri Lanka
India
Table 3 - continued
Withholding tax rates :
on dividends distributed
Statutory Tax Rates
Country
Corporate
Tax Rate 1/
Malaysia
Pakistan
Phillippines
Singapore
Taiwan
Thailand
Hong Kong
Japan
Indones ia
Distributed
: Local
profits tax
2/ : Income
rate, if different : taxes
40.0
60.0
35.0
40.0
25.0
30.0
15.0
40. 0
45.0
28.0
12.0
Realized
Corporate
tax rate 3/
Statutory
or Treaty
Rate
Realized
Rate on
grossed-up
dividends
40.0
15.0
35.0
40.0
10.0
25.0
0.0
10. 0
20.0
28.8
7.1
24.6
29.2
9.4
21.3
0.0
5.6
12.7
0.0
0.0
0.0
0.0
0.0
0.0
21.7
22.6
18.0
37.5
12.2
36.7
15.0
10.0
14.1
29.0
13.2
6.3
27
52
29
26
6
14
15
47.4
36.4
6/
Total realized
tax rate on
grossed-up
dividends
56.
59.
54.
56.
15.
36.
15.
53,
49,
Other Western Hemisphere:
Bahamas
Bermuda
Netherlands
Antilles
Dominican Republic
Jamaica
Puerto Rico
Trinidad & Tobago
5.1
0.3
34.0
41
45
40
45
1
0
0
0
15.0
4.5 6/
5.1
0.3
4.5
35.8
51.6
25.4
43.0
April 6, 1976
Office of the. Secretary of the Treasury
Office of Tax Analysis
NOTES:
1/ For some countries, 1974 rates were unavailable and 1973 rates were used.
"2/ The distributed profits tax rate reflects both split rates and imputation systems.
3/ Estimated by increasing (or decreasing) the 1968 realized corporate rate for manufacturing by the percentage
_
change in the statutory corporate rate.
4/ Dividends are fully deductible from earnings in Greece and Norway; in Belgium, they are deductible within limits.
5/ Included in the corporate rate.
6/ This is the realized rate for all industries
SOURCES: M.E. Kyrouz, "Foreign Tax Rates and Tax Bases," National Tax Journal, March 1975; unpublished data.
- 30 -
principally affect U.S. investment in the 37 countries in the latter
category. Of these 37 countries, 27 were less developed countries
which presumably rely on tax relief to promote development.
4. Administrative aspects. U.S. "shareholders" in a controlled
foreign corporation are required to report the CFC's earnings and profits under U.S. accounting standards.
This information is needed
to calculate the deemed paid foreign tax credit. 1/ In most cases,
therefore, the elimination of deferral would require little information
not already reported for U.S. tax purposes. 2}
However, in practical terms, the Internal Revenue Service would
need to expand its auditing efforts and its staff of international specialists very substantially if deferral were terminated. The present IRS
staff includes some 150 international specialists. These specialists
are re sponsible for questions concerning international pricing and allocation of expenses, Subpart F, DISC and similar special status corporations, and other international tax issues. In 1974, about 700 international audits were completed.
Under existing law, the direct and deemed paid foreign tax credits
are generally m o r e than sufficient to offset U. S. tax liability on dividends from foreign subsidiaries.
F r o m a practical standpoint,
therefore, it is not rewarding for the Internal Revenue Service to
examine the majority of C F C returns (in 1974, about 40, 000 C F C
returns were filed). But with the partial or complete termination of
deferral, the exact calculation of the earnings and profits of a foreign
subsidiary would become more important.
The IRS would have to
increase its international staff very substantially to meet the new
demands.
1/ The deemed paid credit (Section 902) is calculated as:
Dividends x Foreign income tax = Deemed paid credit
Earnings and profits
The denominator of the first term on the left must be calculated
according to U.S. accounting standards. Note that earnings and
profits is an after-tax concept.
2/ Additional information would be required to the extent that the
definition of earnings and profits for purposes of the deemed paid
foreign tax credit (Sections 902 and 964) differs from the general
definition of earnings and profits. Moreover, C F C s that presently
distribute no income would now be required to report earnings
and profits.
- 31 5. Investment impact.
With the termination of deferral
foreign subsidiary corporations, facing a higher tax rate than competing local firms, might diminish their activities. Out of a given
volume of pre-tax earnings, C F C s would have fewer funds available
for reinvestment. In order to maintain the same after-tax earnings
as a percentage of investment, they might sacrifice less profitable
product lines and, where possible, they might raise prices. A s
a result, C F C sales abroad might contract. But there is a wide
range of opinion on the ensuing consequences for investment in the
United States.
Some observers believe that investment would be partly shifted
back to the United States, thereby increasing economic activity in
the United States and domestic corporate earnings. These observers contend that foreign and domestic investment are at least
partial substitutes, and that, when markets and investment opportunities are lost in one area, multinational firms will reallocate
their resources to another part of the globe.
Other observers contend that little or no investment would be
shifted back to the United States. They argue that profitable investment and production opportunities are highly specific both in time
and place, and that the loss of foreign markets abroad does little
to create new investment opportunities in the United States. Indeed,
the loss of foreign markets might impair the access of American
producers to new foreign technology, and might impede the realization of economies inherent in large scale production and international
specialization, with a consequent attenuation of domestic investment
opportunities.
Professor Horst has constructed a mathematical model to
simulate the impact of terminating deferral on manufacturing investment in the United States and abroad ._1/ In this model, foreign
and domestic investment are assumed to be partial substitutes for
one another.
Investment in each location is determined both by
relative after-tax rates of return, and by the firm's overall supply
of financial resources. The model assumes that a multinational
manufacturing firm maximizes its global after-tax earnings. The
firm invests both in the United States and in a single foreign country.
Its investment can be financed out of its own retained earnings,
with new equity capital, or with borrowed funds, raised either in
the American or in the foreign capital markets. U.S. funds can
be transferred to the foreign affiliate either as equity capital or
as interest-bearing debt. The division of taxable income between
countries depends on investment and sales in eachcountry, and on the
level of deductible intrafirm expenses, such as interest payments,
royalties, and he ad-office charges.
1/ T h o m a s Horst, "American Multinationals and the U. S. Economy",
American Economic Review, M a y 1976.
- 32 -
A change in tax policy, either in the United States or abroad,
will have two conceptually distinct effects: a substitution effect,
resulting from any change in the after-tax rate of return on foreign
or domestic investment; and a liquidity effect, resulting from any
change in after-tax earnings available for reinvestment. The size
of the substitution and liquidity effects depends not only on the opportunities for investing and borrowing in the two countries, but also
on the firm's own internal use of debt and equity capital.
Although the model is basically simple, it requires more than
thirty equations to capture the details of foreign and domestic
investment opportunities and tax systems. M a n y parameters must
be estimated before usable results can be obtained. A s in any exercise of this nature, the results are subject to a considerable margin
of error.
The results are summarized in Table 4. The estimates
portray the investment impact after complete adjustment to the
termination of deferral. Complete adjustment could, of course,
require several years. Both the substitution effect and the liquidity
effect are reflected in the estimates.
The estimates in Table 4 suggest that the stock of plant and
equipment investment in the United States manufacturing sector
might ultimately increase by $2.2 billion (a change of 0. 7 percent)
with an end to deferral, while the stock of U.S. owned manufacturing
assets abroad might ultimately decrease by $3.5 billion ( a change
of 2. 3 percent). Consolidated after-tax earnings would decrease by
about $980 million. U.S. corporate taxes would increase by about
$1,000 million, while foreign corporate income and withholding
taxes would decline by about $210 million. These revenue estimates,
like the underlying investment impact estimates, are based on the
assumptions of the particular model. 1/
Professor Horst's model attempts to capture a variety of interactions between U.S. parent corporations and their foreign subsidiaries. Even so, the model requires m a n y simplifying assumptions.
In particular, the following complicating factors are not considered.
The model assumes that foreign and domestic investments are
partial substitutes, and then proceeds to calculate the extent of
substitution. Many observers would dispute the assumption of a
substitute relationship between foreign and domestic investment.
If the assumption is wrong, the estimates of additional investment
in the United States and larger U. S. tax revenues are also wrong.
1/ Revenue estimates made under various assumptions are presented
in Section 7.
Table 4
Estimated Impact of Terminating Deferral on Selected
Economic Variables for U.S. Multinational Manufacturing Firms 1/
(Millions of Dollars)
Initial Values: Estimated Changes
Total domestic assets 2/
314,000
2,200
Total foreign assets 2/ 151,000 -3,500
Consolidated after-tax earnings _3/ 28,500
U.S. corporate income tax on domestic and foreign
income after investment tax credit and foreign
tax credit 3/
980
13,400
1,000 4/
Foreign corporate income and dividend withholding taxes 7,700 -210 5/
Office of the Secretary of the Treasury
Office of Tax Analysis
April 6, 1976
Sources: The estimated changes are adapted from estimates made by Thomas Horst, "American
Multinationals and the U.S. Economy," Fletcher School of Law and Diplomacy,
November 1975, and unpublished work. The initial values are derived from: U.S. Senate,
Committee on Finance, Implications of Multinational Firms for World Trade and Investment
and Labor, February 19 73; Survey of Current Business, October 1975; Statistical Abstract
of the United States, 1975; U.S. Treasury Department, Statistics of Income 1972:
Corporation Income Tax Returns.
1/ The initial value figures refer to the year 1974. The estimated change figures represent
the impact after complete adjustment to the termination of deferral. The figures in the
estimated change column include the impact resulting from the extension of Subpart F in the
Tax Reduction Act of 1975.
2/ The initial value figures are based on the 1970 estimates for giant multinational manufacturing
firms contained in Implications of Multinational Firms, p. 432, increased to reflect smaller
manufacturing firms with overseas investment (15 percent of total overseas investment), and
increased again to reflect growth between 1970 and 1974 (Statistical Abstract of the United
Spates, 1975, p. 500; Survey of Current Business, October 1975). The foreign asset figures
include investment by foreigners in U.S. affiliates. The estimated changes are based on
Professor Horst's model.
3/ The initial values refer to the consolidated after-tax earnings and U.S. and foreign income
taxes for all manufacturing firms claiming a foreign tax credit. The estimated changes are
based on Professor Horst's model.
47 This estimate reflects additional U.S. taxes from: (i) Subpart F as expanded by the Tax
Reduction Act of 1975 ($250 million); (ii) termination of deferral with worldwide pooling,
an overall foreign tax credit limit, and current dividend distribution rates ($365 million);
(iii) an increase in U.S. investment and the greater use of equity capital in the
United States ($385 million). Detail is shown in Table 11.
5/ This estimate reflects a decline in foreign taxes resulting from: (i) a decrease in foreign
investment; (ii) the greater use of debt capital for foreign affiliates.
- 34 -
Professor Stobaugh, for example, contends that the termination of deferral could lead to a cumulative
decline in the
profitability and investment both of foreign affiliates and their U.S.
parent corporationsAl
The U.S. multinational firms would have
fewer funds available for reinvestment, and in order to maintain
the same after-tax rate of return, they might concede some business
to competing foreign firms. With slower growth and smaller sales,
they might be less able to improve techniques of production, and
they would have a smaller base for spreading research, administrative, and other fixed costs. The cumulative effect could be lower
profits and a decline in investment, both in the United States and
abroad.
Apart from investment changes resulting from corporate
decisions, foreign governments might alter their own tax rules
in response to the termination of deferral. The changes could be
designed not only to offset U. S. revenue gains, but also to counter
any shift of investment towards the United States. For example,
foreign governments might provide special investment incentives
for non-American firms. Through bank financing and other avenues,
these incentives could indirectly attract capital from the United
States.
These considerations suggest that the changes portrayed in
Table 4 should be viewed as upper-limit estimates of the investment
impact of terminating deferral.
6. Financial impact. Foreign subsidiaries can finance their
expansion either by issuing debt or by increasing equity capital
(including the retention of earnings). The funds can be provided
either by the parent corporation or by unrelated investors. A change
in deferral would affect the tax cost of only one source of capital, namely equity funding provided by the parent corporation. Other
sources of capital would be available on the same tax terms as
before.
With a limitation on deferral, the foreign affiliate thus
might find it more advantageous to finance expansion through external local borrowing, or through intrafirm debt, rather than through
equity capital supplied by the U.S. parent corporation. 2/ The net
effect is that a larger share of earnings might be paid out as interest
and a smaller share might be retained or paid out as dividends.
1/
Robert B. Stobaugh, "The U.S. Economy and the Proposed U S.
Income Tax on Unremitted Earnings of U. S. Controlled Foreign
Manufacturing Operations Abroad", Harvard Business School,
2/ Financial shifts of this type are included in Professor Horst's
model of investment decisions discussed in the previous section.
- 35 -
Table 5 presents a hypothetical example to illustrate the case
in which local borrowing is increased after the termination of deferral. For simplicity, a U. S. corporate tax rate of 50 percent and
a foreign corporate tax rate of 25 percent are assumed. Foreign
earnings before interest charges are kept constant throughout the
analysis, implying the same real level of foreign activity. 1/ No
dividends are distributed from subsidiary to parent, and tnus no
withholding taxes are paid.
The parent firm can choose between raising a certain amount of
debt abroad, limited to 200 in this example, or financing the affiliate
entirely with equity capital. If it raises debt abroad, the parent can
reduce its equity commitment to the foreign affiliate and increase its
use of equity capital in the United States. The interest rate on foreign debt is assumed to be 10 percent, while domestically owned
assets are assumed to earn 15 percent before tax. Domestic assets
thus earn a higher pre-tax return than the cost of foreign debt.
This is a crucial assumption; otherwise it would not be sensible
for the firm to incur the risk of borrowing abroad.
Under present U. S. law, the firm would be indifferent between
borrowing abroad and financing the affiliate entirely with equity. In
both cases, its total after-tax income would be 175. 2/
If deferral is terminated, the outcome changes. The firm's
total income after tax declines, and U. S. tax collections rise.
Equally important, the firm now has an incentive to borrow abroad.
Consolidated income after tax would be 150 with all equity financing and 155 with some local debt. The hypothetical firm can thus
increase its after-tax income by redeploying some of its assets
from investment in the foreign subsidiary to investment in the United
States. The process of redeployment would increase U. S. tax from
125 to 135. The partial or complete termination of deferral could
place some U. S. firms1 foreign subsidiaries in the position of this
hypothetical firm. They might find it advantageous to substitute
local borrowing by the affiliate for equity capital supplied by the
parent firm. 3/
V
In fact, foreign operations would probably contract in face of the
higher tax burden on foreign earnings.
2} The tax authorities of the two countries are not, however, indifferent to the means of finance. The substitution of local debt for
equity capital would reduce the foreign corporate tax from 25 to
20 and increase the U. S. corporate tax from 100 to 115.
3/ A similar example could be devised to illustrate the effect of substituting intrafirm debt for equity financing.
Table 5
1/
The Effect of Deferral on the Use of Local Debt by a Hypothetical Foreign Subsidiary
With U.S. Deferral
Some Local
All Equity
Debt
Finance
Without U.S. Deferral
Some Local
All Equity
Debt
Finance
__£___»
(D
nu
Ql
100
100
100
100
0
20
0
20
100
80
100
80
25
20
25
20
0
0
25
20
75
60
50
40
7. Domestic taxable income
200
230
200
230
8. U.S. corporate tax on domestic income at 50 percent
100
115
100
115
9. Domestic income after tax
100
115
100
115
10. Total income after tax
175
175
150
155
11. Total U.S. tax
100
115
125
135
Foreign Subsidiary 2J
1. Foreign earnings before interest charges
2. Interest paid locally
3. Foreign taxable income
4. Foreign corporate tax at 25 percent
5. U.S. corporate tax at 50 percent, after credit
6. Foreign income after all taxes
U.S. Parent
Consolidated Results
Office of the Secretary of the Treasury
Office of Tax Analysis
February 4, 1976
1/ The following assumptions are made: (a) the foreign interest rate equals 10 percent; (b) the foreign debt
in cases (2) and (4) equals 200, and the addition to domestically owned assets also equals 200; (c) pre-tax
earnings equal 15 percent of domestically owned assets; (d) no actual distribution of dividends is made from
the subsidiary to the parent.
_
2/ The foreign subsidiary is 100 percent owned by the U.S. parent corporation.
- 37 It is difficult to estimate the potential importance of taxinduced changes in means of finance. Many firms m a y have already
borrowed abroad as m u c h as they realistically can. Foreign debt
has advantages, but it also has risks--in particular the risk of
credit rationing with a change in government policies abroad. Likewise, there m a y be administrative and other limits on intrafirm
debt.
Table 6 illustrates the extent of debt and equity financing by
foreign affiliates in 1972. N e w foreign debt supplied a major part
of available funds, ranging between 38 percent in the case of m a n u facturing affiliates to 57 percent in the case of other industries.
Intrafirm debt and other debt from U. S. sources supplied between
8 and 25 percent of available funds. N e w equity capital from the
United States only supplied between 4 and 6 percent, while retained
earnings supplied between 16 and 45 percent of available funds.
There appears to be little scope for the substitution of fresh debt
for fresh equity capital, but fresh debt might, to a limited extent,
replace retained earnings.
7
« Revenue impact. In general, revenue estimates are made to
indicate actual or potential U. S. tax collections resulting from the
existing tax structure or a change in that structure. The focus
here is on changes in tax revenue resulting from the partial or
complete elimination of deferral, or the selective expansion of Subpart F. Background estimates are also given for present tax revenues attributable to Subpart F. The Tax Reduction Act of 1975
substantially extended the scope of Subpart F, and correspondingly
reduced the scope of remaining revenue gains from the termination
of deferral. These effects are reflected in the comparison between
estimates for 1974 and 1976 in Table 7. Note that the collateral
tax changes enumerated in Table 1 which would m o v e the United
States closer to a system of capital-export neutrality are not shown
in Table 7. Instead, Table 7 focuses on the taxation of undistributed earnings viewed in isolation. The estimates of possible
revenue gains from the further termination of deferral are influenced
both by the policy option chosen and by possible behavioral changes.
(a) Policy options. The revenue estimates obviously depend on
three important policy choices: (i) the extent to which deferral is
eliminated or Subpart F is extended; (ii) whether the overall or the
per-country limitation is applied to the foreign tax credit (under
the Tax Reform Act of 1976, virtually all firms must use the overall
limitation); (iii) the extent to which foreign subsidiary losses are
permitted as an offset against foreign subsidiary profits. The policy
options are analyzed in Part IV. Tables 8 and 9 present revenue
estimates for the alternative policies. The revenue estimates are
based on the standard assumption of no behavioral change, discussed
in the following subsection (b).
Certain important features should be noted. Under prior law,
the great majority of firms customarily elected the overall limitation in calculating the foreign tax credit. Under the Tax Reduction
- 38 Table 6
1/
Financing of Foreign Affiliates, 1972
(Percent of Total Funds)
Petroleum : Manufacturing : Other
Source of funds:
1. Internal funds:
Retained earnings
15.6
45.1
23.8
2. External funds:
Equity capital:
4.5
5.5
4.1
U.S. owned 2/
0.1
3.4
3.9
Foreign owned
Debt capital:
U.S. owned:
24.2
5.0
5.9
intrafirm debt 2/
unrelated financial
0.7
2.8
5.0
institutions
1.9
1.8
20.1
Foreign owned:
related firms
53.0
36.4
37.2
unrelated financial
institutions
T
°tal 100.0 100.0 100.0
Office of the Secretary ot the Treasury February 4, 1976
Office of Tax Analysis
Source: U.S. Department of Commerce, Survey of Current Business
(July 1975). t
Detail may not add to totals due to rounding.
1/ Estimates are based on a sample of majority-owned foreign
affiliates.
2/ The apportionment of funds between U.S. owned equity and
intrafirm debt was based on the ratio of net equity to total
net capital outflows for 1973 reported in U.S. Department of
Commerce, Survey of Current Business (October 1975), p. 47.
-39Table 7
Actual Revenue from Subpart F and
Potential Revenue from Termination of Deferral,
with Overall Limitation on Foreign Tax Credit
(Millions of Dollars)
1974 Calendar : Changes Resulting : 1976 Calendar
Year Tax
: from the Tax Reduc-:
Year Tax
Liabilities : tion Act of 1975
: Liabilities 1/
Total actual and potential
revenue from current taxation
of CFC retained earnings
615
n.a.
615
Potential revenue from the
termination of deferral,
total 2/
59Q
-225
365
Mining 0
0
0
Petroleum and Refining 0
0
0
-215
362
-10
3
225
250
n.a.
25
225
225
Manufacturing 577
Other 13
Actual revenue from Subpart F,
total
25
Pre-1975 revenue 25
Tax Reduction Act changes _3/
Office of the Secretary of the Treasury April 6, 1976
Office of Tax Analysis
n.a. indicates not applicable.
1/ It is assumed that there was no change between 1974 and 1976 in corporate foreign
source income affected by deferral.
2/ These estimates assume: (i) dividends from less developed country corporations
are "grossed up" for purposes of calculating the tentative U.S. tax and the
foreign tax credit; (ii) foreign subsidiary losses are fully offset against
foreign subsidiary profits; (iii) all firms use the overall limitation in
calculating the foreign tax credit; (iv) no behavioral change.
3/ The Tax Reduction Act changes were: (i) eliminate minimum distribution ($100
million); (ii) eliminate the less developed country corporation exception
($15 million); (iii) change the 30-70 rule to a 10-70 rule ($75 million);
(iv) repeal the shipping exclusion ($35 million).
Table 8
1/
Revenue Changes from Alternative Proposals to End Deferral
(Millions of Dollars)
1976 Calendar Year Tax Liabilities "3T
Earnings and Profits Plus
Required Percentage
Earnings and Profits
Branch and Royalty Income
Distribution 2/
Overall
Per-country
Overall
: Per-country
Limitation 4/
Limitation
Limitation
Limitation 4/
$ 630
$ 365
$ 630
$ 365
100
250
150
385
215
75
50
10
150
55
50
February 3, 1976
Office of the Secretary of the Treasury
Office of Tax Analysis
1/ The estimates assume: (i) dividends from less developed country corporations are "grossed
~~ up" for purposes of calculating the tentative U.S. tax and the foreign tax credit; (ii)
CFC profits and losses are consolidated on the same basis as the foreign tax credit limitation
that is, either on an overall or a per-country basis; (iii) no behavioral change, in
4s
particular the current dividend distribution rate is maintained.
o
2/ With a 100 percent required distribution, deferral is totally ended. With a 75 percent
~ or 50 percent required distribution, U.S. parent corporations would be deemed to have
received the difference between 75 percent or 50 percent of income (defined either as
earnings and profits or as earnings and profits plus branch and royalty income) and the
amount actually received (either dividends or dividends plus branch and royalty income).
3/ These figures represent additions to 1976 revenues collected under Subpart F ($250 million)
4/ These estimates assume that the per-country limitation is already in place, and that
~ deferral is then ended. The revenue changes refer only to the additional impact of
eliminating deferral.
- 41 Table 9
Termination of Deferral with Alternative
Consolidation Requirements and with Current
Dividend Distribution Rate 1/
(Millions of Dollars)
: 1976 Calendar Year
: Tax Liabilities _l
Overall limitation on foreign tax credit
Worldwide consolidation of CFCs 365
No consolidation of CFCs 1,100
Per-country limitation on foreign tax credit -I
Country consolidation of CFCs 630
No consolidation of CFCs 1,300
Office ot the Secretary ot the Treasury April 6, 1976
Office of Tax Analysis
1/ These estimates are variants of the estimates in Table 5. The
estimates assume: (i) dividends from less developed country
corporations are "grossed up"; (ii) no behavioral change, in
particular, the present dividend distribution rate is maintained.
2/ These figures represent additions to the 1976 revenue collected
under Subpart F ($250 million).
3/ These estimates assume that the per-country limitation is
already in place, and that deferral is then ended. The
revenue changes refer only to the additional impact of
eliminating deferral.
- 42 Act of 1975, petroleum firms were required to use the overall limitation
for foreign oil related income in taxable years ending after December
31, 1975. Under the Tax Reform Act of 1976, compulsory use of the
overall limitation was extended to all firms for taxable years beginning
after December 31, 1975._1/ Transition rules were provided for mining
companies and firms operating in U.S. possessions. The overall
limitation permits extensive tax averaging between income from hightax and low-tax jurisdictions. Thus, the elimination of deferral coupled
with the overall limitation produces less revenue than the elimination of
deferral coupled with the per-country limitation.
If losses are not allowed as an offset against profits as between
related subsidiaries, the revenue estimate becomes much larger. This
reflects the substantial losses experienced by foreign subsidiaries.
Contrary to popular belief, it is not true that the bulk of foreign losses
are concentrated in foreign branches. Rough estimates for 1975 indicate
that foreign subsidiaries experienced losses of $2.2 billion while foreign
branches had losses of $0. 3 billion.
(b) Behavioral change. Revenue estimates are usually based on a
standard assumption of no behavioral change. The standard assumption
is useful in two respects: first, it is helpful to know the initial impact
of a tax measure before adjustment occurs; second, the nature, extent
and speed of behavioral changes are not easily forecast. Yet behavioral
changes usually accompany any important tax measure. In the international tax area, not only will multinational firms adjust their dividend
distribution rates, investment decisions, and financing policies in
response to U.S. tax legislation, but also foreign governments may
modify their own tax rules. At least four reactions are possible.
First, foreign subsidiaries might increase their dividend
distributions in order to ensure and accelerate recognition of the
foreign tax credit for dividend withholding taxes.
Second, the extent of investment in foreign subsidiaries
might be curtailed. At the same time, U.S. parent firms might
increase their investment in the United States. The financing of
foreign subsidiaries might be modified to reduce reliance on intrafirm equity, and increase reliance on intrafirm debt, and more
importantly, external debt.
Third, U.S. parent firms might place greater stress on minority participation in new ventures and they might attempt to "decontrol" some existing C F C s .
Four, foreign governments might selectively increase their
own taxation of U.S. controlled foreign corporations.
1/ The reason for compulsory use of the overall limitation is to prevent
U.S. corporations from offsetting foreign branch losses incurred in
some countries against U.S. source income, while claiming aforeign
tax credit on foreign source income earned in other countries.
- 43 -
Each of these four reactions would affect the revenue implications
of terminating deferral. Some would increase U. S. revenue; others would
decrease U. S. revenue. The following paragraphs summarize the possible
revenue consequences of these behavioral changes.
(i) Change in distribution rates. U. S. foreign subsidiaries typically
distribute approximately 45 percent of their after-foreign-tax earnings.
The revenue estimates in Table 7, 8, and 9 are based on this distribution
rate. By contrast, Table 10 shows the revenue effect of increasing the
distribution rate to 100 percent of foreign after-tax earnings. U. S. revenue
gains would be substantially or completely eroded because foreign withholding taxes creditable under Section 901 would be larger. 1/
In fact, if the termination of deferral induced a 100 percent distribution
rate, with an overall limitation on the foreign tax credit and worldwide
u° n f^ 1 c d a t i ° n ° f f o r e i g n subsidiary income, the U. S. revenue loss would
be $375 million. Under a per-country limitation, the revenue loss" would
be $105 million. The revenue losses are calculated by reference to taxes
otherwise collected under Subpart F, as expanded by the Tax Reduction
Act of 1975.
The reason for these revenue losses is that additional
foreign withholding taxes would be credited against existing U. S. taxes
collected both on Subpart F income and on foreign source dividends,
interest, rents, royalties, fees, and branch income.
The revenue losses would be more than proportional to any intermediate increase in dividend distributions from the current rate of about
45 percent to the hypothetical m a x i m u m rate of 100 percent. Most of
the loss would occur with the first increments in the overall dividend
distribution rate, since additional dividends would presumably be distributed first from C F C s paying the highest foreign taxes.
(ii) Foreign vs. domestic investment. Tables 11 and 12 present
rough and conflicting estimates of the revenue consequences of changes
m investment behavior resulting from the termination of deferral. The
revenue estimates in Table 11 are based on Professor Horst's model
which attempts to measure the investment and financial position of a
multinational firm after it has fully adjusted to the termination of deferral. The model, described in Section 5, assumes that the firm can to
some extent choose between foreign and domestic investment, and between
alternative means of financing its assets.
The estimates in Table 11 are made from two starting points: the
current dividend distribution rate and a 100 percent dividend distribution
rate. The dividend distribution rate affects both the division of revenue
changes between the United States and foreign governments, and the total
amount of these changes.
V
The same revenue effects would result if foreign governments imposed
withholding taxes on deemed distributions of foreign affiliates.
- 44 Table 10
Revenue Effect of 100 Percent Dividend Distribution Rate
(Millions of Dollars)
1976 Calendar Year Tax Liabilities
Overall
: Per-country
Limitation : Limitation 2/
Total actual and potential
revenue from current taxation
of CFC earnings
Potential revenue from
100 percent dividend
distribution rate 1/
Mining
-125
145
-375
-105
-5
5
115
Petroleum and Refining
Manufacturing
315
-240
Other
-55
15
Actual revenue from Subpart F,
total
250
250
Pre-1975 revenue 25 25
Tax Reduction Act changes 225 225
Office of the Secretary of the Treasury February 3, 1^76"
Office of Tax Analysis
1/ The estimates assume: (i) dividends from less developed
country corporations are "grossed up" for purposes of
calculating the tentative U.S. tax and the foreign tax
credit; (ii) CFC profits and losses are pooled on the
same basis as the foreign tax credit limitation; (iii) no
behavioral change, except that all CFCs increase their
actual dividend distribution rates to 100 percent.
2/ These estimates assume that the per-country limitation is
already in place, and that deferral is then ended. The
revenue changes refer only to the additional impact of
eliminating deferral.
Table 11
Termination of Deferral with Assumed Changes in Investment
Location and Means of Finance
(Millions of Dollars)
1976 Calendar Year Tax Liability
Current Dividend
100% Dividend
Distribution Rate
Distribution Rate
Total actual and potential U.S. revenue from current
taxation of CFC earnings, with specified investment
and financing changes 1/
1,000
Actual revenue from Subpart F, total
250
250
Potential revenue from termination of deferral with
no investment or financing changes
365
-375
_3__5_
385
-15
-15
-10
-10
90
90
320
320
Potential revenue from possible changes in investment
and financing: 2/
(1) Effects on foreign source income—
(a) Decrease in CFC earnings
(b) Decrease in royalties, fees, and interest
repatriated to the United States
(2) Effects on domestic source income —
(a) Increase in domestic investment
(b) Increase in use of equity capital in the
United States and increase in use of
external debt abroad
Change in foreign revenue from corporate
income and dividend withholding taxes 31
(D Effect of 100 percent dividend distribution
rate on dividend withholding taxes
(2) Effect of reduced size and increased use of
external debt by CFCs on corporate income tax
and withholding tax
260
Addenda:
Office of the Secretary of the Treasury
Office of Tax Analysis
1/
2/
3/
-210
—
-210
630
840
-210
February 4, 1976
The estimates assume: (i) dividends from less developed countries are "grossed up" for purposes of
calculating the tentative U.S. tax and the foreign tax credit; (ii) worldwide pooling of CFC profits
and losses, and an overall limitation on the foreign tax credit; (iii) specified behavioral changes in
dividend distribution rates, investment and financing. The detail underlying these figures appears in
Tables 7 and 10.
The estimates represent the revenue impact after full adjustments to the current taxation of CFC earnings,
including adjustments to the Tax Reduction Act of 1975. The adjustments would, in fact, take several
years.
The estimates are adapted from a model developed by Thomas Horst, "American Multinational and
the U.S. Economy," American Economic Review, May 1976.
The estimates assume
no change in foreign tax laws.
Table 12
Termination of Deferral with Assumed Adverse Impact on
Competitive Position of U.S. CFCs
(Millions of Dollars)
Calendar Year Tax Liabilities"
1976
;
TWL
Estimated U.S. revenue from corporate
taxation of all foreign source income
with termination of deferral 1/
Estimated U.S. revenue from corporate
taxation of all foreign source income
under current law 2/
Estimated change in U.S. revenue with
termination of deferral
Office of the Secretary of the Treasury
Office of Tax Analysis
2,610
3,200
2,245
3,600
365
-400
April 6, 1976
1/ The 1976 figure is based on estimated 1976 revenues plus the potential revenue
~" from complete termination of deferral. The 1981 figure is adapted from a model
developed by Robert B. Stobaugh, "The U.S. Economy and the Proposed U.S. Income
Tax on Unremitted Foreign Earnings of U.S. Controlled Foreign Manufacturing
Operations Abroad," Harvard Business School, 1975.
2/ The 1976 figure reflects the Tax Reduction Act of 1975. The 1981 figure assumes
~* an annual growth rate of 10 percent in the foreign source of U.S. corporations.
-47-
The potential U.S. revenue gain from changes in the location of
investment and the means of finance, after all adjustments have taken
place, is very roughly estimated at $385 million whether the dividend
distribution rate remains at current levels or increases to 100 percent
The figure of $385 million reflects a revenue loss of about $25 million
from smaller C F C earnings and reduced intrafirm payments of interest,
rents, royalties, and management fees, and a revenue gain of about
$410 million from larger U.S. corporate investment and a shift in the
means of finance. Foreign subsidiaries would rely to a greater extent
on local debt finance, while U.S. parent corporations would use more
equity capital.
These calculations do not take into account possible attempts by
foreign governments to offset the shift of investment location and means
of finance through modification of their own tax laws.
Under current dividend distribution rates, the model suggests that
firms would pay an additional $750 million in U.S. taxes while they
would pay $210 million less in foreign taxes. The net increase in corporate tax payments at h o m e and abroad would thus be $540 million.
Under a 100 percent dividend distribution rate, the model suggests that
firms would pay an additional $10 million in U. S. taxes and an additional
$630 million in foreign taxes. The net increase in corporate tax payments at h o m e and abroad would be $640 million under this assumption.
The revenue estimates in Table 12 are based on Professor
Stobaugh's model which attempts to measure the long-term consequences
of placing U.S. controlled foreign corporations at a competitive disadvantage through the termination of deferral. Again , these calculations
do not take into account possible offsetting measures by foreign
governments.
The Stobaugh model assumes that higher U.S. taxes on CFCs will,
after a period of time, cause a cumulative contraction in their market
share, profitability, and the remittance of interest, royalties, and
management fees to the U.S. parent corporations. Moreover, C F C s
will find it advantageous to distribute a larger share of earnings and
rely more heavily on debt finance.J./ The predicted result is a cumulative reduction in U.S. taxes not only on the foreign earnings of C F C S
but also on the associated types of foreign income paid to U.S. parent
firms. In 1981, five years after the termination of deferral, the model
estimates that U.S. taxes on all foreign source income would be $400
million less than under present law. In succeeding years, the adverse
revenue impact would be even larger.
1/ Both the Horst and Stobaugh models envisage a larger role for debt
finance if deferral is terminated.
- 48 -
(iii) Minority participation and "decontrol". If deferral is terminated, some multinational firms might seek to minimize the impact
of current U. S. taxation either by undertaking new foreign investments
through
minority ownership in joint
venture arrangements or by
"decontrolling" some of their existing C F C s . Either way, the retained
earnings of the foreign corporation would not be subject to current
U. S. taxation. However, decontrol of an existing C F C could entail
substantial U. S. taxes on accumulated earnings and profits. Moreover,
even if decontrol in the tax sense does not involve the total loss of
control, it at least inhibits managerial flexibility, and makes international business decisions more difficult. A new minority ownership
arrangement raises similar problems.
While the difficulties associated with decontrol and minority
ownership arrangements cannot be quantified, a useful perspective may
be gained by comparing the total tax burden on U. S. multinational
corporations with and without deferral. In 1976, total U. S. and foreign
taxes on foreign source corporate income, other than income earned
by the petroleum sector, were approximately $12. 3 billion. The complete termination of deferral might increase the tax burden by as
much as $0.6 billion, or by 5 percent.^/ Because this figure is relatively modest, and because the tax costs alone of reorganization are
substantial, it seems unlikely that m a n y multinational firms would
reorganize their corporate structure as a means of avoiding current
U. S. taxation. 2/
Table 13 gives the estimated structure of foreign affiliate earnings
classified by the percentage of U. S. ownership in the affiliate. Only 5.2
percent of profits were earned by foreign affiliates owned less than
50 percent by U. S. parent corporations.
Even if this percentage
doubled or tripled, and even if the growth were concentrated in low-tax
countries, the tax avoidance would be modest. If deferral was terminated, and if the proportion of earnings accounted for by non-CFC
foreign affiliates subsequently increased to 10 percent, the revenue
gain would be reduced by $50 million; at 15 percent, the reduction
in revenue gain would be $100 million (Table 14).
The potential revenue loss could be a greater problem if foreign
affiliates owned exactly 50 percent by "U. S. shareholders" generally
escaped classification as CFCs.
Under the Garlock and Kraus decisions, U. S. ownership of exactly 50 percent of a foreign affiliate,
coupled with actual U. S. control of the affiliate, might meet the test
of Subpart F. The CCA, Inc. case represents a contrary position.
V
This figure, from Table 7, assumes an overall limitation on the
foreign tax credit and includes Subpart F revenue.
2' J. S. Kramer and G. C. Hufbauer, "Higher U.S. Taxation Could
Prompt Changes in Multinational Corporate Structure", International Tax Journal, Summer 1975. But see Forbes, "The Terrible
Worry", July 15, 1976, p. 33.
- 49 -
Table 13
Net Earnings by Extent of
U.S. Ownership in Foreign Affiliates
(Millions of Dollars or Percent)
U.S.
ownership
percentage
1073
net
earnings 1/
BY AREA
:
:
:
Percent of
net
earnings
All Areas
17,495
100.0
95-100%
50-94%
25-49%
10-24%
1-9%
Canada
14,290
2,290
584
285
46
2,846
81.7
13.1
3.3
1.6
0.3
100.0
95-100%
50-94%
25-49%
10-24%
1-9%
Western
Europe
1,904
781
93
44
21
66.9
27.5
3.3
1.6
0.7
95-100%
50-94%
25-49%
10-24%
1-9%
Latin America
and other
Western Hemisphere
95-100%
50-94%
25-49%
10-24%
1-9%
5,957
4,742
815
176
205
11
79.6
13.7
.3.0
3.4
0.2
2,628
100.0
2,387
185
43
9
4
90.8
7.0
1.7
0.4
0.1
- 50 "
Table 13 - continued
Percent of
net
earnings
—UTS:
ownership
percentage
Africa, Asia
and Australia
95-100%
50-94%
25-49%
10-24%
1-9%
6,065
100.0
5,109
84.2
514
321
109
7
8.5
5.3
1.8
0.1
BY INDUSTRY
Petroleum
6,183
100.0
95-100%
50-94%
25-49%
10-24%
1-9%
Manufacturing
5,475
88.6
560
92
29
26
9.1
1.5
0.5
0.4
7,286
100.0
95-100%
50-94%
25-49%
10-24%
1-9%
All other industries
5,668
1,138
77.8
,15.6
' 4.1
4,026
100.0
95-100%
50-94%
25-49%
10-24%
1-9%
3,145
78.1
14.7
300
160
19
592
192
26
1
Office of the Secretary of the Treasury
Office of Tax Analysis
Source
2.2
0.3
4.8
2.4
0.0
April 6, 1976
Based on Table B-10 of the Preliminary Draft of
U.S. Direct Investments Abroad 1966 Part I:
Balance of Payments Data (U.S. Department of
Commerce, ly/U,, pp. 83-84; and Table 9 of
J. Freidlin and L.A. Lupo, "U.S. Direct
Investment Abroad in 1973," Survey of Current
Business, (August 1974), Pt. II, pp" 16-17.—
1/ Net earnings are after-foreign tax. Foreign affiliates
include foreign branches, counted as 100 percent owned
by the U.S. parent corporation.
Table 14
Estimated Revenue from Subpart F and Termination of
Deferral with Increase of Non-CFC Earnings
1976 Calendar Year Tax Liability
5% of Earnings : 10% of Earnings : LD% of Earnings
in non-CFCs
: in non-CFCs
: in non-CFCs
Total actual and potential revenue
from current taxation of CFC retained earnings
Actual revenue from subpart F,
total
615
565
515
250
250
250
Potential revenue from termination
of deferral, total 1/
365
365
365
-50
-100
Change in revenue from new minority
participation or decontrol of CFCs 2/
February 4, 1976
Office of the Secretary of the Treasury
Office of Tax Analysis
1/ These estimates assume: (i) dividends from less developed country corporations are
"grossed up" for purposes of calculating the tentative U.S. tax and the foreign tax
credit (ii) foreign subsidiary losses are fully offset against foreign subsidiary
profits and all firms use the overall limitation in calculating the foreign tax
Credit! (iii) no behavioral change other than the specified changes in non-CFC earnings
II Assumes that incremental non-CFC earnings are taxed by the foreign government at a
" 20 percent rate, including withholding taxes. Non-CFC earnings are defined as the
earnings of those foreign affiliates which are owned less than 50 percent by U.S.
shareholders."
- 52 (iv) Higher foreign taxes.
If deferral were terminated, foreign
U
' •1_\*L\A
opipctivelv increase the tax burden on U.S. controlled
f^^r^^
Whe
?,
thG f eign taX r a te aS
^
-t h h J
o w e r t h l t h e U.S. tax rate. Alternatively, they could raise withholding
to
rates and reat deemed dividend distributions as actual dividend
distributions for withholding tax purposes. Such changes in foreign
t a f S t T c e s would take time, and would probably not occur as an
immediate'response to the termination of deferral, but the long-term
££ulofsucTchanges would be lower U.S. tax collections and higher forPi^tax collections. The revenue outcome would be similar to the estiX s ^ e s S t a
Table 10 for a 100 percent distribution rate. U.S.
Sxes collected on the retained earnings of foreign subsidiaries would
be diminished as a result of higher foreign taxes.
8. Summary of the analysis. Before turning to the policy options,
it might be useful to restate the major issues and findings. The debate
surrounding deferral has often lacked a clear definition of objectives
The termination of deferral has been urged at different times by different
groups seeking at least five different objectives.
(a) To improve tax neutrality;
(b) To eliminate tax avoidance;
(c) To simplify the tax law;
(d) To discourage foreign investment;
(e) To increase U.S. tax revenues.
These different objectives can lead to conflicting policies.
(a) Tax neutrality. The termination of deferral would, of course,
be diametrically opposed to the principles of capital-import neutrality.
The current taxation of retained C F C earnings is usually urged as a step
not toward capital-import neutrality, but rather as a step towarJ
capital-export neutrality.
But the termination of deferral would not
by itself advance the standard of capital-export neutrality. With tne
end of deferral, the U.S. tax system would on the whole favor domestic
investment even more than it does now. Collateral changes would
be required in the investment tax credit, the accelerated depreciation
range, DISC, and other tax practices in order to approach capital-ex port
neutrality.
(b) Tax avoidance. In the context of foreign corporate investment,
tax avoidance is sometimes very broadly defined to occur whenever tne
realized foreign tax rate is less than the statutory U.S. rate of 48 percent. If this broad definition is accepted, then the termination of deferral
would eliminate virtually all cases of tax avoidance.
However, tax avoidance is often defined more narrowly, either wi ^
reference to realized U. S. tax rates or with reference to artificial corporate structures and business arrangements.
- 53 W h e n tax avoidance is defined with reference to realized U. S. tax
rates, then its extent is much less significant. The investment tax credit,
asset depreciation range, DISC, and other domestic tax preferences all
serve to reduce the realized U.S. corporate tax rate on domestic income
which, in 1974, was about 41 percent._l/ However, the termination of
deferral would generally subject C F C income to a tax of 48 percent
Tax avoidance would be more than offset, and in fact, foreign corporate
income would generally be taxed at a higher rate than domestic corporate
income.
Fv.-_.ci-e
When tax avoidance is defined with reference to artificial corporate
structures and business arrangements, then the appropriate solution might
involve an extension and strengthening of Subpart F rather than the general
8
termination of deferral. 2/
H^k? Ta^ s|mpl^cation. It has been argued that the termination of
^/.fi/
V T t 0 t h G s i m P l i f i c ^ion of tax law and administration.
Subpart F could be repealed, since all C F C income would be taxed
currently. Moreover, there would be somewhat less pressure on arm'slength pricing rules (Section 482), on the non-recognition provisions
involving transfers of capital, technology, and other property to foreign
corporations (Sections 351 and 367), and on reorganizations involving
foreign corporations (Section 367).
involving
However, the partial termination of deferral would introduce
m X T e T h r 7 r m p l i C + a t i ° n S / n t ° the taX C O d e ' T h e s e complications could
Tlloctnnl? J % T
fn,°l a u ? . i n i m u m Percentage distribution and the
rpia^H
a deemed distribution among C F C s in the same group of
related corporations (in the case of partial termination), the measurement
of subsidiary earnings and profits and taxable income according to U S
accounting standards, the extent of consolidation of C F C s , and r es
to deal with attempted avoidance through decontrol. These complications
are discussed in Section 3 of part IV.
v.umpncaiions
,+ u i?} fovestmentand financial impact. Based on one economic model
; " a s been calculated that the termination of deferral might, over a period
as * T ; hfufon S# ^ o r P ° r a t i o n s to reduce their foreign assets by as much
m c r e a s e tneir
I L M I A \ ™ '
^
domestic assets by $2.2 billion
liable 4). These estimates depend on numerous assumptions, and m a y
S t a t e n e n t s of the
sulltTLTvl™
?
investment impact. Other models
suggest that U.S. corporations would reduce both their U.S. and foreign
investment as a result of the termination of deferral. In general the
estimates do not reflect the possibility of adverse foreign reaction. '
1/ The realized tax rate figure of 41 percent does not reflect the base
broadening meaures contemplated in Table 1. For example, accelerated depreciation and certain reserves (e.g. for bad debt) are not
taken into account.
2/ It should be noted that the overall limitation, which permits an averaging of the taxes imposed by high-tax and low-tax countries, can create
more potential for tax avoidance than deferral.
-54-
In addition to its impact on real investment, the termination of
deferral might encourage firms to change their means of finance.
Some firms might find it advantageous to substitute borrowing for
parent firm equity. The extent of such substitution would depend on a
variety of considerations, including tax rules adopted by host
countries.
(e) U.S. tax revenue. The effect of terminating deferral on
U.S. revenue depends oh several factors . Under the standard
assumption of no change in corporate or foreign government behavior,
the revenue gain could be $365 million (Table 7). Other assumptions
suggest lower revenue gains, or even revenue losses. For example,
under the assumptions that all C F C earnings would be actually distributed following the termination of deferral, the U.S. loss could
be $375 million (Table 10).
-55IV.
OPTIONS
Legislative options on deferral can be grouped into four broad
categories:
(1) retain the present system; (2) broaden Subpart F to
include m o r e types of income; (3) partly or completely terminate
deferral by requiring that deemed and actual distributions equal some
portion or all of C F C earnings; and (4) terminate deferral in the context either of providing a special statutory deduction for foreign source
income or of repealing domestic tax preferences. Option (3) involves
secondary questions as to the extent of consolidation between subsidiaries, and the choice of exclusively using the overall limitation on the
foreign tax credit, or reinstating the per-country limitation as the
exclusive method.
1. Retain present system. It can be argued that no further
legislation is needed on the deferral issue. The Tax Reduction Act of
1975 substantially extended Subpart F, and as a result the principal areas
of tax abuse have been closed off. Further legislative restrictions
could prove counter-productive by accelerating actual distributions,
triggering legislative reactions abroad, reducing the profitability and
growth of American firms, adding complexity to the Internal Revenue
Code and placing undue administrative demands on the Internal Revenue
Service. Moreover, while the present tax system favors foreign investment in some cases, it favors domestic investment in m a n y other cases.
2. Broaden Subpart F. Subpart F could be broadened in several
respects, consistent with its objective of reaching foreign income with
tax abuse characteristics.
(a) The substantial reduction test. Under Section 954 (b)(4), a
C F C that does not have as one of its significant purposes a substantial
reduction of taxes is generally excluded from Subpart F. _/ This
exemption underscores the anti-tax avoidance purpose of the statute,
but it has been drafted in a manner that limits the application of Subpart
F. The test is basically whether the effective tax rate paid by the foreign
corporation equals or exceeds 90 percent of, or is not less than 5 percentage points lower than, the effective foreign tax rate that would have
been paid if the income had not passed through a foreign base company
(Regulations 1. 954-3(b)(4), example (1)).
Certain foreign countries
impose low rates of tax, while others exclude certain kinds of income
from taxation altogether. Therefore, the C F C can meet the 90 percent
or the 5 percentage point test, yet still be paying far less than the U.S.
corporate tax rate of 48 percent. Moreover, the test poses substantial
administrative difficulties, because it requires the Internal Revenue
Service agent to have an intimate knowledge of third country tax laws.
1/ Particular items of income m a y still be taxed under Subpart F if
the transaction was structured to avoid taxes.
-56-
This difficulty could be eliminated in the context of Subpart F
by recasting the "substantial reduction" test to refer not to alternative
foreign tax rates, but to the U.S. corporate tax rate. If the present
"substantial
reduction" test obstructs the revenue gains projected
under Subpart F as expanded by the Tax Reduction Act of 1975, then
very large amounts of revenue could depend on an appropriate modification, perhaps as m u c h as $100 million.
However, this amount is not
additional to, but rather a part of, the revenue collections already
estimated for Subpart F.
(b) 50 percent subsidiaries. The present language of Subpart F
appears to exclude foreign corporations that are owned exactly 50 percent by U.S. shareholders. However, the Tax Court has found that
50 percent ownership, combined with actual control, will suffice for
Subpart F purposes. The statute could be strengthened to avoid the
C C A , Inc. decision by including foreign subsidiaries owned exactly
50 percent
by U. S. shareholders, with a rebuttable presumption of
actual control. The revenue consequences of this change are estimated
at less than $5 million.
(c) Shipping income. The Tax Reduction Act of 1975 included
international shipping income under Subpart F, to the extent it is not
reinvested in shipping operations.
However, the earnings of most
shipping companies are likely to come within the reinvestment exclusion.
Subpart F could be broadened to include all shipping income, whether or
not reinvested.
Such a provision should be related to other changes
in the taxation of shipping income discussed elsewhere in this volume.
The potential revenue gains are estimated at $70 million.
(d) "Runaway plants" and tax holiday manufacturing. In 1973, the
Treasury proposed that tax haven manufacturing corporations, defined
to include runaway plants" and tax holiday operations, should be taxed
currently under provisions similar to Subpart F.
A runaway plant would be defined as new investment in a controlled
foreign corporation which realized more than 25 percent of its gross
receipts from the manufacture and sale of products to the United States,
and paid a foreign effective tax rate of less than 80 percent of the U.S.
corporate tax rate. A tax holiday manufacturing corporation would be
defined as any controlled foreign corporation which increased its investment in excess of 20 percent during or in anticipation of a foreign tax
incentive.
Foreign tax incentives would be broadly defined under
regulations prescribed by the Secretary of the Treasury. The tax haven
manufacturing proposal would increase revenue by about $25 million.
(e) Simplification. Although Subpart F was based on the earlier
foreign personal holding company statute, no effort was made to combine
the two pieces of legislation or to enact identical statutory tests to define
the controlling group or constructive ownership. Section 951(d) attempts
-57-
to coordinate Subpart F with the foreign personal holding company provisions.
However, the method of coordination can lead to complexity
and can m a k e it advantageous to become a foreign personal holding company as means of avoiding Subpart F. In addition the line of demarcation
between deemed distributions and the penalty tax on personal holding
8
companies is not clear.
These statutes could be simplified by taxing foreign personal holding companies solely within the framework of Subpart F, and by establishing a clear boundary between deemed distributions and the penalty tax
on personal holding companies. The revenue effect would be small.
. 3: PurUal °r comPlete termination of deferral. Some observers
contend
tnat the separate entity system of taxing foreign corporations
reduces U.b. tax revenue and encourages foreign investment at the
expense
of domestic investment.
These observers argue that the
remedy lies m the partial or complete termination of deferral.
Other observers point out that the termination of deferral might
produce only short-run revenue gains, and that, as an isolated step,
it would move the United States further away from a system of capitalexport neutrality. Moreover, adverse foreign reaction could be intense
especially
from
countries such as Israel, Egypt, and Ireland which
promote industrial development through tax relief.
^ uThe complete termination of deferral would clearly replace Subpart
b, but the partial termination of deferral would not serve the same
iunction,
since Subpart F provides for current taxation of all C F C
income m selected situations.
Partial termination legislation would
need to be carefully coordinated with existing Subpart F to avoid overlapping coverage that could cause very severe administrative problems
for taxpayers and the Internal Revenue Service. In any event, partial
termination would require very complex legislation.
The revenue estimates for the complete termination of deferral
under the
standard assumption of no behavioral changes range from
$365 million to $630 million depending on whether an overall or percountry
limitation
is used for the foreign tax credit (see Table 8)
If allowance is made for behavioral change, the revenue gains would
be less, and there might even be a revenue loss of up to $375 million
from the termination of deferral (see Table 10). The partial termination of deferral would involve both smaller revenue gains (under the
standard assumption) and smaller revenue losses (under the worst
case assumption).
The partial or complete termination of deferral involves several
Choices as to coverage and mechanics. The important choices are
outlined in the following paragraphs.
-58(a) Required m i n i m u m percentage distribution.
The partial
termination of deferral would involve a percentage test for the distribution of earnings and profits. To the extent actual distributions
do not meet the minimum percentage, earnings would be distributed
on a deemed basis.
The percentage could be based on after-tax
earnings and profits, or on after-tax earnings and profits plus other
categories of foreign source income, such as interest, royalties,
management fees and branch earnings. The broader the base amount,
the easier it is to meet the test, as illustrated by Table 8.
(b) Allocation of the deemed distribution between CFCs. The
partial termination of deferral would also involve allocation of the
deemed distribution between C F C s . This allocation is needed both to
trace the foreign tax credit associated with each deemed distribution
and to maintain an inventory of deemed distributions for each C F C . The
allocation
could be made on a pro rata basis with respect to the
undistributed earnings of all C F C s , or the allocation could be made
only with respect to the C F C s not meeting the m i n i m u m percentage.
The allocation rule should be consistent with the consolidation rule.
(c) The extent of consolidation. In the case of partial termination, the question arises whether the m i n i m u m percentage applies to
each C F C individually, or to a U.S. parent corporation's C F C s grouped
on a country, on a worldwide, or on some other basis. In the case
of complete termination, the extent of consolidation is also important.
The wider the grouping, the smaller the revenue impact of any given
percentage test, as shown in Table 8. This relationship reflects two
phenomena: first, some C F C s have losses, and these losses increase
the apparent distribution rate of profitable C F C s ; second, C F C s with
high foreign taxes already tend to distribute a larger percentage of
earnings than C F C s with low foreign taxes, and if high-tax C F C s are
consolidated with low-tax C F C s , the average creditable foreign tax
is increased. There are several possible consolidation alternatives.
(i) Individual foreign corporation approach. This approach would
employ the present Subpart F mechanism of computing the income to
be deemed distributed separately for each foreign corporation. There
would be no consolidation of foreign corporations either with other
foreign corporations owned by the same U.S. parent, or with the U.S.
parent itself. Losses and blocked currency already create problems
under this system, and these problems would become more important
if deferral were eliminated. Under the individual foreign corporation
approach, there are two methods for computing the amount of income
of a lower-tier subsidiary which is included in the income of the U.S.
shareholders: the so-called "hopscotch" method; and the so-called
"link-by-link" method.
(aa) Hop-scotch method. This is the mechanism by which
Subpart F presently attributes the income of a lower-tier C F C to its
shareholders.
Under this method, the income is attributed directly
to the U. S. shareholders, and cannot be offset by any loss incurred
- 59 -
by intermediate foreign corporations.
Under this method there are
problems concerning the source country of a deemed distribution. In
addition, if the intermediate corporation is in a country which restricts
the repatriation of earnings, there can be blocked currency problems.
Compulsory adoption of the overall limitation for the foreign tax
credit renders the source problem almost moot. 1'
However, if the
per-country limitation is restored, it would be necessary to establish
a source rule for the deemed dividend.
Under present law, actual
dividends are sourced in the country of incorporation of the subsidiary
paying the dividend to the U. S. shareholder. Thus, if lower-tier C F C
A distributes dividends to higher-tier C F C B, which in turn distributes
dividends to the U. S. parent corporation, the dividends are sourced in
country B. A rule more in keeping with the intent of the per-country
limitation would require that dividends be sourced in the country of
incorporation of the lower-tier subsidiary which earns the income.
Blocked currency creates a problem under Subpart F, and the
problem would continue if the hop-scotch method were used more widely.
The problem here is the effect on the lower-tier corporation if the
intermediate corporation's country of residence restricts distributions
so that the lower-tier corporation cannot distribute up the chain of
ownership.
Thus, the U.S. shareholder might be taxed on income
which he could never realize. One solution is to apply the present blocked
currency rules as if the country of incorporation of the lower-tier subsidiary restricts the repatriation.
(bb) Link-by-link method. The link-by-link method was considered
by the Treasury in 1962. iTwas rejected partly because its complexity
was not justified in light of the limited goals of Subpart F as then enacted.
The question now is whether the complete or partial termination of
deferral, with its impact on all foreign corporations controlled by U. S.
persons, would justify reconsideration of the link-by-link approach.
Under the link-by-link method, the retained earnings of a lowertier subsidiary
would be constructively distributed up the chain of
ownership.
The profits of a lower-tier subsidiary would thus offset
the losses of a higher-tier subsidiary in the same chain. However,
there would be no offset of losses in the lower-tier by profits in the
higher-tier, nor would there be offsets as between different chains of
C F C s owned by the same U. S. parent.
I
A problem can still arise for a C F C with U. S. source income or,
during the transition period, for a U. S. parent corporation which
owns a possessions corporation or a mining company.
- 60 -
If the per-country limitation of the foreign tax credit is reinstated
and the present income source rules are not changed, the source of
the deemed
distribution would be the country of incorporation of the
first-tier corporation. Again, this result would circumvent the purpose of reinstating the per-country limitation, and suggests a reconsideration of the source rules.
If the link-by-link approach is adopted, the computation of earnings
and profits must be correspondingly altered. If the constructive distribution is treated as an actual distribution, the earnings and profits
of the lower-tier foreign corporation should be reduced by the amount
of the constructive distribution, and the earnings and profits of the
foreign
corporation next in the chain should be correspondingly
increased. This process should continue up the chain to the domestic
parent. Thus each controlled foreign corporation would keep two sets
of accounts: one set would reflect actual distributions while the other
set would reflect deemed distributions for U. S. tax purposes. These
two sets of books are presently kept for C F C s subject to Subpart F.
(ii) Consolidation of foreign operations. Under this method, all
foreign corporations within a controlled group would file a consolidated
return in a manner similar to that currently available for domestic
corporations. The consolidated return would presumably reflect only
the U. S. parent corporation's share of the earnings and profits of its
CFCs. If the consolidated return showed an overall profit on foreign
operations, the U. S. parent corporation would receive a deemed distribution of the foreign profit. If the consolidated return showed an
overall loss, the parent might be allowed to claim the loss as a deduction against domestic income, or at least carry over the loss against
future foreign profits. The purpose of a rule limiting the deductibility
of overall foreign losses would be to protect the U. S. tax base.
Which foreign corporations would be allowed (or required) to
consolidate ? Consolidation should probably be limited to foreign corporations which are m e m b e r s of the same affiliated group, as that
term is defined in Section 1504(a). However, consideration might be
given to lowering the required ownership to 50 percent from 80 percent, so that most controlled foreign corporations would be includable
in the consolidated return, or even to 10 percent so that all C F C s would
be includable.
Consolidation could be required, or it could be provided as an
elective alternative to computation of income on an individual foreign
corporation basis. If an election is provided, it would seem best to
make it binding for future years, revocable only with the consent of
the Commissioner. Standards for allowing revocation could be included
in the legislative history or in the statute.
- 61 -
Blocked currency would raise problems.
If one of the foreign
corporations in the affiliated group is prevented by its home country
from making a distribution, what is the effect on the group? Should
that corporation be excluded from the group, or should it be assumed
that the rest of the group will be able to distribute enough to make up
the difference? A percentage test might be appropriate so that, if the
income of the blocked currency corporation is less than a fixed percentage of the income of the group (for example, 10 percent), then that
corporation will be consolidated; otherwise it will be excluded.
(iii) Consolidation of worldwide operations. Under this approach
the controlled group of corporations would file a single U. S. tax return
for its worldwide operations rather than separate returns for domestic
and foreign activities.
The questions concerning which corporations are to be included,
an elective as opposed to a mandatory system, and blocked currency
exist here
as with the consolidated foreign operations approach.
Additional questions arise. Should an electing corporation still be treated
as a foreign corporation for purposes of Section 367? Arguably not,
because most tax avoidance potential is gone. O n the other hand, high
overall foreign tax rates might make it advantageous to transfer income
producing assets from the United States to tax havens. Worldwide consolidation clearly raises several difficult issues.
(d) The problem of decontrol. The partial or complete termination
of deferral could encourage firms to decontrol their existing C F C s and
to take minority positions in new joint ventures as a means of avoiding
U. S. taxation.
If decontrol and minority positions are a matter of concern, the
foreign tax credit for deemed paid taxes (Section 902) might be limited
to those U.S. shareholders claiming "actual control" of the foreign
corporation (alone or acting in concert with other U.S. taxpayers),
and thus presumptively subject to current taxation of earnings retained
by the foreign corporation.
Minority U. S. shareholders in a foreign
corporation could thus elect either current taxation coupled with the
deemed paid credit, or deferral without the deemed paid credit. 1/
Under present law, the deemed paid credit is not available for passive
portfolio investments, generally defined as investments where U.S.
corporate shareholders have less than 10 oercent ownership or investments by individuals.
The rationale of the deemed paid credit is to
avoid double taxation when a U.S. corporation has an active management
stake in the foreign investments.
A n explicit link between ^actual
1/ In both alternatives, a credit for direct foreign taxes, for example
withholding taxes on dividends, would still be available under Section
901.
-62-
control" and the deemed paid credit would bring the basic purpose
of Section 902 into sharper focus. The estimated amount of deemed
paid foreign tax credit claimed in 1976 for foreign corporations owned
less than 50 percent by U. S. shareholders is about $250 million, it
is uncertain how m u c h of this amount would be claimed under an
"actual control" election, and it is very difficult to predict the potential
extent of decontrol following the termination of deferral.
4. Terminate deferral in the context of a special statutory
deduction or the repeal of domestic tax preferences. As Table 1 indicates, the termination of deferral as an isolated measure would move
the U. S tax system further away from a standard of capital-export neutrality for the non-extractive industries. 1/ The partial or complete
termination of deferral, by itself, would favor manufacturing and other
nonextractive investment in the United States by comparison with investment abroad. If tax neutrality between domestic and foreign investment
is the goal, then deferral should be changed only in the context of a
broader program.
Specifically, the termination of deferral should be
accompanied by collateral tax changes.
It is often assumed that termination of deferral would necessarily
imply the taxation of undistributed earnings at the U. S. corporate rate
of 48 percent.
The average realized tax rate for U. S. industry as
a whole is closer to 41 percent than 48 percent . Thus, if undistributed
earnings of foreign subsidiaries were taxed at the nominal 48 percent
rate, foreign investment income would bear a m u c h heavier average
tax burden than domestic investment income.
One solution would involve imposition of a lower nominal U. S.
corporate rate on foreign income. The lower nominal rate could be
established either by statute or, more flexibly, by the Secretary of
the Treasury, with reference to the average realized corporate tax
rate on domestic investment. F r o m a mechanical standpoint, a lower
nominal rate could most easily be implemented by a special statutory
deduction equal to a percentage of foreign source income. In structure,
the deduction would be comparable to the Western Hemisphere Trade
Corporation deduction.
For example, a statutory deduction equal to
16. 7 percent of foreign source income would convert a nominal corporate
rate of 48 percent into a realized corporate rate of 40 percent. While
the special statutory deduction could be restricted to undistributed earnings, logic suggests that it be extended to all corporate foreign source
income.
V
This is true whether capital-export neutrality is defined by reference to present U. S taxation of corporate income, or by reference
to U. S. taxation of corporate income in the absence of domestic
tax preferences.
- 63 -
Other changes would be appropriately coupled with the concept
ot a special statutory deduction. Some of these changes were enacted
in the Tax Reform Act of 1976, namely, elimination of the Western
Hemisphere Trade Corporation (+ $20 million), and inclusion of less
developed country corporations in the gross-up requirements (+ $55
million). In addition, provision should be made for a deduction rather
than credit for foreign taxes comparable to state taxes (+ $450 million).
The net decrease in tax revenues from non-extractive industries
under a system designed to achieve capital-export neutrality in this
manner could reach approximately $1. 2 billion. 1/
Instead of a special statutory deduction, the termination of
deferral might be coupled with the general repeal of corporate tax
preferences
and
base-narrowing provisions, and a simultaneous
reduction mthe nominal corporate tax rate to approximately 33 percent
The net revenue loss of such an approach as applied to foreign source
income would be approximately $3.0 billion (Table 1). Extensive
international tax cooperation would be required to achieve a reasonable
division of the revenue loss resulting from such a fundamental change
m tax practices.
It would not be reasonable for the United States
alone to absorb the entire revenue loss. O n the other hand, the United
States could not increase its own revenues through the termination of
deferral and reasonably expect other countries to undertake all the
revenue losmg changes required to achieve a system of international
tax neutrality.
_L/ This
figure is calculated in reference to present U.S. taxation
of domestic corporate income.
See the first column of Table 1
,lt is assumed that the special statutory deduction would be calculated to have approximately the same effect as extension of the
investment tax credit, A D R , and DISC to foreign investment. Thus,
the special statutory deduction would entail a net revenue loss
of approximately $1.2 billion (Table 1), implying a deduction of about
16 percent of 1976 non-extractive foreign source income of $24. 9
billion (Table 1) offset by the repeal of certain preferences. The
foreign tax credit would not be affected by the special
q allowable
deduction.
-64-
TAX TREATMENT OF INCOME
FROM INTERNATIONAL SHIPPING
Marcia Field
and
Richard Gordon
-65TABLE OF CONTENTS
Page
I. Introduction
67
Part A: Reciprocal Exemption
II. Issue /-o
III. Present Law go.
1. Equivalent exemption. 59
2. Treatment of income which does not
qualify for reciprocal exemption
70
IV. Analysis 71
1. Impact on ocean freight rates 71
2. Rationale and effect of the exemption
3. Source rules and administrative aspects
4. Competitive and treaty implications
V. Options 34
72
75
78
1. Retain present law 34
2. Change the flag test to a residence test
3. Require a dual test
4. Repeal the statutory exemption
VI. Revenue Estimates 37
_ . . 84
'..'.'. 84
84
Part B: Tax Deferral
VII. Issue 39
VIII. Present Law 90
IX. Analysis 91
1. Reasons for foreign incorporation 91
2. Modifications to Subpart F in 1975
3. Effect of including snipping income
within Subpart F
X. Options 95
1. Retain present law 95
2. Remove shipping income from Subpart F
3. Include foreign shipping income under
Subpart F as foreign base company service
income
96
XI. Revenue Estimates
91
93
95
95
- -
-66LIST O F T A B L E S
Page
Table 1 Principal Countries of Registry of
Merchant Fleets as of December 31,
1974
73
Table 2 U. S. Foreign Trade Transported Under
Foreign Flags, 1974
74
Table 3 Gross Receipts of Foreign Ships Carrying
U.S. Trade, 1973
76
Table 4 Exemptions Confirmed Either by Income Tax
Treaty or by Exchange of Notes or by a Ruling.... 77
Table 5 Ratio of Net (Taxable) Income to Gross Income
from International Shipping Operations for a
Sample of U. S. -Controlled Foreign Shipping
Corporations, 1972
Table 6 Taxation of Income from International Shipping
in Selected Countries
81
Table 7 Estimated Revenue Effect of Taxing Presumed
Net Income of Foreign Flag Ships
88
79
Table 8 Foreign Flag Ships Owned by United States
Companies or Foreign Affiliates of United States
Companies Incorporated Under the Laws of the
United States
Table 9 Earnings and Profits, Foreign Taxes and
Dividends Paid, Selected CFCs Engaged in
Shipping, 1973
97
Table 10 Estimated Revenue Effect of Eliminating
Deferral on the Income of Shipping CFCs
in 1973
98
92
-67I. I N T R O D U C T I O N
The broad issue of what changes, if any, should be made in the
taxation of income from international shipping operations has two
aspects.
The first aspect concerns the statutory exemption from
U. S. income tax, on the basis of reciprocity, of foreign flag ships
which engage in traffic to and from U.S. ports. This aspect also
involves consideration of how U.S. tax is imposed on those foreign
flag ships which do not qualify for the exemption.
The second aspect concerns U.S. taxation of foreign shipping
corporations which are controlled by U.S. shareholders, whether
or not they engage in traffic to and from U.S. ports. This aspect
focuses on the deferral of U. S. tax for U. S. shareholders of controlled foreign corporations.
In formulating a coherent policy for the taxation of international shipping income, the two aspects should be viewed together.
However, since each raises distinct issues, they are considered
separately in Parts A and B of this paper.
- 68 P A R T A: R E C I P R O C A L E X E M P T I O N
II. ISSUE
The issue is whether the statutory exemption from U.S. income
tax of ships registered in foreign countries which provide an "equivalent exemption to U.S. citizens and corporations should be amended or repealed. _/
The exemption is a departure from the general rules of taxing income from international business activities. Under the general rules,
the country in which the business operations are conducted is granted
the prior right to impose tax and the country of residence is granted
the residual right. Since international shipping is likely to involve
many countries in the course of a year, reserving the exclusive right
to tax to the country of residence clearly has administrative advantages. But it also makes it attractive to establish residence and register
ships in a country which does not tax foreign income. Shipping companies have great latitude in choosing their place of residence, and
much of the world merchant fleet is registered in countries which impose no income tax. Since worldwide exemption was not the purpose
of the reciprocal exemption of the Internal Revenue Code, the question
arises whether those provisions should be amended or repealed.
J./ See Internal Revenue Code Sections 872(b)(1) and (2) and 883(a)(1)
and (2). These sections also provide reciprocal exemption for foreign
airlines, a topic which is not discussed here. International airlines
are generally government owned or subsidized, often operate at a
loss, and rarely incorporate in tax haven countries. Thus, they
raise different tax issues. The discussion of alternative methods of
taxing those shipping companies which are not exempt from U.S.
tax is relevant to airlines as well, however.
-69-
III. P R E S E N T L A W
!• Equivalent exemption.
Section 883(a)(1) excludes from the
gross income of a foreign corporation the earnings derived from the
operation of a ship documented under the laws of a foreign country
which grants an equivalent exemption to citizens of the United States
and to corporations organized in the United States. Section 872(b)(1)
contains a parallel provision for non-resident alien individuals. The
IRS has taken the position that to qualify for the exemption the foreign
country granting the exemption must be the country of registration
of the vessel (Rev. Rul. 75-459, 1975-2 C.B. 289). This position reverses the "dual test" of an earlier ruling which held that the country
granting the exemption must be not only the country of registration
of the vessel (the "flag" test), but also the country of residence of
the operator of the vessel (Rev. Rul. 73-350, 1973-2 C.B. 251).
The law is not clear on the circumstances under which income
from leasing a ship qualifies as income from the operation of a ship.
In general, income from time or voyage charters does qualify, but
bareboat charter hire (payment for the use of the vessel alone without
crew) m a y not be considered as income from the operation of a vessel
but rather as rental income for the use of property. This result is
explained in Rev. Rul. 74-170 (1974-1 C.B. 175) which held that a
foreign corporation's income from leasing its ships under time or
voyage charters, and the income of a foreign charterer from the operation of ships under time, voyage, or bareboat charters qualify for exemption as earnings from the operation of ships within the meaning of
Section 883, while the income of an owner from leasing a ship under a
bareboat charter is not exempt unless the ship owner is regularly
engaged in the shipping business and the lease is merely an incidental
activity. Consequently the question of whether payments received by an
owner for bareboat charter leasing will be eligible for the Section 883
exclusion will depend on the facts and circumstances of each case. 1/
1/ The outcome can have significant tax consequences. If it does not
qualify for the reciprocal exemption as income from the operation
of a ship, bareboat charter hire is subject to U.S. tax, to the extent
derived from U.S. sources, either at 30 percent of the gross rental
(except where an income tax treaty provides more favorable treatment) or at the ordinary rates on net income if the income is "effectively connected" with a U.S. trade or business.
The latter
treatment would in m a n y cases be less burdensome than a 30 percent tax on gross rentals because of the high deductions incurred
in operating a ship; but to be "effectively connected" the income
would have to meet the tests of Section 864(c)(2) and the regulations thereunder, principally the asset use test or the business
activities test. Clearly there are serious administrative problems
involved in making such a determination.
-70-
2. Treatment of income which does not qualify for reciprocal
exemption. In those cases where the foreign country does not grant
an equivalent exemption to U. S. citizens and corporations, the U. S.
tax liability of the foreign shipper is determined by applying the ordinary U.S. tax rate to taxable income from U.S. sources. In the case
of gross income derived from sources partly within and partly without
the United States, Section 863(b) provides that taxable income may
be computed by deducting expenses apportioned or allocated thereto
and a ratable part of any expenses which cannot definitely be allocated
to some item or class of gross income. The portion of the taxable
income attributable to sources within the United States m a y be determined by processes or formulas of general apportionment prescribed
by the Treasury.
This provision is specifically made applicable to
transportation income in Section 863(b)(1).
The original allocation rule published by the Treasury seemed to
provide that all of the income from an outward bound voyage from the
United States was U.S. source income (T.D. 3111, 4 C.B. 280(1921)).
In 1922, this rule was abandoned in favor of the present rules (T D.
3387, 1-2 C.B. 153 (1922)).
The present rules (Regulation 1.863-4) involve a complicated formula by which the gross income from U.S. sources is considered to
be that fraction of the total gross revenues which equals the fraction
of (a) expenses incurred within the United States plus a reasonable
rate of return on property used within the United States over (b) total
expenses of the business and a reasonable return on the total business
property. Expenses not directly attributable to U. S. operations are
apportioned on the basis of days spent or miles traveled in U.S.
waters to the total time and distance of the voyage. Property must be
valued net of the appropriate depreciation measured by U.S. standards.
Eight percent is ordinarily taken as a reasonable rate of return.
Under these rules, income from U.S. sources is limited to income
allocable to operations within U.S. territorial waters. The United
States observes a three mile limit to its territorial waters. All income derived on the high seas is regarded as income from sources
outside the United States.
-71IV. ANALYSIS
*• Impact on ocean freight rates. A s a general matter, the U. S.
tax on corporate income is approximately equivalent to a tax on equity
capital. Contrary to popular belief, it is not a tax on economic profit.
A tax on economic profit would require a deduction for the "normal"
rate of return on equity capital in computing the taxable income base.
No such deduction is permitted under U.S. tax law.
A tax on equity capital, like any other factor tax, will be reflected
in a higher price of goods or services sold. A s an approximation, a
corporate income tax imposed at rate t on a single sector will raise the
price of that sector's good by tu, where u is the proportion of the sales
price accounted for by corporate profit. In addition, there will be a
small reduction infhe after-tax rate of return to capital, but that effect
will be spread over capital throughout the economy.
On the basis of these principles, it is easy to see that the reciprocal
exemption of shipping income from corporate tax lowers the price of
shipping services. Thus, if the reciprocal exemption were repealed,
freight charges on U.S. imports and exports would rise to reflect the
tax. Depending on the elasticities of demand and supply for imports
and exports, the burden of the tax would be divided between domestic
and foreign producers and consumers. Unless the supply and demand
circumstances for exports are very different from the supply and
demand circumstances for imports, it is reasonable to suppose that
about one-half the tax would be borne by foreign producers and
consumers, and about one-half by U.S. producers and consumers.
If a U.S. initiative on taxing shipping income were followed by other
countries, the tax incidence would be similar, with part borne by the
U.S. economy and part borne by foreign economies.
The end result of the imposition of corporate taxes on shipping income would be a general increase in freight rates, approximately on
the order of 5 percent. _/ At first sight, this seems undesirable.
No one likes higher prices. However, it must be remembered that
the present virtual exemption of shipping income from taxation results in a discriminatory advantage for the ultimate consumers of shipping services. The prices they pay are too low relative to the prices
paid by consumers of goods produced by taxed sectors. Moreover,
the virtual exemption of shipping income from taxation results in the
inefficient allocation of capital.
1/ This figure assumes a 50 percent tax on net income, or a 5 percent
tax on shipping receipts. See the revenue estimates in Section VI.
-72The impact on labor of repealing the statutory exemption is less
clear. O n the one hand, the exemption is an incentive to foreign
registry and thus also encourages the employment of foreign labor,
so its repeal would be expected to have the opposite effect and to
benefit U.S. labor.
Lower labor costs abroad are themselves an
incentive to foreign registry, and taxes m a y have only a marginal
effect, but the tax exemption increases the attractiveness of foreign
registry and reduces the relative attractiveness of the tax and subsidy
benefits to U. S. registry. O n the other hand, repeal of the statutory
exemption by the United States alone would subject foreign flag ships
carrying U.S. trade to tax only on their U.S. source income, whereas U.S. flag ships would be subject to tax (as under present law) not
only by the United States but also by foreign ports of call. This additional
taxation might somewhat diminish the attractiveness of the U.S. flag
and thus the employment of U.S. crews. If other countries continued
to grant exemption on the basis of reciprocity, some ships would find
it attractive to move from U.S. registry to registry in a country where
reciprocal exemption was still available.
2. Rationale and effect of the exemption. It is difficult to allocate
expenses among the various jurisdictions crossed in an international
voyage. If each country taxed the worldwide income of its residents,
the situation could be best taken care of by exemption at source, leaving
it to the residence country to tally all receipts and expenses and levy
the tax on net income.
This is the solution aimed at by the provisions in the Internal Revenue Code (Sections 872 and 883) which
take international shipping (and aviation) out of the ordinary rules
for taxingthe income of foreign investors and grant a special exemption
from U. S. tax on the basis of reciprocity.
When introduced into the law in 1921, the exemption for foreign
ship operators was explained as a method of avoiding double taxation.
It now could more accurately be described as a method of providing
double exemption.
Some 30 percent of the world merchant fleet is
registered in Liberia, Greece, and Panama which impose no income
tax on their ships (see Table 1). These vessels also enjoy exemption
from tax in most ports of call including the United States.
The provision of a statutory reciprocal exemption puts foreign ship
operators in a preferred position over other foreign persons engaged
in business in the United States. Foreign flag ships carry more than
90 percent by volume and more than 80 percent by value of U. S. trade
(Table 2). Very little of the income they derive is subject to U.S.
taxation. Datafor 1973 indicate that gross receipts of foreign flag ships
- 73 Table 1
Principal Countries of Registry of Merchant Fleets
as of December 31, 1975
(Thousands of Tons)
:
All Vessels
:
Tankers
Percent
of Total
Country of Regis try
: Gross
: Tons
Percent : Gross
of Total : Tons
Total, all Countries
: 333,042
100.0%
163,731
100,0%
Liberia
70,139
21.1
45,227
27.6
Japan
37,164
11.2
18,640
11.4
United Kingdom
33,229
10.0
18,252
11.1
Norway
27,167
8.2
15,207
9.3
Greece j j
22,598
6.8
8,604
5.3
U.S.S.R.
14,292
4.. 3
4,030
2.5
U.S.A.!/
12,301
5,432
Panama
13,743
3.7
4.1
5,815
3.3
3.6
102,409
30.7
42,474
25.9
All Other
Office of the Secretary of the Treasury
Office of Tax Analysis
'' f
1/ Includes 2 million tons of government-owned reserve fleet, of which
111,000 tons are tankers.
Source: U.S. Department of Commerce, Maritime Administration, Merchant
Fleets of the World, September 1976.
- 74 Table 2
U.S. Foreign Trade Transported Under Foreign Flags
1974
Tota 1
Tons
I of
(000)
Total
Irregular
Tanker
Liner
Tons
% of Tons
% of Tons
7o of
(000)
Total (000)
Total (000)
Total
1971
433,058
94.7
34,080
77.1
215,949
97.8
183,029
95.1
1972
489,802
95.4
34,843
78.1
238,769
98.4
216,190
95.5
1973
591,669
93.7
38,028
74.2
277,375
98.4
276,266
92.6
19741/587,720
93.5
37,381
70.6
276,609
98.3
273,730
93.0
Total
Liner
Iregular
Tanker
Dollars
% of Dollars
% of Dollars
% of
Dollars
7. of
(Millions) Total (Millions) Tot:al (Millions]) Total (Millions0 Total
1971
40,539
80.4
23,196
12,755
4,588
96.9
94.5
71. 6
1972
49,410
81.6
27,035
72. 3
16,980
97.6
5,395
93.8
1973
68,106
81.1
35,215
70. 9
24,578
97.5
8,313
90.9
1974-/102,179
82.2
44,213
69. 4
33,767
97.7
24.199
93.1
Office of the Secretary of the Treasury
Office of Tax Analysis
1/ Preliminary Data
Source: U.S. Department of Commerce, Maritime Administration, Statistics
Branch, Division of Trade Studies and Statistics.
-75from carrying U.S. trade amounted to roughly $6 billion of which
approximately $5.5 billion was derived by ships exempt from U.S.
tax (Table 3). The ships of some 50 countries qualify for exemption
from U.S. income tax on the basis of reciprocity; 37 of these exemptions are confirmed in U.S. bilateral income tax treaties (Table
4). Thus the equivalent exemption can be criticized as an unintended
incentive to ships of foreign registry carrying U.S. goods. 1/
3
- Source rules and administrative aspects. Repeal of the
statutory exemption would have little effect unless accompanied by
changes in the source rules.
Under present source rules only
a small portion of the total net income
is treated as having a
U.S. source, and all income derived from the high seas is regarded
as foreign source. It has been estimated that U.S. source income
under these rules represents only 10 percent, on average, of the
total taxable income. On this basis, the revenue effect of eliminating
the statutory exemption, but retaining the present source rules,
would be negligible, probably less than $5 million. 2/
A number of countries treat part of the income earned on the
high seas as having a domestic source. Most regard the outbound
voyage as generating domestic source income and the inbound voyage
as generating foreign source income. Australia, the Philippines,
Indonesia, Malaysia, and Singapore follow this practice. Venezuela
achieves the same effect by treating one-half of a round trip to
and from a domestic port as generating domestic source income;
this approach might be more easily reconciled with the jurisdiction
of other countries having foreign tax credit systems.
The administrative burden of imposing tax on foreign flag shipping could be minimized by giving the operators an election to compute their tax on presumed net income, calculated as a flat
J./
Repeal of the equivalent exemption provision would not, however, put the tax treatment of foreign and domestic flagships
on an equal footing because special tax benefits and construction
subsidies are available exclusively to U.S. owners of domestic
flag ships in foreign commerce.
2/ In 1972, the latest year for which such data are available, the
U.S. tax collected from foreign corporations engaged in transportation activity (shipping, airlines, trucking, etc.) was only
$850, 000. It is unlikely that this amount would increase more
than five times with repeal of the reciprocal exemption and
retention of the present source rules.
- 76 Table 3
Gross Receipts of Foreign Ships Carrying
U.S. Trade, 1973
(Billions of Dollars)
Charter
Flag of Registry : Exports : Imports : Hire
Total Forei-gn
Flags
.Passenger : Total
Fares
2.9
2.5
0.4
0.3
6.1
Exempt by
Treaty e/
1.7
1.5
0,2
0.2
3.6
Exempt by
Statute e/
0.9
0,8
0.2
0.1
2.0
Not exempt e/
0.3
0.1
*
*
0.5
Office of the Secretary of the Treasury
Office of Tax Analysis
January 14, 1976
e/ estimated
* Less than $50 million
Source: Totals and some flag data on import shipments from U.S.
Department of Commerce, Bureau of Economic Analysis.
Exempt and non-exempt categories estimated on the basis
°f treaty and statutory exemptions and relative tonnage
of fleets of exempt and non-exempt flags.
- 77 Table 4
Exemption confirmed
by income tax treaty
Exemption confirmed by
exchange of notes or by
a ruling (examples)
Austria
Chile (notes, 1976)
Australia
Jordan (notes, 1974)
Barbados 1/
Brazil (Rev. Rul. 74-309)
Belgium
Taiwan (notes, 1972)
Burundi 1/
Spain (Rev. Rul. 70-464)3/
Canada
De facto exemption
Denmark
(examples)
Egypt 2/
Bahamas
FinlanH
Bermuda
France
Liberia
Gambia 1/
Not exempt (examples)
Germany
Iceland
India
Ireland
Indonesia
Israel 2/
Malaysia
Italy
Philippines
Jamaica 1/
Singapore
Japan
Venezuela
Korea 2/
Luxembourg
Malawi 1/
Netherlands
Netherlands Antilles 1/
New Zealand
Nigeria 1/
Norway
Pakistan
Poland
Romania
Rwanda 1/
Sierra Leone 1/
South Africa
Sweden of the Secretary of the Treasury
Office
Switzerland
Office of Tax Analysis
Trinidad
and Tobago
1/
By extension
of another treaty (U.K., Belgian, or the Netherlands).
United
Kingdom
__/ Not yet approved by the U.S. Senate for ratification.
U.S.S.R.
3/
Certain other countries were found to fulfill the equivalent exemption
Zaire
test1/in prior years; Lebanon (Rev. Rul. 67-183) , and by notes , Mexico ;'1964)
Zambia
1/
Columbia
(1961), Argentina (1950), and Panama (1941).
-78-
percentage of gross receipts.
Several other countries impose tax
on gross receipts, but not all make the gross receipts base elective.
Such an election would seem a desirable feature; on the other hand,
where exercised it should be binding for future years. Such a presumptive tax should seek to approximate average profitability, taking into
account good years and bad.
The limited data available (Table 5)
indicate that the ratio between net and gross income varies widely
from company to company, but suggest that 10 percent m a y be a reasonable ratio on average.
If an operator elected to be taxed on a gross receipts basis, charter
hire payments to a third party would not be separately taxed. If the
tax were computed on net income, the charter hire payments would
show up as a deduction, and the operator would be the withholding agent
for U.S. tax purposes.
Companies not electing the presumptive income tax would be required to file a return and pay tax on net income, supplying the necessary
books and records to calculate profit and loss on individual voyages.
Alternatively, they might be permitted to measure net income as a
percentage of their worldwide net income, equal to the ratio between
U.S. gross receipts on shipments to (or from) the United States and
worldwide gross receipts. _/ It might be desirable, especially if net
income were calculated on the basis of a return, to limit certain
deductions, for example, to deny accelerated depreciation, in order
to avoid artificial losses. It would also be important to prevent avoidance of the U.S. tax by transshipment through Canada or Mexico.
One possible approach would be to define the relevant voyage in terms
of the ultimate point of origin or destination of the goods.
4. Competitive and treaty implications. A sweeping repeal of the
present exemption system initiated by the United States acting alone
could result in taxation by many countries of U.S. ships, since reciprocity would no longer exist. However, ships of other countries would
continue to enjoy reciprocal exemption. Thus, U.S. ships engaged
in trade between third countries would be placed at a competitive disadvantage.
A sweeping repeal of the present system would also require
Treasury to terminate U.S. income tax treaties with 37 countries
in order to delete the shipping exemption; reinstituting the other treaty
provisions might require concessions on unrelated issues.
1/ Singapore, for example, permits this apportionment method to be
used by companies incorporated in countries for which Singapore
is prepared to accept the certification of the national tax authorities as to worldwide gross and net income.
- 79 Table 5
Ratio of Net (Taxable) Income to Gross Income
from International Shipping Operations for a
Sample of U.S.-Controlled Foreign Shipping
Corporations, 1972
Ratio of net operating income
to gross operating receipts
:
:
,T ,
. . ,. .
Number of subsidiaries
Total number of subsidiaries
77
Negative or zero net income 14
Total subsidiaries with net income
63
Net income as percent of gross:
1 through
9%
8
10 through 19%
21
20 through 29%
11
30 through 39%
9
40 through 49%
8
50 through 59%
1
60 through 69%
1
70 through 79%
2
80 through 89%
2
Aggregate ratio, subsidiaries with
net income
11%
Aggregate ratio, all subsidiaries 9%
Office of the Secretary of the Treasury
Office of Tax Analysis
Source:
Tax Forms 2952
February 13, 1976
-80O n the other hand, maintaining a policy of exemption by tax treaty
could simply transfer tax haven benefits from the traditional tax
havens, such as Liberia and Panama, to treaty countries which m a y
also not tax foreign shipping income (see Table 6).
A compromise solution to both these problems would permit selective reciprocal exemptions by treaty but require that existing and
future treaties be reviewed. Where the other country constitutes a
tax haven for foreign owned shipping companies, future treaties would
not grant an exemption, and existing treaties would be renegotiated
to remove the exemption.
Table 6 and the following text describe
some of the features of other countries' taxation of income from international shipping.
Table 6 attempts to summarize the principal features of foreign
country tax laws as they apply to income from international shipping.
The information summarized in the table must be regarded as both
tentative and partial. The detailed information needed for a thorough
report is not readily available, and the implementation of the laws
is subject to considerable administrative discretion. Moreover, the
statutory rates cited ignore such features as accelerated depreciation,
investment allowances and investment reserves, which substantially
reduce the effective tax rates.
With respect to the taxation of domestic flag ships, Liberia, Greece
and Panama, which together account for over 30 percent of the gross
tonnage of the world's merchant fleet, do not tax income derived from
international commerce by ships flying their respective flags, and
each country makes it easy for foreign companies to register ships
locally. Cyprus and Singapore tax the foreign income of their shipping
companies only when it is remitted to Cyprus and Singapore, respectively.
In contrast, although France and the Netherlands exempt most foreign source income from taxation, they m a y tax the income of their
domestic shipping companies. For example, the Netherlands exemption
of foreign source income is conditioned on the derivation of foreign
income through a foreign permanent establishment which has borne
some foreign income tax (the amount does not matter); since much
of the foreign income of shipping companies is earned on the high seas
or in countries which exempt ships of Dutch registry by treaty or
statute, that condition will frequently not be met. A s a general rule,
the foreign source income of a French company is excluded from the
French tax base without regard to whether any foreign tax liability
is incurred;but French officials report that one consequence of Article
209 of the General Tax Code, which gives France the right to impose
tax where a treaty specifies that France m a y tax, is that French
shipping companies are subject to tax on their foreign source income
from the countries with which France has a treaty reserving to France
the right to tax French ship and aircraft companies. It is not clear how
France determines taxable income in such cases.
- 81 Table 6
Taxation of Income from International Shipping in Selected Countries, 1976
Country
; Million
(by gross tonnage : Gross
of merchant fleet): Tons
Percent
of
Total
Total, all countries
306.4
100.0
Liberia
Japan
United Kingdom
Norway
Subtotal
Greece
U.S.S.R.
U.S.
Panama
France
Italy
Germany
Sweden
The Netherlands
Spain
Denmark
India
Cyprus
Singapore
Subtotal
All Others
60.0
36.0
32.2
25.1
153.3
22.3
13.5
12.5
11.5
19.6
11.7
10.5
8.2
Taxation of domestic companies:
Taxat ion of foreign companies
Taxable on
Applicable
: Statutory : Rate of tax
Tax base limited
foreign source
statutory
reciprocal:
where
to profits of a
income
rate 1/
: exemption : applicable 1/
permanent
establishment 2/
—
—
no
yes
yes
yes
0
52.61/40.88
52/26.It.
50.8/24.3
yes
yes
0
52.61
no
?
52
yes
50.8
yes
yes
50.0
9.5
9.4
7.3
4.4
4.1
3.8
3.1
3.1
yes
8.5
6.8
2.8
2.2
yes
yes
4.7
1.5
yes
4.4
4.2
1.4
1.4
yes
yes
3.7
3.6
3.3
1.2
1.2
1.1
no
no
271.2
35.2
88.5
11.5
no
yes
yes
no
0
3/
48
0
it/
—
—
50/25
49.7
27.5/15-5/
54.4
?
38.24
no
yes
yes
0
48
no
?
10-50
yes
no
50
yes
yes
49.7
51
54.4
1/
48
yes
48
yes
no
11
7/
32.69
37
57.75
42.5
37
34
73.5
42.5
40
yes
no
no
—
—
?
yes
no
yes
yes
yes
yes
yes
no
•>
40
no
—
—
Office of the Secretary of the Treasury
Office of Tax Analysis
Sources: Submission by various countries: Harvard University, World Tax Series, various volumes; various issues of the
Price Waterhouse Information Guides; and the United Kingdom Board of Trade, Report of the Committee of Inquiry
a
L
into Shipping (London, May 1970).
—
~
1/
1/
H
A/
5/
1/
7/
Where two rates are shown divided by a slash (/) the first applies to undistributed profits and the second to
distributed. If divided by a hyphen (-) the rates indicate the range of marginal rates in a graduated scale.
These are statutory rates; effective rates are lower due to accelerated depreciation, investment allowances
investment reserves and other tax benefits.
"Yes" signifies that tax is imposed only if there is a local "permanent establishment" (which usually includes
an agent who signs contracts for the home office but not a commission agent) and the tax base is limited to the
profits of that establishment. In some cases, e.g., Norway and Sweden, this amounts to exemption in practice
and in most cases the taxable income is comparable to a freight forwarder's commission.
U.S.S.R. vessels are state owned, so apart from amounts allocated to certain reserves, the net earnings belong
to the Government.
In general, French companies are not taxed on their foreign source income; but French law (Article 209, C.G.I.)
specifically authorizes France to tax in those cases where an income tax treaty reserves to France the right to
tax. This is the case in most French income tax treaties with respect to shipping profits; the usual treaty rule
reserves the right to tax shipping profits to the country of residence of the company.
One half of the income from shipping (the outbound portion) is presumed to be foreign source income and is taxed
at the special 27.5/15 rate with no foreign tax credit. The rates are the rates prevailing before the German
corporate tax reform of 1976. The portion considered domestic source is taxable at the ordinary 51/15 rate
Alternatively, the taxpayer may elect to be taxed at the ordinary rate on the full amount and claim a foreign
b
tax credit.
Foreign source profits are exempt from Netherlands tax if they are derived through a permanent establishment in
another country and have been taxed by that country.
Foreign source profits are taxable if remitted to Cyprus and Singapore.
-82-
Germany presumes that one half of the income of domestic companies from international shipping has a domestic source and that one
half is taxed at the ordinary rate. The other half is presumed to be
foreign source and is taxed at a reduced rate with no foreign tax
credit.
Alternatively, the shipping company can elect to be taxed
on all income in the ordinary way with a foreign tax credit against
the tax on the half deemed to be foreign source. The taxpayer's choice
will depend on how m u c h foreign tax was paid.
The United Kingdom has made an effort to compete with the flags
of convenience by offering liberal depreciation and investment grants
which greatly reduce, or eliminate, the tax liability of U.K. flag ships.
Similarly, the United States has attempted to keep its flag shippers from
fleeing to flags of convenience by giving tax benefits and direct subsidies.
The United Kingdom, unlike the United States, permits the use
of foreign crews on its flag ships. The U.K. tax preferences go beyond
those of the United States in one respect: as of 1970, shipping companies of other Commonwealth countries could fly the U.K. flag; thus
a Bahamas corporation, liable to no domestic income tax, could register its ships in Britain. _/
The other countries listed in Table 6 typically subject their corporations to tax on their worldwide income and provide a credit for
foreign taxes paid on foreign source income. However, liberal depreciation allowances, investment grants, and similar measures generally ensure that the net tax burden is small.
Traditionally, countries have exempted foreign flag ships from
income tax on the basis of reciprocity, without the need for any special
bilateral agreement between the countries. But three countries listed
in Table 6 (India, Cyprus, and Singapore) are exceptions to this rule.
They do not exempt foreign flag ships on the basis of de facto reciprocal
exemption, and are unwillingto grant exemption by tax treaty, although
they m a y be willing to reduce the tax in a treaty. There are a number
of other countries not listed in the table which also unilaterally impose tax on foreign flag ships in the absence of a formal tax treaty
_/ The U.K. Board of Trade, Report of the Committee of Inquiry
into Shipping, London, 1970, reports that Bahamas and Bermuda
companies represented only about 1.5 million gross tons of the
U.K. flag fleet in 1970.
- 83 (e.g., Australia, Singapore, Indonesia, Malaysia, the Philippines,
Venezuela). The reluctance to grant exemption even by treaty appears
to be growing, as evidenced by several recent treaty negotiations.
The countries which do not grant reciprocal exemption tend to tax
on presumptive net income, usually a flat percentage of gross receipts from outbound traffic. Singapore is an example of this approach.
Singapore imposes tax equal to 2 percent of the gross receipts (calculated as the corporate tax rate of 40 percent times presumed net income
equal to 5 percent of gross receipts) of any voyage outbound from
Singapore to the point of destination or transshipment. The company
may elect to be taxed instead at 40 percent of that portion of its
worldwide net income which gross receipts from Singapore bear to
worldwide gross receipts. This pattern varies somewhat among other
taxing countries, as to the gross receipts figure used, the net election,
and the transshipment rule.
The countries which have traditionally granted reciprocal exemption usually rely on the general statutory rules for taxing foreign business activities in their jurisdictions to determine the taxable income
of foreign shippers who are not eligible for the exemption. In most
cases this means that tax is imposed only on the profits derived by
a local office authorized to contract for the company; thus the tax
base is roughly the commission income of a freight forwarding agent.
In some cases even this element is ignored, for example, where the
law specifically limits the taxation of foreign companies to income
derived in the taxing country. Sweden has interpreted such language
narrowly and has rarely, if ever, imposed tax on a foreign shipping
company. Denmark has ' followed a similar interpretation, and
Panama's law would support exemption on the same interpretation.
Norway has not exercised its authority to tax. Japan, Italy and
Greece have broader source rules. Japan considers income from outbound traffic to have a domestic source, but it is not clear whether
net income is determined as a percentage of worldwide net or computed separately on the basis of books and records. Italy m a y use
an imputation of profit per ton where net income cannot be determined.
When a foreign shipping company maintains a local office in Greece,
Greece m a y tax not only the income attributable to Greek sources
but also a portion of the foreign source income. In no case is the
method of determining taxable income clear. The U.S. rules are also
imprecise.
- 84 -
V.
OPTIONS
1. Retain present law. It can be argued that repeal of the present
reciprocal exemption would raise the cost of ocean freight and, if such
legislation overrode tax treaties, would disturb our tax relations with
treaty countries. Further, any change in the reciprocal exemption
system might result in selectively heavier foreign taxation of U.S. flag
vessels, which would place those vessels at a competitive disadvantage.
On the other hand, the present system allows international shipping
income to be free of most (or all) taxes.
2. Change the flag test to a residence test. Residents of any country
which grants an equivalent exemption to U.S. ships operated by U.S.
residents would be exempt from U.S. tax on income from the international operation of ships (and aircraft), without regard to where the
ships were registered. This approach would have the advantage of not
depriving a U.S. or treaty country operator of exemption solelybecause
it uses foreign flag feeder vessels. But it does not address the basic
criticism that international shipping frequently pays tax to no country.
3. Require a dual test. Under adual test, the foreign country would
have to be both the country of registry of the ship and the country of
residence of the operator. This was the position taken in Revenue
Ruling 73-350 (subsequently reversed by Rev. Rul. 75-459). The dual
test would make the conditions for reciprocal exemption parallel for
both countries, since foreign countries are now only required to exempt
U.S. citizens and residents operating U.S. flag vessels. But it would
have the presumably unintended effect that while Liberian and
Panamanian ships would be exempt from U. S. tax when operated by
residents of Liberia and Panama, respectively, the exemption would
no longer apply if either operator were to lease the ship of the other.
4. Repeal the statutory exemption. Repealing the statutory exemption would make the tax treatment of foreign flag shipping comparable
to that of other foreign business activity in the United States, cut back
on the tax-free status of international shipping, and thereby reduce the
appeal of tax havens. U.S. action in this direction might encourage
other countries to take similar steps.
These are desirable policy
objectives. But simple repeal of the U.S. statutory exemption while
maintaining the present source rules would accomplish little toward
these goals, and would have the disadvantages of multiplying the administrative burden of taxpayers and tax collectors and (at least initially)
making U.S. flag ships subject to foreign taxes while ships of other
countries continued to enjoy reciprocal exemption. These disadvantages could be largely overcome by additional changes along the
lines indicated below:
- 85 (a) Change the source rules to define as U.S. source income
one half of the gross income from any voyage to or from a U.S. port.
This change should be considered for international aviation as well as
shipping.
(b) Levy the tax at ordinary rates on net income realized in
or apportioned to U.S. sources, provided the taxpayer furnishes adequate accounts.
However, the taxpayer could elect to be taxed on
presumptive net income, with the election to be revocable only with
the consent of the Commissioner. A s an example, this alternative
tax might be set at 5 percent of gross receipts from U.S. sources
(roughly 48 percent of net income presumed at 10 percent of gross
receipts).
(c) Require the operator in certain cases to post a bond in an
amount equal to the tax on gross income, unless sufficient business
contacts with the United States were regularly maintained so that the
Internal Revenue Service could be reasonably sure of collecting the
tax.
(d) Grant reciprocal exemptions in income tax treaties with
countries that are not tax havens for shipping, with instructions to
the Treasury that existing agreements with countries that constitute
tax havens for international shipping be renegotiated to terminate the
•exemption. Guidelines for identifying tax havens could be provided
by regulation. For example, a shipping tax haven might be defined
in terms of the following characteristics: little or no tax on shipping
income, a large fleet in relation to the volume of exports and imports,
ease of registry of foreign owned vessels, and foreign beneficial ownership of a substantial portion of the fleet. Some of the characteristics
might be found in a number of countries, but a tax haven would
generally meet all of them.
(e) Change Subpart F to ensure the current taxation of the U.S.
controlled foreign flag fleet, as discussed in Part B.
Repeal of the reciprocal exemption, together with these collateral
changes, would place the tax treatment of foreign flag shipping on
the same basis as other foreign activity in the United States and would
produce additional revenue of about $100 million. Some U.S. flag
ships would still be subject to a competitive disadvantage through the
loss of foreign tax exemption, but this effect would be relatively minor
in view of the possibility of treaty exemptions. Moreover, in light
of the low volume of U.S. trade carried on U.S. flag vessels, this
effect should not be overestimated.
- 86 -
The Task Force on Foreign Income of the Ways and Means
Committee considered the taxation of international shipping income
as part of its agenda early in 1976. The Task Force decided to recommend certain changes, as outlined by its Chairman, Representative
Rostenkowski, in a speech to the Chicago Council on Foreign Relations on March 29, 1976:
In trying to achieve these goals, the Task Force is
seriously considering a proposal along the following general lines:
A limitation would be placed on the so-called "statutory reciprocal exemption" in the Internal Revenue Code
which allows ships coming into the United States to avoid
paying U.S. tax if the country in which the ship is registered does not tax U. S. ships traveling to that country.
This reciprocal exemption would be extended only to those
ships which are engaged in the domestic or foreign commerce of the country under whose laws the ship is registered and to ships owned, in fact, by nationals of that country. This change in the reciprocal exemption would not,
however, override existing U.S. tax treaties, which generally provide for a complete exemption of shipping income
between the two treaty countries. Instead the Treasury Department would be requested to reexamine the treaties and,
where necessary, renegotiate them on a basis similar to
the modified statutory exemption.
The Task Force may also propose both a change in the source
rules and the taxation of net income at ordinary rates or, in certain
cases, a tax on presumptive net income, along the lines described
above.
- 87 -
VI. R E V E N U E E S T I M A T E S
Option (1), retaining present law, would involve no revenue change.
Option (2), eliminating the flag test, would involve a negligible revenue
loss. Option (3), requiring the dual test, would involve a negligible
revenue gain. Option (4) would impose a net income tax on half of
the gross receipts on all traffic to and from U.S. ports, but the taxpayer could electa presumed income tax of 5 percent of gross receipts.
Selected exemptions would be permitted by treaty. This option would
yield an estimated revenue gain of $100 million.
The revenue estimate for option (4) is derived from Table 7.
Figures were based on 1973 data, projected forward to 1975 on the
assumption that gross receipts of foreign flag ships from carrying
U.S. trade increased proportionately with the value ofwaterborne U.S.
trade. The estimate assumes no change in the treaty exemptions already agreed to, but no new treaty exemptions.
Table 7
Estimated Revenue Effect of Taxing Presumed
Net U.S. Source Income of Foreign Flag Ships
(Millions of Dollars)
Gross Receipts 1/
Tax base
U.S. gross
(10% of
receipts
U.S.gross)
(50% of
total)
inbound
outbound total
1973
2,700
All Foreign Flags
950
-exempt by statute
750
Liberia, Panama
1,600
150
-exempt by treaty
-taxable
Est. 1975
All Foreign Flags
-exempt by statute
-exempt by treaty
-taxable
Estimated revenue gain
On flags exempt by statute
On flags taxable under present
3,100
1,000
450
1,800
300
Tax (5% of U.S
gross)
5,800
1,950
1,200
3,400
450
2,900
975
600
1,700
225
290
98
60
170
20
145
49
30
85
10
9,300
3,100
5,500
700
4,650
1,550
2,750
350
465
155
275
35
235
80
140
20
100-/
80
20
rules 2/
Office of the Secretary of Treasury
Office of Tax Analysis
January 28, 1976
1/ The inbound figures are rounded to the nearest $50 million; the outbound are available only
"~ to the nearest $100 million.
2/ The tax now collected is estimated at about $2 million.
3/ A.s sumtng no foreign tax credits from other income.
00
00
- 89 P A R T B: T A X D E F E R R A L
VII. ISSUE
The issue is whether U.S. shareholders of controlled foreign
shipping corporations should be taxed currently on their share of the
profits of such corporations. This could be accomplished by amending
the Internal Revenue Code so that profits of international shipping
operations are fully included in Subpart F, without the current exception
for profits reinvested in shipping operations.
Foreign registry is attractive to U.S. shipowners for a number of
reasons. Lower operating costs are most frequently cited, but tax savings are also important. The possibility of deferring tax on foreign
flag shipping runs counter to other legislation designed to encourage
U.S. flag shipping. Moreover, given the prevalence of tax haven countries as the chosen place of registry of m a n y U.S. owned foreign flag
ships and the fact that their services are largely performed outside
the country of registry, foreign shipping services exemplify the type
of activity to which Subpart F applies. The issue then, is whether
the partial inclusion of shipping income within Subpart F under the
Tax Reduction Act of 1975 is adequate, or whether shipping should be
included under Subpart F in full.
- 90 VHI.
PRESENT L A W
Under Subpart F of the Code, certain categories of earnings and
profits of a controlled foreign corporation (CFC) are includable in the
gross income of the U.S. shareholder. The most important of these
categories is foreign base company income. A s originally enacted,
Subpart F provided an exclusion from foreign base company income
for income derived from, or in connection with, the use (or hiring or
leasing for use) of any aircraft or vessel in foreign commerce, or the
performance of services directly related to the use of any such aircraft or vessel (section 954(b)(2)).
This outright exclusion for shipping income was repealed, effective
for taxable years beginning after December 31, 1975, by the Tax
Reduction Act of 1975.
Under that Act, foreign base company income includes foreign base company shipping income except to the
extent reinvested in foreign base company shipping operations. (The
Tax Reform Act of 1976 provides that income from shipping operations
within one country is not base company shipping income if the ships
are registered within that country and the company is incorporated
locally.) Foreign base company shipping income, as defined in Section
954(f), includes income derived from the use (or hiring or leasing
for use)ofany aircraft or vessel in foreign commerce, the performance
of services directly related to the use of an aircraft or vessel, or
the sale or exchange of the aircraft or vessel. It also includes dividends
and interest from certain foreign subsidiaries and gain from the sale
of securities of those corporations to the extent attributable to foreign
base company shipping income.
- 91 IX.
ANALYSIS
1. Reasons for foreign incorporation. U.S. owners of ships, by
incorporating in a country which imposes no income tax, can avoid
tax on most or all of their worldwide income since m a n y countries,
like the United States, provide statutory exemptions on the basis of
reciprocity.
According to the Maritime Administration, as of
December 31, 1974, there were 706 U.S. owned foreign flag ships,
totalling 27 million gross tons. More than 80 percent of these ships,
by gross tonnage, were registered in Liberia, the United Kingdom,
and Panama (Table 8). Liberia and Panama impose no income tax;
the United Kingdom imposes tax but provides generous writeoffs for
shipping investments, and permits ships owned by residents of
tax haven colonies, like Bermuda, to fly the U.K. flag.
Tax savings are not the only factor influencing the choice of foreign
over U. S. registry. Costs of operation, particularly wages for the
crew, 1/ are often very m u c h less abroad. Ships which engage exclusively "In commerce between third countries are not eligible for U.S.
subsidies. But tax exemption provides an added attraction. In the past
it has been particularly attractive for integrated companies which could
shelter some profits from other activities in tax haven shipping subsidiaries, using excess foreign tax credits on other income to repatriate
the tax sheltered income to the United States free of U.S. tax. More
than 85 percent of the U.S. owned foreign flag ships, by gross tonnage,
were oil tankers, most of which were owned by the large oil producing
companies (Table 8). However, the Tax Reduction Act of 1975 and
the Tax Reform Act of 1976 set special limits on the credit which
m a y be claimed for foreign taxes paid on oil and gas extraction income;
as of 1977 the foreign tax credit for such taxes is limited to 48 percent
of foreign oil and gas extraction income.
2. Modifications to Subpart F in 1975. Under the Tax Reduction Act
of 1975, shipping profits are subject to Subpart F except to the extent
they are reinvested in shipping operations. In one sense shipping is
now treated more harshly than other Subpart F activities, since profits
characterized as foreign base company shipping income are "tainted"
even if derived from unrelated companies. But shipping also continues
to enjoy a preferred status in qualifying for partial exclusion by virtue
of the reinvestment condition.
1/ In order to qualify for U.S. registry, all the officers and 75 percent
"~ of the crew must be U.S. citizens. If the ship receives operating
subsidies, then all the crew must be U.S. citizens.
Table 8
FOREIGN FLAG SHIPS OWNED BY UNITED STATES COMPANIES OR FOREIGN AFFILIATES OF
UNITED STATES COMPANIES INCORPORATED UNDER
THE LAWS OF THE UNITED STATES
As of December 31, 1974
SUMMARY
Tankers
Total
Country
of Registry
Gross
Tons
No.
Gross
Tons
Deadweight
Tons
No.
Freighters
DeadGross
weight
Tons
Tons
Bui k 6. Ore Cc
irriers
DeadGross
weight
No.
Tons
Tons
706 27,551,941 52 ,776,925 508 23,976,373 46,355,732
86 402,378 400^659
112 3,173,190 6,020^534
Liberia
339 15,978,413 31,882,734 240 13,172,661 26,477,539
United Kingdom 122 4,410,591 8,151,572 74 4,098,941 7,747,887
Panama
106 2,402,495 4,249,219 88 2,280,909 4,088,942
France
11 1,196,653 2,334,899 11 1,196,653 2,334,899
Netherlands
26
843,040 1,504,204 14
770,787 1,432,533
10 62,146 73,246
39 141,897 147,574
12 54,590 48,280
89 2,743,606 5,331,949
9
169,753
256,111
6
66,996
111,997
Total
Germany (West) 12
Spain
5
Italy
10
Norway
10
Belgium
10
651,769 1,227,045
489,149
931,367
333,880? 494,091
254,916
453,895
200,889
324,393
11
Argentina
8
Denmark
6
Venezuela
3
Australia
British Colonies 1
169,791
136,461
116,113
98,241
59,267
258,183
235,649
172,569
165,857
111,052
66,481
50,766
53,494
14,560
17,998
101,244
85,830
49.916
23,421
9,972
6,974
9,813
Canada
Uruguay
Honduras
South Africa
Greece
"
Finland
Source:
No.
Deadweight
Tons
7
2
10
1
3
12
5
10
10
9
7
2
1
-
651,769
489,149
333,880
254,916
163,159
1,227,045
931,367
494,091
453,895
259,393
96,037
136,461
116,113
16,890
59,267
141,921
235,649
172,569
26,642
111,052
66,481
50,766
14,560
-
101,244
85,830
.23,421
6,974
9,813
12 72,253" 71,671
vo
NO
10
3
53,494
49,916
17,998
9,972
37,730
65,000
73,754
116,262
81,351
139,215
U.S. Department of Commerce, Maritime Administration, Foreign Flag Merchant Ships Owned bv U S Parpnt
Companies , October 1975.
"
~——**—•—'•—-—
- 93 -
It is too early to tell what effect the reinvestment condition will
have. In fact, the rules are so complex that even the affected taxpayers will find it very difficult to assess their impact, l] However,
while the reinvestment condition might not benefit foreign shipping
companies when the industry is experiencing a prolonged recession,
it could easily be satisfied in a growing economy for those companies
that are renewing or expanding their fleets. 2/ For example, assume
that $10 million is borrowed to finance a ship which will yield gross
receipts of 25 percent, or $2.5 million, and a pre-tax profit, after
payment of interest and other expenses, of $500, 000 per year. The
profit could be used to retire the mortgage over 20 years, and during
this time there would be no U. S. tax liability under Subpart F. To
continue qualifying after 20 years, the shipping company would have
to replace the one ship or expand its fleet. So long as the reinvestment
condition is met, shipping profits will continue to enjoy exclusion from
Subpart F; and when it is not met, shipping profits will be subject to
Subpart F but with special and extraordinarily complex rules (even
by comparison with other Subpart F rules).
3. Effect of including shipping income within Subpart F. The nature
of international shipping services, especially the frequency of incorporation in tax havens with most of the services performed outside
the country of incorporation, is analogous to the general concept of
base company service income, which suggests including shipping income under Subpart F on the same basis.
It has been argued that taxing the undistributed profits of foreign
shipping companies could cause their sale to foreign interests and their
consequent loss to the United States in time of national emergency.
It is not clear that current taxation under Subpart F would provoke substantial sales, although it might result in some changes in country of
registry. For some U. S. owners, shipping is an important part of an
integrated enterprise which would not readily be disposed of. Moreover, both the Maritime Administration and the Defense Department
have expressed doubts about the usefulness of the "Effective U. S.
1/ Proposed regulations were published in the Federal Register on
August 7, 1976; as reprinted in the C o m m e r c e Clearing House
Standard Federal Tax Reporter they take up 36 pages of single
spaced print.
2j Of course in a prolonged shipping recession, the profits of foreign
shipping companies might be modest or nonexistent, sothat current
U. S. taxation under Subpart F would result in little additional
burden.
- 94 -
Control Fleet". In recent emergencies, such as the closing of the
Suez Canal and in Vietnam, both practical and legal problems have
arisen with respect to commandeering foreign registered ships manned
by foreign crews. Control of such ships is especially difficult when
they engage primarily or exclusively in third country commerce and
have virtually no contact with the United States. This is probably true
of many U.S. controlled foreign flag ships.
The Maritime
Administration estimated in 1974 that only about 20 percent of the
U.S. owned foreign flag tankers carried U.S. trade. (As of April 1975,
330 of the 461 ships on the Effective U.S. Control List were oil tankers. ) Other C o m m e r c e Department data indirectly support this general
view by indicating that, on average, under 10 percent of the sales of
foreign affiliates of U.S. international transport corporations are to
U.S. purchasers. Thus, it is doubtful that the sale of some of the
U. S. controlled foreign flag ships would have a serious adverse effect
on the national security of the United States.
To the extent U.S. controlled foreign flag ships were sold,
presumably they would escape taxation, and there would be little or
no impact on freight charges. However, to the extent these ships
remained under U.S. control, and paid U.S. taxes, there would be
some increase in freight rates, mainly between third countries. In
any event, there would be no discernable effect on the employment
of U. S. seamen, since U. S. crews are seldom used on foreign flag
vessels, whether or not controlled by U.S. corporations.
To effectively bring foreign shipping income within the purview of
Subpart F it would be important to clarify the applicable rules for deter mining when the foreign corporation is considered not to have been
formed or availed of for the substantial reduction of taxes. The rules
applicable to foreign base company service income in this respect
would raise serious administrative problems in the case of shipping
income, since they refer to the effective foreign tax rates where the
services are performed, and might well be ineffective since many
countries impose little tax on their shipping companies and no tax is
attributable to income generated on the high seas.
In addition, if the deferral of U.S. tax on the undistributed profits
of foreign shippmg companies were eliminated and the statutory reciprocal exemption of Section 883 were repealed, it would be necessary to
avoid double taxation of the same income.
Section 952(b) achieves
this result for Subpart F income by defining it as excluding income
effectively connected with a U.S. trade or business unless U.S. tax
is reduced or waived by treaty.
- 95 -
X.
OPTIONS
1. Retain present law.
This option could be supported on the
grounds that the treatment of shipping income under Subpart F was
just changed and that any further changes should be delayed long enough
to see the results of the earlier legislation. But the 1975 and 1976
changes are not satisfactory.
The Tax Reduction Act of 1975 and
the Tax Reform Act of 1976 put shipping services neither in nor out
of the foreign base company services category, but in a special inbetween category, sometimes favored and sometimes penalized compared to other covered services.
Moreover, applying the new
provisions promises to be extremely complicated.
2. Remove shipping income from Subpart F. This option would
return to the pre-1976 situation, which permitted the use of tax haven
companies by U. S. ship owners, contrary both to the general tax
policy of denying deferral benefits to tax haven companies and to
the policy of granting special tax benefits and direct subsidies to U.S.
flag ships.
3. Include foreign shipping income under Subpart F as foreign base
company service income. The purpose of the Subpart F provisions with
respect to foreign base company service income is: ".. . to deny tax
deferral where a service subsidiary is separated from manufacturing or
similar activities of a related corporation and organized in another
country ordinarilyto obtain alower rate of taxforthe service income."
(S. Rep. No. 1881, 37th Cong., 2d Sess., C.B. 1962-3, 703, at 709).
The use of tax haven corporations to furnish international shipping
services answers this description.
If shipping income were to be treated like foreign base company
service income under Subpart F, the substantial reduction test would
have to be strengthened. Using the foreign effective rates where the
services are performed as the standard is extremely complex and
leaves much to the discretion of the taxpayer.
Any substantial change in the reciprocal exemption (discussed in
Part A ) should be accompanied by the inclusion of shipping income
under Subpart F. Otherwise, to the extent that other countries continue
to grant exemption on the basis of reciprocity, owners of U. S. flag
vessels would have an additional incentive to transfer those vessels
to a controlled foreign corporation and register them outside the United
States.
- 96 XI. R E V E N U E E S T I M A T E S
Option (1), retaining present law, would involve no revenue change.
Option (2) would return to pre-1976 rules which specifically exclude
snipping from Subpart F. This would involve some revenue loss, but
a small one; in general the exception for shipping profits reinvested
in shipping operations is tantamount to an exclusion.
Option (3) would define foreign base company service income to
include shipping profits without exception and would strengthen the
substantial reduction test.
The estimated revenue gain from this
option viewed in isolation is $240 million. However, an estimated $40
million of this amount would represent double counting if the statutory
exemption under section 883 were also eliminated. In other words,
if both proposals were enacted, the additional revenue gain from the
Subpart F proposals is estimated at $200 million. This figure does not
take into account the availability of excess foreign tax credits on other
foreign income.
The estimation of the revenue gain under Option (3) may be briefly
explained. A sample representing about two-thirds of the gross tonnage
of U.S. owned foreign flag ships showed pre-tax earnings and profits of
$690 million in 1973, an effective foreign tax rate of 3 percent and dividends paid of $260 million, or 40 percent of earnings and profits (Table
9). Based on that sample, the estimated revenue gain of eliminating
deferral for shipping C F C s would be about $240 million after foreign
tax credits assuming no usable excess credits. This assumes that all
of the profits qualified for the exception from Subpart F provided by
the Tax Reduction Act of 1975 (Table 10). While the 1974 figure would
have been higher than for 1973, the current depressed market for
tankers suggests a drop from 1974 levels for 1975 and 1976. The
estimate assumes that the 1976 figure would be roughly the same as
for 1973.
It is estimated by the Maritime Administration that only about 20
percent of U.S. owned foreign flag oil tankers carry U.S. trade, the
rest engaging exclusively in foreign commerce.
Assuming that 50
percent of the nontankers carry U. S. trade, and that the ships which
carry U.S. trade derive two-thirds of their pre-tax income from U.S.
sources, the tax imposed on their U.S. income by eliminating the
statutory exemption would have amounted to perhaps $40 million.
Thus, excluding that income from Subpart F would reduce the net
revenue gain of eliminating deferral to $200 million (Table 10).
Table 9
Earnings and Profits, Foreign Taxes and Dividends
Paid, Selected CFCs Engaged in Shipping, 1973
Foreign Tax Paid
Pre-tax
Percent
Earnings
: of pre& profits
($ millions) ($ millions): tax E&P
Dividends Paid
Percent of
after tax
($ millions) ($ millions)
E&P
After Tax
E&P
Sample of U.S. owned
foreign flag ships 1/
687.2
23.0
3.3
664.3
256.8
38.7
Owned by oil
companies
636.4
22.8
3.6
613.6
232.7
37.9
Owned by others
50.8
0.2
0.4
50.6
24.2
47.8
July 17, 1975
Office of the Secretary of the Treasury
Office of Tax Analysis
1/ Representing two-thirds of the total gross tonnage of U.S. owned foreign flag ships.
Includes some CFCs which also engage in other activities.
Source: 1973 tax return data for selected parent companies and their shipping CFCs
^4
Table 10
Estimated Revenue Effect of Eliminating Deferral on the Income of
Shipping CFCs
(Millions of Dollars)
:Gross
:tonnage
Undistributed
Foreign
:of ships
pre-tax
Tentative
tax
Revenue
:(thousand
earnings and
U.S. tax
credit
gain 4/
: tons)
profits 2/
Sample of U.S. owned foreign
flag ships
Owned by oil companies
Owned by others
Estimated others
17,771
15,755
1,936
6,834
427
399
28
120 3/
205
192
13
58
_4
187
174
13
54
Estimated total
24,605 1/
527
253
21
240
18
18
Less credit for tax on U.S.
source income
40 5/
Net revenue gain
Office of the Secretary of the Treasury
Office of Tax Analysis
00
200
December 1976
1/
As of December 31, 1974. Reported in U.S. Department of Commerce, Maritime Administration,
Foreign Flag Merchant Ships Owned by U.S. Parent Companies, October 1975. Excludes ships
owned by individuals.
2/ Based on 1973 tax return data. Assumed generally in line with 1976 magnitudes given the slow
tanker market in 1975/76.
3/ Estimate based on estimated profits per gross ton and estimated foreign tax and dividend ratios
4/ This is a maximum estimate; it assumes no usable excess foreign tax credits and makes no
allowance for the various escape mechanisms of Subpart F.
5/ Assumes that 20% of the tankers and 50% of the oti.er ships engage in U.S. trade, that those
ships derive 757D of their profits from such trade and that U.S. tax at 48% is imposed on
507o of the profits from traffic to and from the U.S.
Source:
1973 tax return data for shipping CFCs and estimates explained above.
-99-
U. S. TAXATION OF FOREIGN EARNED INCOME
OF PRIVATE EMPLOYEES
Marcia Field
and
Brian Gregg
-100TABLE OF CONTENTS
Page
Issue 1Q2
Present Law 103
1. Explanation 103
2. Legislative history
104
Analysis 106
1. Impact of repeal of Section 911 on employees and employers- . . . 10
(a) Employees who would be most affected in general 106
(b) Some empirical evidence
(c) W h o would bear the added tax burden, employee or
employer ?
,
2. Possible exceptions or modifications if Section 911 were
repealed
«
(a) Employees of United States charities 110
(b) Extraordinary living expenses
(c) Burden of foreign sales taxes
108
109
110
Ill
.. . WW.All
3. Additional considerations 113
(a) Effect on United States exports 113
(b) Competitiveness of United States firms . .' .' .' . . . .'.'.[ .' .' [
Options -Q4
1. Retention vs. repeal of the Section 911 exclusion as modified
m the Tax Reform Act of 1976
,
H4
2. Repeal the exclusion but introduce a deduction for
extraordinary living costs . . ,
114
3. Repeal the exclusion but introduce a deduction for specific
costs of foreign residence
114
4. Repeal the exclusion but introduce a deduction for 'foreign
&
sales taxes
^15
Statistical Tables t 116
1. Returns reporting foreign earned income exclusion in 1972
compared with 1968
. . . .
116
2. Additional data from the 1968 returns
!..'.'!."!!.''.!!.'.'!!! 116
3. Examples of high and low tax countries .......
117
-101-
LIST O F T A B L E S
Table 1
Table 2
Table 3
Table 4
Page
Summary Data on Returns Reporting a Foreign
Earned Income Exclusion, Tax Years 1968 & 1972.
118
Summary Characteristics of Returns Claiming
a Foreign Earned Income Exclusion for 1972
By Amount of Adjusted Gross Income
119
Returns Filed, 1968, Claiming an Exclusion of
Foreign Earned Income Under Section 911
120
Returns Filed with an Exclusion of Foreign Earned
Income, by Size of Adjusted Gross Income, 1968.
121
Table 5
Returns Claiming a Foreign Tax Credit, 1968 122
Table 6
Returns Filed with an Exclusion of Foreign Earned
Income, Developed and Developing Countries, 1968
123
Principal Countries of Foreign Residence of Persons
Claiming Foreign Earned Income Exclusion, 1968
124
Duration of Foreign Residence of Bona Fide Foreign
Residents, 1968
;
125
Returns Excluding More than $25,000 of Foreign
Earned Income, 1968
;
126
Examples of High and Low Tax Countries, Relative
to the United States
127
Table 7
Table 8
Table 9
Table 10
-102-
I.
ISSUE
The issue is whether Section 911, the foreign earned income
exclusion, of the Internal Revenue Code should be eliminated, and
the currently excluded income made fully taxable. The Section 911
exclusion is a departure from the general rule that U. S. citizens,
whether or not resident in the United States, are subject to U.S.
tax on their global income.
Prior to the passage of the Tax Reform Act of 1976, Section 911
of the Internal Revenue Code provided that U.S. citizens who
remained outside the United States for prolonged periods, other
than as U.S. Government employees, excluded from their gross
income $20, 000or $25, 000 annually of their foreign earned income.
The Tax Reform Act of 1976 reduced the amount of excludable income
and modified the computation of tax on non-excluded income. The
excludable amount is reduced to $15, 000 in general. A $20, 000 exclusion is provided for employees of U. S. tax-exempt organizations
described in Section 501(c)(3) of the Internal Revenue Code. The
applicable U.S. tax on income in excess of the excludable amount
is calculated as if there were no exclusion; foreign taxes paid on
excluded income are not allowed as a credit; and income received
outside the country where it is earned, in order to avoid tax in
that country, is not eligible for the exclusion. The Tax Reform
Act of 1976 also extended the right to claim a foreign tax credit
to taxpayers who use the standard deduction.
-103-
IL
PRESENT L A W
1. Explanation.
Section 911 of the Internal Revenue Code
excludes from gross income, and therefore exempts from tax,
$15, 000 of annual income from foreign employment of U. S. citizens
who remain in a foreign country or countries for 17 months (510
days) in any consecutive 18 month period (the "physical presence"
rule) or who are bona fide foreign residents and have been for
at least one full taxable year. The excluded amount is $20,000
for employees of U. S. organizations which qualify as tax exempt
organizations under Section 501 (c)(3) of the Internal Revenue Code.
Computing the 510 day period becomes complicated when
partial tax years and travel over international waters or air space
are involved, especially since the 18 month periods can be overlapping. Bona fide foreign residence is determined on the facts
and circumstances of each case in terms of indications, such as
ties with the local community, or intent to maintain one's permanent
home in that country.
The exclusion is not available to U. S. Government employees.
Although restricted to U. S. citizens by statute, it is extended by the
nondiscrimination clause of income tax conventions to resident aliens
who are citizens of certain other countries. 1/
The exclusion is limited to "earned income" which means compensation for personal services actually rendered. Taxpayers who
combine labor and capital in an unincorporated business m a y exclude
up to 30 percent of their income from the business as representing
compensation for personal services. Income is considered earned in
the year the services were performed. Amounts received as a pension or annuity are not excludable, except to the extent that they
represent employer contributions made before 1963 or with respect
to services performed before 1963.
The excluded amount is taken into account in determining the tax
on other income. Under this method, often referred to as "exemption with progression", if $15,000 of income is excludable and
$35,000 not excludable, the tax liability is the difference between
the tax on $50, 000 and the tax on $15, 000.
1/ Rev. Rul. 72-330 and 72-598 (1972-2 C. B. 444 and 451).
-104-
No deductions properly chargeable against the excluded income
m a y be taken against other income. For example, to the extent that
moving expenses or travel and entertainment expenses associated
with the foreign employment are not fully reimbursed by the employer, they m a y not be deducted from other income.
Foreign taxes paid on excluded income may not be deducted in
determining taxable U. S. income, nor are these taxes allowed as
a foreign tax credit against U. S. tax onforeign source income. Taxpayers eligible under Section 911 m a y make a permanent election not
to claim the exclusion.
2. Legislative history. When introduced in 1926, the exclusion
under Section 911 was an unlimited exemption of foreign employment
income for citizens who spent six months a year outside the United
States. The exclusion was intended to benefit export salesmen and
was called the "foreign trader" exemption. Over the years it has
undergone a number of amendments, to exclude government
employees, to introduce the concept of foreign residence and later
the concept of physical presence abroad, and to introduce dollar
limits to curb abuses by individuals, notably movie stars, who could
arrange their employment to take advantage of the opportunity to
escape U. S. tax. The principal changes are summarized in the
following paragraphs.
As introduced by the House of Representatives in 1926, the
"foreign trader exemption" would have excluded from taxable
income the salaries and sales commissions received by U.S.
citizens employed abroad for foreign sales of tangible personal property produced in the United States, provided that the recipient was
employed abroad for more than six months of the year. The Senate
Finance Committee rejected the House bill, arguing that the foreign
tax credit made such a benefit unnecessary; but the Senate as a
whole agreed with the House and even broadened the measure. As
enacted into law, the forerunner of Section 911 allowed a U. S.
citizen who lived outside the United States for m o r e than six months
of the tax year to exclude from his taxable income all foreign earned
income.
The original intention of tying the exclusion to income
generated by U. S. exports never made its way into law.
In 1932, the exclusion was denied to U. S. Government
employees, who are generally exempt from foreign income taxes.
In 1942, the eligibility requirement was tightened from six
months absence from the United States to bona fide residence in
a foreign country for an entire tax year.
-105-
In 1951, the residence requirement, which had been interpreted
strictly by the Internal'Re venue Service and the courts, was relaxed
somewhat by providing that persons physically present in a foreign
country or' countries for a period of 17 out of 18 consecutive months
(the "physical presence" test) could also qualify for exemption.
In 1953, the House proposed repealing the "physical presence"
exemption due to abuses. The solution enacted into law was to limit
the exclusion to $20, 000.
In 1962, the unlimited exclusion of foreign earned income of
bona fide foreign residents was limited to $20, 000a year for the first
three years and $35, 000 a year thereafter.
In 1964, the $35, 000 maximum exclusion for bona fide foreign
residents was lowered to a level of $25, 000. The exclusioiTTemained
at $20,000 for the first three years of bona fide foreign residence
and for those physically present abroad.
In 1976, the excludable amount of foreign earned income was
reduced to $15, 000, with the exception of employees of tax-exempt
organizations, for w h o m the exclusion is $20,000. In addition, the
applicable U. S. tax rate on income in excess of the excluded
amount is to be calculated at the higher graduated rates, as if
there were no exclusion, and the foreign income taxes which otherwise qualified for the foreign tax credit are to be apportioned
between foreign taxes attributable to excluded income (no longer
eligible for a U.S. foreign tax credit) and other foreign income
taxes. Because these changes can in some cases result in the exclusion being less advantageous than if the taxpayer included that
income and claimed the foreign tax credit, the Tax Reform Act
of 1976 permits taxpayers to elect not to claim the provisions of
Section 911. The 1976 Act also provides that foreign earned income
which is received outside of the country in which it' is earned is
not eligible for exclusion if one of the purposes of receiving such
income outside that country is to avoid local income tax.
-106-
III.
ANALYSIS
Throughout the history of the foreign earned income exclusion
there has been a thread of criticism that the foreign tax credit
makes such an exclusion unnecessary. It is argued that U.S.
citizens should pay the same tax without regard to where they are
employed, while relying on the foreign tax credit to avoid double
taxation.
This line of reasoning has been opposed by the view
that full taxation of U. S. citizens employed abroad would hurt the
competitive position of U.S. companies in world markets, since
the United States is one of only a very few countries which tax
nonresident citizens on their foreign source income.
Issues considered in this review of Section 911 are: (1) the
impact its repeal would have on employees and employers; (2) modifications of Section 911 contained in the Tax Reform Act of 1976;
and (3) special circumstances which might warrant retention of
the exclusion in its present form or otherwise.
1. Impact of repeal of Section 911 on employees and employers.
(a) Employees who would be most affected in general. In 1974,
there were roughly 120,000 U.S. taxpayers who filed F o r m 2555,
an information return reporting foreign earned income excluded
under Section 911. 1/ In 1972, 100,000 taxpayers excluded an
aggregate of $1.4 billion of income. The net revenue gain if the
excluded income were made taxable in full is estimated at $60
million for 1976, after foreign tax credits. The changes introduced
by the Tax Reform Act of 1976 are estimated to increase revenue
by approximately $45 million, before taking into account the easing
of the law in permitting persons using the standard deduction to
claim a foreign tax credit.
The benefit of Section 911 varies inversely with the foreign tax
liability, since the U.S. income tax is reduced dollar for dollar by the
foreign tax paid. Thus, in general, repeal of Section 911 would hurt
those who pay a foreign income tax lower than the U. S. tax and would
hurt most those whose foreign earned income is exempt from foreign
tax. It should be noted that in some cases it is the employer rather
than the employee who would be affected; this point is brought out
more clearly in Section (c).
1/ Part V summarizes some further statistical characteristics of
the taxpayers claiming the benefits of Section 911.
-107-
Employment in countries where no income tax is imposed, such
as Saudi Arabia and the Bahamas, would be less attractive if Section
911 were repealed.
But there are also other less obvious cases
in which countries which ordinarily impose high taxes grant selective tax exemption or reductions. This can occur for a variety of
reasons. For example, a foreign country m a y treat all persons
employed at a U. S. Government installation or on a governmentfinanced project as if they were government employees and exempt
their earnings from tax, even though some are employed by private
firms. Some foreign countries grant special relief to employees
who are not permanent residents, such as taxing them only on income
received in that country, or permitting special deductions.
Certain occupations may enjoy tax relief. For example, the
charters of international organizations typically provide for exemption from
tax of employees' salaries. Some occupations involve
extensive travel, enabling the employees to be out of the .United
States for seventeen months without remaining in any one country
long enough to become taxable there (visits.of less than six months
by employees of foreign companies often do not give rise to local
income tax liability). Performers, fishermen, and m e m b e r s of ship
crews might fall in this category.
To the extent that Section 911 reduces U.S. tax, it provides
an incentive to reduce foreign tax liability to the same level. Some
persons m a y respond to this incentive by using methods that constitute tax evasion. One such method is the splitting of salaries,
with one part reported for local tax purposes and the other deposited
to the employee's bank account in the United States or another
country, without the knowledge or approval of the foreign government.^/ Another method is not to report income in kind as required.
Where the salary is deducted in full by a local company, it is
more difficult to conceal income than when part or all of the payment
is made from the United States. A foreign subsidiary m a y try to
disguise a reimbursement to the parent as royalties or technical
V
Under the Tax Reform Act of 1976 income earned abroad which is
received outside of the country in whichearned, in order to avoid
tax in that country, is ineligible for the exclusion under
Section 911.
-108-
service fees, but such payments are often subject to a high
withholding tax. The employee m a y simply rely on weak local
enforcement not to discover the discrepancy between the salary
deducted by the employer and that reported by the employee, or
to overlook income in kind.
(b) Some empirical evidence. A detailed survey of the 100, 000
taxpayers claiming the benefits of Section 911 in 1968 showed that the
largest concentrations were in Canada (11 percent of the total),
Germany, the United Kingdom, and South Vietnam (6 percent each).
With the exception of South Vietnam, these countries presumably
continue to be among the principal places of residence. In 1968
they accounted for 23 percent of the total number of persons claiming
Section 911.
Under the United Kingdom's remittance basis of taxation it was
possible to remit to the United Kingdom only the m i n i m u m needed for
living expenses and be taxed only on that amount. Some reduced
their U.K. tax liability still further or even to zero by receiving
none of their salary in the United Kingdom and borrowing to meet
living expenses (remitted capital was not taxed). The United
Kingdom tightened its remittance basis' of taxation beginning in April
1975. Persons not ordinarily resident in the United Kingdom are
now subject to tax on one half of their income from services performed in the United Kingdom whether or not the income is actually
remitted. However, the U.K. tax on one-half the income remains
below the U.S. tax on the entire income for most U.S. citizens
employed there. The Canadian and German taxes are as high or
higher than the U. S. tax, except for special cases, such as those
private sector employees associated with U.S. bases in Germany
who are exempted by German tax authorities as if they were U.S.
Government employees.
Among the other principal places of residence in 1968, and
presumably also today, were Japan, Mexico, Brazil, Australia, the
Philippines, and Italy, all of whichare high-tax countries relative to
the United States, and Thailand, Venezuela, the Marshall Islands,
France, Saudi Arabia, Switzerland, the Bahamas, and Bermuda,
all of which are low-tax countries relative to the United States.J./
Employees in the low-tax group would experience an increased U.S.
tax liability if Section 911 were repealed.
But the high-tax group
would be largely unaffected, since the foreign tax credit would offset
most or all U. S. tax liability.
1/ See Table 10 for other examples of high and low tax countries.
-109-
F r o m the 1968 data, tentative inferences can be drawn about
some of the employees who would be most adversely affected by
repeal of Section 911. U. S. citizens employed by international
organizations would be affected, wherever located. Affected groups
in some countries can be identified with particular industries, such
as finance (Switzerland, the Bahamas, Bermuda), oil (Saudi Arabia,
Venezuela) and defense contracts (the Marshall Islands and
Thailand). Oil company employees in other Middle Eastern
countries, Iran, Indonesia and the North Sea could also be affected
since low taxes often apply in those countries by contract, for
employees engaged in petroleum exploration and development.
(c) Who would bear the added tax burden, employee or employer? The next question is who would pay the increased tax?
If Section 911 were repealed, the resulting increased U. S. tax liability would mean an increased total tax burden for employees
subject to low foreign taxes. Whether the burden would fall on
them or be passed on to their employers would depend in the first
instance on the method of tax reimbursement, and ultimately on
the demand for and supply of the skills of the affected employees.
The two principal methods by which U. S. firms reimburse
their employees for foreign tax liabilities m a y be designated "tax
equalization" and "tax protection", although different companies
use different names. The "tax equalization" approach in effect
removes the employee from the scope of Section 911. The employer
calculates the base salary to approximate the amount the employee
would have received after U.S. income tax if employed in the United
States, and then pays the foreign tax liability incurred by the e m ployee on that amount. Under such plans the employee does not
benefit if the foreign tax is lower than the amount of U.S. tax
by which the salary was reduced; the savings accrue to the e m ployer,]/ Under "tax protection" plans the employee is paid the
1/ For example, if the U.S. salary would be $50,000 and the estimated U.S. tax on that amount in the absence of the Section
911 exclusion is $15, 000, the overseas employee would be paid
$35, 000. Assuming that the foreign tax on $35, 000 is $10, 000,
the company pays that amount and keeps the other $5,000 of
the $15,000 reduction in base salary. The employee adds the
foreign tax payment to his income in the year it is paid,' so
each year there is an increased tax base even at the same salary
level (as in any such tax reimbursement scheme) but the starting
level is lower with this approach than under the tax protection
method.
-110-
full U. S. base salary is considered subject to an assumed U. S.
tax and the employer pays any excess of foreign tax over that U. S.
liability. If the foreign tax is lower, the employee saves the difference. Thus, under the first approach, the immediate impact of
the loss of the exclusion would be on the employer, while under
the second approach the immediate impact would be on the
employee.
Even where the U. S. company would compensate the employee
for the full increase in U. S. tax resulting from the repeal of Section
911, some employees might have to accept a reduction in income.
If there is high unemployment in that occupational field in the United
States, employers m a y be able to offer lower premiums and allowances for foreign positions. There has been a tendency in recent
years for U. S. multinationals to cut back on the various supplements
paid to U. S. overseas employees. There is also a tendency to employ
more foreign nationals, even where foreign laws do not so dictate,
as it becomes increasingly possible to obtain comparable skills at
lower costs. An increased tax liability for American employees
would probably accelerate both tendencies in low-tax countries.
Americans employed abroad by foreign employers presumably
would be less able to pass on to the employer an increased U. S. tax
cost than those employed by U. S. companies or their subsidiaries.
This would not always be the case, but the preference for U. S. labor
would tend to be greatest among companies with the strongest ties to
U. S. technology, methods of doing business, and working in the
English language.
In general, an increased tax burden due to repeal of Section
911 would probably result in an increased cost to employers,
although not necessarily by the full amount of the tax increase,
lower net pay to U. S. citizens employed on foreign assignments,
and an overall reduction in the employment of U. S. citizens abroad.
2. Possible exceptions or modifications if Section 911 were repealed.
(a) Employees of United States charities. The Tax Reform Act
of 1976 preserved a $20, OUU per year exclusion of foreign earned
income for persons who meet either the bona fide foreign residence
test or physical presence (510 day) test aTicTare^mployed by a U. S.
organization which qualifies under Section 501 (c)(3) of the Internal
Revenue Code. Such organizations m a y be operated for religious,
charitable, scientific, testing for public safety, literary, or educational purposes, or for the prevention of cruelty to children or
animals. They must be created under the laws of the United States;
thus foreign charities, such as the International Red Cross, do not
qualify. Contributions to the qualifying organizations are deductible
to the donor. The justification for preserving an exclusion for employees of such organizations is that an increase in their tax burden
-Ill-
would be an increased cost to the non-profit organizations and would
force them to cut back on their activities. The effect of the exclusion
is to give such organizations an incentive to assign employees to
foreign countries where the tax is lower than the U.S. tax, rather
than to assign them to activities in the United States or in other
countries where the tax is comparable to the U.S. tax. Employees
of those organizations in the United States do not enjoy a similar
exclusion.
(b) Extraordinary living expenses. One of the principal complaints of beneficiaries of the Section 911 exclusion when faced with
its proposed repeal has been that they could not afford to stay at
overseas assignments (or, if employers, to station U.S. citizens
in overseas positions). Extraordinary living costs in m a n y foreign
posts, it is argued, would raise the required income level above
the comparable U.S. level, and payment of U.S. tax on that
additional salary would m e a n either a reduction in after tax income
for the employee or a reduction in profit of the employer.
The principal component of extraordinary living costs in foreign posts seems to be housing. T o rent a Western style, airconditioned apartment in Tokyo m a y cost more than $1, 000 a month,
and costs are also very high in remote outposts where housing
approximating U.S. standards is scarce.
Within the United States, costs also vary substantially, but
the tax law does not adjust for such differences. To make such
an adjustment for some taxpayers and not others gives a selective
subsidy to employment in those high cost areas which qualify for
the adjustment. Moreover, costs of living in m a n y foreign posts
are lower than the United States standard.
The point is frequently made that high living costs incurred
in foreign countries do not represent any personal benefit to the
taxpayer. H e m a y in fact have preferred an apartment in Washington,
D.C. for $300 a month to the one for which he must pay $1,000
a month in Tokyo. But under present law taxable income is not
defined to be net of living expenses. The Tax Court addressed
this issue in two recent cases concerning taxpayers who had not been
reporting the portion of their rental costs paid for them by their
employers. In one case the Tax Court expressed sympathy with the
taxpayer's dismay at the high cost of reasonable housing in Tokyo,
but observed that if the company had not paid the additional rent,
the employee would have had to pay it to live in such quarters,
and that therefore the company's payments did represent a financial
-112-
benefit to the taxpayer._/ In a second similar case the Tax Court
also held that the rent paid by the employer was includable in gross
income of the employee because the housing furnished did not qualify
as for the convenience of the employer. _/ It can be argued that
the tax law should be changed to exempt from tax a basic minimum
amount to cover living costs, which would vary with the cost of
living in different places and years. But the problem, as mentioned
before, is a general one affecting domestic as well as foreign
employees and involving lower as well as higher costs in different
situations. There are also severe administrative difficulties in
implementing sucha concept, and its implementation would diminish
the incentives for employers to locate in low cost-of-living areas.
(c) Burden of foreign sales taxes. Sales taxes imposed in foreign countries are not deductible for U.S. income tax purposes,
unlike U.S. state and local sales taxes. Nor m a y a deduction be
taken for foreign personal property taxes or contributions to foreign
charities.
O n the other hand, foreign income taxes imposed by
political subdivisions m a y be credited against the U.S. income tax
while U.S. state and local income taxes m a y only be deducted.
Countries with substantial sales taxes are not necessarily those
with substantial local income taxes, so the two features cannot
be assumed to offset each other. Foreign sales taxes are generally
a more onerous burden than foreign personal property taxes. The
nondeductibility of contributions to foreign charities is mitigated
by the possibility of routing some such contributions through U.S.
charities.
As long as state and local sales taxes are considered a proper
deduction in arriving at taxable income for Federal tax purposes, a
deduction for foreign sales taxes can be justified. There would be
severe administrative difficulties in monitoring a deduction for
.actual foreign sales taxes incurred, although one could imagine a
workable arrangement based on sales tax tables, perhaps initially
just for high, low, and medium sales tax countries, grouped accordingly. Such an approach would move toward making the tax
base computation consistent for resident and nonresident taxpayers.
Alternatively, denial of a deduction for U.S. state and local sales
taxes could have the same effect.
1/ T.C. m e m o r a n d u m 1976-13, filed January 20, 1976; Philip H.
and Cherie M . Stephens vs. Commissioner of Internal Revenue.
2/ 66 T.C. , No. 25, May 5, 1976; James H. McDonald and
Amelia H. McDonald vs. Commissioner of Internal Revenue.
-113-
3. Additional considerations.
(a) Effect on United States exports. The argument is often
made that repeal of the exclusion would m a k e U. S exports less competitive in world markets since other countries do not tax their
nonresident citizens. Since the exclusion is not limited to
employees engaged in export-related activities, this argument holds
true only in selected cases. One such case would be where a U.S.
exporter maintains a sales outlet in another country. Another would
be where a U.S. firm sends employees abroad for prolonged periods
to supervise the assembly, installation or use of exported products.
Other activities of U.S. firms abroad, such as manufacturing, m a y
also generate demand for U.S. exports, but the exclusion is not
limited to such cases. The exclusion could, perhaps, be modified
to benefit only exporters. But given the foreign tax credit, an
export incentive in the form of an exclusion from gross income
would necessarilybe selective in its effects, favoring.exports which
involve the assignment of U.S. personnel to low tax countries.
(b) Competitiveness of United States firms. U. S companies
with employees overseas frequently maintain that their ability to
compete with third country companies (e.g. to compete against the
French in Morocco) is hindered when U.S. citizens continue to be
subject to U.S. tax while citizens of other countries working in
such third countries pay only the host country. This situation occurs
when the U.S. and foreign companies are competing in a place
where the income tax is below the U.S. level, so that a net U.S.
tax is due after the foreign tax credit. It does not occur if the host
country income tax is as high as the U.S. income tax. Thus,
the exclusion gives a tax incentive to production in low tax countries.
-114-
IV.
OPTIONS
1. Retention vs. repeal of the Section 911 exclusion as modified in the Tax Reform Act of 1976. The modifications introduced
by the Tax Reform Act of 1976 substantially curtailed the benefits
of Section 911; consequently, outright repeal of the exclusion m a y
now have less appeal. It can be argued that the repeal of Section
911 is too extreme. It would result in an increased U. S. tax liability
for U. S. taxpayers employed abroad who pay foreign income taxes
below the ordinary U. S. tax. This cost will frequently be borne
by U.S. companies, while companies employing foreign nationals
who are subject only to local taxes will not incur a comparable
cost. O n the other hand, for m a n y U.S. employees overseas, foreign
taxes are as high or higher than the ordinary U.S. rates, and
Section 911 is of no benefit. Nor does it benefit recipients of other
types of income, such as U.S. citizens who retire to another
country. The pattern of benefits does not correspond to any stated
policy objective. The administrative complexity which has long
characterized Section 911 was increased rather than reduced by
the 1976 amendments.
2. Repeal the exclusion but introduce a deduction for extraordinary living costs. The cost of living in some foreign locations
can be considerably higher than in the United States, requiring the
payment of higher salaries to attract competent employees. The
W a y s and Means Committee studied this question and concluded that
"Given these wide variations both within and without the United
States, your committee believes that the tax laws in practice cannot
be fairly adjusted for these costs. "(House Report 94-658, November
12, 1975, p. 200).
3. Repeal the exclusion but introduce a deduction for specific
costs of foreign residence. Although cost of living differentials are
not adjusted for in current U. S. tax law, and such adjustments would
be difficult io make and administer fairly on a broad scale, there is
some sentiment for granting tax relief to nonresident citizens for
specific costs which are frequently higher in other countries. The
House version of the bill which became the Tax Reform Act of 1976
(H.R. 10612) provided a deduction for tuition expenses of dependents,
up to a certain amount, in recognition that language barriers,
physical distance and the importance of preparation for U. S. universities make private schooling necessary in many cases where
U.S. public schools would be used if available. Relief for excess
housing costs is another possibility for selective relief. A n excess
housing cost deduction would be more difficult to administer than a
tuition expense deduction and raises the question whether it is
-Inappropriate for the U.S. Government to selectively subsidize such
costs. But such a deduction offers one approach for treating private
and public sector foreign service employees equitably if both the
Section 911 exclusion and the Section 912 tax free allowances of
overseas U.S. Government employees were replaced by uniform
allowances for unusually high education and housing costs.
4. Repeal the exclusion but introduce a deduction for foreign
sales taxes. Such a deduction would remove a discrepancy in the
tax base which (although not expressed in terms of resident vs.
nonresident U.S. taxpayers) has the general effect of putting at
a disadvantage those taxpayers who reside in foreign countries.
However, it would raise serious administrative difficulties. In
addition, there are other discrepancies in computing the tax base,
such as the allowance of a credit for income taxes imposed by foreign
political subdivisions compared to a deduction for U. S. state and
local income taxes. It might be appropriate to consider these
various issues together.
-116V.
STATISTICAL T A B L E S
1. Returns reporting a foreign earned income exclusion in
1972 compared with 1968. in 1972, approximately 102, 00U returns
were filed reporting a foreign earned income exclusion. The aggregate amount excluded was $1.4 billion, or an average of $13,600
per return. In 1968, nearly the same number of returns reported
total excluded income of $1. 2 billion or $11, 800 per return (Table
1). Foreign earned income not eligible for the exclusion more than
doubled between 1968 and 1972, indicating an increase in salary
levels. The amount of other income subject to tax remained constant.
Table 2 shows further detail on the 1972 returns, classified by size
of adjusted gross income.
2. Additional data from the 1968 returns. A special tabulation
was taken of returns reporting a foreign earned income exclusion
for 1968. The returns were classified by amount of foreign earned
income, which reveals information about the total income of the
taxpayers, and information on location of the taxpayers. Those
data are summarized in Tables 3 through 9.
As illustrated in Table 3, there were 101,295 returns filed
for tax year 1968 reporting an aggregate of $1. 2 billion of excluded
foreign earned income. Two-thirds of the taxpayers, reporting 80
percent of the excluded income, identified themselves as bona fide
foreign residents, as opposed to persons claiming the exclusion on
the basis of physical presence abroad.
Only 15 percent of the persons claiming the exclusion had foreign earned incomes higher than the excludable m a x i m u m ; however
70 percent had some income subject to tax. O n average, bona fide
foreign residents had $9,000 of adjusted gross income after the
Section 911 exclusion, and those physically present abroad had
$5,000 of adjusted gross income after the Section 911 exclusion
(Table 4).
Only 17 percent of the bona fide foreign residents and 3 percent
of those physically present abroad claimed a foreign tax credit, as
shown in Table 5. For all returns the average credit per return
amounted to 2.3 percent of total income (adjusted gross income
plus the excluded income); for returns with foreign earned income
of more than $25,000, the credit averaged 6.5 percent of total
income.
Table 6 indicates that slightly more than half of the returns
were filed by persons in developing countries. The proportion of
returns claiming physical presence abroad was somewhat higher
in developing countries (40 percent of the total) than in developed
countries (30 percent of the total). But the size of foreign earned
income varied little; in both developing and developed countries 70
percent of the bona fide foreign residents and 90 percent of those
physically present earned less than $20, 000.
-117-
The principal country of residence of bona fide foreign residents was Canada (Table 7). Mexico was also important, as were
the United Kingdom and Germany. The other major countries of
residence included Venezuela, Brazil, Switzerland and Japan.
The largest groups of persons physically present abroad reflected
the location of
military activities, for example, South Vietnam,
Kwajalein and the Marshall Islands, and Thailand. Germany, Japan
and Italy also had fairly large concentrations of military activities,
and substantial numbers of civilians claiming physical presence
abroad as the basis for the exclusion.
Taking all the bona fide foreign residents together, 44 percent
had resided abroad less than three years, 33 percent between three
and ten years and 23 percent more than ten years (Table 8). Those
residing in developing countries tended to have been abroad longer;
however, they need not have resided in the same country the entire
time.
There were 186 persons who excluded more than $25, 000 of
foreign earned income in 1968 (Table 9). Most of those persons
had been foreign residents longer than seven years, that is, before
the 1962 Revenue Act. In their case, the unlimited exclusion of
foreign earned income available to bona fide foreign residents prior
to 1963 continues to apply provided that the right to receive such
payments existed as of March 12, 1962. The most likely form of
payment to have continued into 1968 is pensions (employer contributions made prior to 1963 or related to services performed
prior to 1963). Other possibilities are deferred compensation and
stock options; if stock acquired by exercising an option is sold and
does not qualify for capital gains treatment, the income is treated
as compensation excludable under Section 911 and attributable to
the year the services were rendered which gave rise to the option.
For those who excluded more than $25,000 in 1968 but reported
the duration of their foreign residence as less than four years (i. e.,
since the Revenue Act of 1964 which instituted the present limits),
the most likely explanation is that they might have formerly resided
abroad, either in a different country or under the physical presence
rules, and reported only the dates of their present residence. Some
may have used one F o r m 2555 to report the excludable earnings
of both husband and wife.
3. Examples of high and low tax countries. Table 10 compares
other countries' income taxes on the total income of U.S. employees
stationed there with the U.S. income tax liability.
Table 1
Summary Data on Returns Reporting a
Foreign Earned Income Exclusion,
Tax Years 1968 and 1972
1968
;
1972
Number of returns
Total
With no adjusted gross income
With adjusted gross income
With taxable income
Claiming a foreign tax credit
Amount of income ($ thousands)
Excluded income # ]/
Adjusted gross income (less deficit)—'
foreign earned income not excluded
other (less deficit)
Foreign tax credit
Office of the Secretary of the Treasury
Office of Tax Analysis
101,295
29,622
71,643
25,989
12,449
1,195.8
552.7
223.9
328.8
40.8
101,832
25,799
76,033
40,780
23,914
1,381.7
810.0
486.2
328.8
77.3
1/ Adjusted gross income is defined net of the Section 911 exclusion.
Source: Internal Revenue Service, Statistics of Income 1972, Individual Income
Tax Returns, Table 1.16, and unpublished tabulations of 1968 returns.
Table 2
Summa.ry Characteristics of Returns Claiming a Foreign Earned Income Exclusion for 1972
By Amount of Adjusted Gross Income
(Amounts in $ Thousands)
Amount of adjusted
gross incoitfp (AGI) 1/
Number of
returns
Total
101,832
Returns with no A.G.I. 25,799
$5,000 42,044
- 10,000
- 15,000*
- 20,000
- 25,000
- 50,000
50,000
$ 1,38.1.7
Foreign earned
income not
excluded
$ 486.2
214.9 0.5
Returns with A.G.I. 76,133
A.G.I, under
5,000
10,000
15,000
20,000
25,000
over
Excluded
inc ome
12,471
4,014
4,978
3,772
6,561
2,293
Total
AGI
$ 810.0
Income subject to tax Income tax :Foreign tax credit
Number of
before
: Number of :
returns
Amount
credits : returns : Amount
40,780
$ 550.6
$ 159.3
23,914
$
40,780
550.6
159.3
23,914
77.3
br
A a nr et f f S j D a |? d °?
1/
AGI
Source:
to
36,073
$
82.0
-3.2
1,166.8
485.7
813.2
567.4
222.0
76.0
76.8
58.5
117.7
48.4
34.0
61.4
22.4
45.5
46.7
172.8
102.9
70.6
83.2
48.9
86.4
82.9
226.7
214.5
*
11,715
38.2
A
4,978
3,772
6,561
2,292
53.
60.
184.
174.
6.0
*
10.6
13.1
48.7
74.4
° s"? 1 1 a sample of returns to be relied upon separately.
is defined net of the Sec ;:.on 911 exclusion.
36,073
82.0
9,727
2.2
*
Office of the Secretary of the Treasury
Office of Tax Analysis
* T/8
77.3
Income tax after credits
Number of :
returns : Amount
y
Internal Revenue Service, Statistics of Income 1972. Individual Income Tax Returns. Table 1.16.
10,725
2,612
4,536
2,066
10.1
6.4
25.9
34.1
A
4,905
3,010
5,680
2,118
A
6.4
6.7
22.8
40.2
TABLE 3
Returns Filed, 1968, Claiming an Exclusion of Foreign Earned Income Under Section 911
Foreign Earned Income
under $5,000
5,000-- 10,000
10,000 -15,000
15,000 -20,000
20,000 -25,000
25,000 -50,000
50,000 and over
Total
:
:
:
:
:
Bona fide
All Returns
Foreign residents
17 month presence test
: Excluded
:
: Excluded
:
: Excluded
Number of : income
: Number of: income
'. Number of: income
returns
: ($thousands). returns
: ($thousands): returns
:($thousands)
22,042
22,667
19,452
14,515
9,592
11,490
1,537
$57,890
162,553
232,197
243,341
195,981
263,765
40,122
15,760
14,264
9,961
8,270
7,048
10,222
1,494
. $42,692
100,462
119,427
140,082
146,905
238,385
39,280
6,282
8,403
9,491
6,245
2,544
1,268
43
$15,197
62,090
112,770
103,259
49,076
25,379
842
101,295
$1,195,848
67,019
$827,233
34,276
$368,614
Office of the Secretary of the Treasury
Office of Tax Analysis
source: IRS tabulation of Forms 2555 filed in 1968.
o
i
Table 4
Returns Filed with an Exclusion of Foreign Earned Income, by
Size of Adjusted Gross Income (AGI) 1968
Foreign Earned Income
All returns, total
under $10,000
10,000-20,000
20,000-25,000
25,000 and over
Bona fide residents
under $10,000
10,000-20,000
20,000-25,000
25,000 and over
Physical presence
under $10,000
10,000-20,000
20,000-25,000
25,000 and over
Total
With
no AGI
101,295
44,709
33,967
9,592
13,027
29,652
16,935
11,435
1,032
250
71,643
27,774
22,532
8,560
12,777
67,019
30,024
18,231
7,048
11,716
21,041
13,364
6,592
2,661
1,085
45,978
16,660
11,639
4,387
10,631
34,276
14,685
15,736
2,544
1,311
8,611
3,571
4,843
172
25
25,665
11,114
10,893
2,372
1,286
Office of the Secretary of the Treasury
Office of Tax Analysis
Source:
See Table 3.
W i t h : A G I
AGI
; under $5,000
42 ,833
18 ,709
16 ,361
5 ,854
1 ,909
26 ,309
11 ,953
8,,352
4,,171
1-,833
16,p524
6,,756
8,r009
1,,683
76
AGI
over $25,000
4.311
461
475
307
3,068
3,918
425
401
273
2,819
- 393
36
94
34
249
TABLE 5
Returns Claiming a Foreign Tax Credit, 1968
Foreign Earned Income
Total
Number of
returns
101,r295
Total, all returns
44 r709
under $10,000
33 r967
10,000 - 20,000
9 r592
20,000 - 25,000
13 r027
25,000 and over
67 ,019
Bona fide residents, total
30 ,024
under $10,000
18 ,231
10,000 - 20,000
7 ,048
20,000 - 25,000
11 ,716
25,000 and over
34 f276
Physical presence, total
14
,685
under $10,000
15
,736
10,000 - 20,000
2 ,544
20,000 - 25,000
1 ,311
25,000 and over
Office of the Secretary of the Treasury
Office of Tax Analysis
Source:
See Table 3,
Returns
claiming
foreign tax
credit
12, 449
1.r428
Iir529
1 ,060
8.,432
11 ,431
1 ,176
1 ,150
961
8 ,144
1 ,018
252
379
99
288
Total Income
CAGI plus the
Foreign Tax
Section 911
credit
exclusion)f. .
______
($ thousands)
$1,748,525
$40,795
350,970
1,073
579,768
1,228
1,598
247,336
36,896
570,451
$39,662
$1,248,296
946
217,738
1,443
321,166
1,166
186,247
36,107
524,145
$1,133
$500,230
127
133,232
145
258,602
62
61,090
789
46,306
K>
TABLE 6
Returns Filed With An Exclusion of Foreign Earned Income, Developed and
Developing Countries , 1968
(number of returns and percent of total)
Foreign Earned Income
Total
under $10,000
10,000 - 20,000
20,000 - 25,000
over
- 25,000
Developed countries, total
under $10,000
10,000 - 20,000
20,000 - 25,000
over
- 25,000
Developing countries, total
under $10,000,
10,000 - 20,000
20,000 - 25,000
over
- 25,000
Office of the Secretary of the Treasury
Office of Tax Analysis
Source: See Table 3.
: All
:
:Returns :
Bona fide
foreign
residence
:
:
:
17 month
presence
test
101,295
44.1%
33.5
9.5
12.9
100.0%
67,019
44.8%
27.2
10.5
17.5
100.0%
34,276
42.8%
45.9
7.4
3.8
100.0%
40,067
43.8%
33.0
8.7
14.5
100.0%
53,885
43.2%
34.8
10.4
11.6
100.0%
31,322
43.3%
29.1
9.1
18.5
100.0%
35.697
46.2%
25.5
11.7
16.6
100.0%
12,378
49.3%
39.5
6.7
4.4
100.0%
21,898
39.2%
49.5
7.8
3.5
100.0%
1
l-»
N3
Co
1
TABLE 7
Principal Countries of Foreign Residence of Persons Claiming Foreign
Earned Income Exclusion, 1968
Number of returns
Total
11,277
Canada
6,068
South Vietnam
5,870
United Kingdom
5,791
Germany
3,739
3,674
Japan
3,068
Mexico
2,804
Thailand
2,661
Venezuela
2,588
2,430
Brazil
2,350
Marshall Is., Kwajalein
2,307
France
2,284
Saudi Arabia
2,194
2,183
Switzerland
2,128
Australia
63,416
Bahamas, Bermuda
101,295
Philippines
62.6%
Italy
Office of the Secretary of the Treasury
Subtotal
Office of Tax Analysis
___
World Total
Subtotal
as % world
total
Source:
See Table
3.
:
Bona fide
foreign
residence
10,141
1,158
3,995
3,164
2,031
3,470
1,095
2,625
2,066
326
1,976
1,782
2,051
1,579
1,649
1,419
1,093
40,041
67,019
59.7%
:
:
Physical
presence
1,136
4,910
1,875
2,627
1,708
204
1,973
179
595
2,262
454
568
256
705
545
764
1,035
21,091
34,276
61.5%
TABLE 8
Duration of Foreign Residence of Bona Fide Foreign Residents , 1968
Total
less than
3 years,
Number of returns, total
developed countries
developing countries
67,019
31,322
35,697
,29,156
14,639
14,517
Percent of total
developed countries
developing countries
100.0%
100.0%
100.0%
43.5
46.7
•40.7
: 3 - 5
: years
10,601
5,291
5,310
15.8
16.9
14.9
: 5 - 7 : 7 - 10: More than
: years ; years : 10 years
6,274
3,265
3,009
9.4
10.4
8.4
5,457
2,555
2,902
15,524
5,576
9,948
8.1
8.2
8.1
Office of the Secretary of the Treasury
Office of Tax Analysis
Note:
There are minor errors in the tabulation which cause the totals to differ
somewhat from the sums of their components. In computing the percentages,
the totals used were 67,012; 31,326; and 35,686.
Source:
See Table 3.
23.2
17.8
27.9
TABLE 9
Returns Excluding More than $25,000 of Foreign Earned Income' 1968
Foreign earned
income
Total
Duration of
foreign residence
Amount
less
: 7yrs
Developed .Developing
unidenexcluded
than
:or
countries countries U n i d e n t i f i e d ($thousands) 3 yrs 3-5 5-7:more tified
yrs yrs
92
87
$6,689
13
25 18 : 121
9
Total
186
$25,000 - 35,000
127
57
65
3,740
8
19 14 79 7
35,000 - 50,000
51
30
19
2,213
5
5 4 35 2
50,000 - 100,000
2
1
1
112
0
0 0 2 0
over 100,000
6
4
2
3,624
0
10-5 0
Office of the Secretary of the Treasury
Office of Tax Analysis
N3
Source:
See Table 3
a*.
I
-127Table 10
Examples of High and Low Tax Countries,
Relative to the United States
Higher than
U.S. tax
Generally higher
than U.S. tax
Lower than
U.S. tax
Austria
Argentina 1/
Bahamas 10/
Barbados
Australia 2/
Belgium IT/
Canada
Brazil 2/
Bermuda TO"/
Chile
Costa Rica 2/
Dominican Republic
Colombia
Germany 3/
El Salvador
Cyprus
Greece 2/
France
Denmark
Iran 4/
Guatemala
Ecuador
Italy 5/
Honduras
Ethiopia
Japan 3/
Hong Kong
Finland
Malawi 6/
Kuwait 10/
India
Mexico 77
Lebanon
Indonesia
Morocco 8/
Mozambique
Ireland
Nigeria 1/
Netherlands
Jamaica
South Africa 9/
Nicaragua
Kenya
Panama 10/
Korea
Paraguay 10/
Luxemborug
Saudi AraBTa 10/
Malaysia
United Kingdom
Netherlands Antilles
Uruguay
New Zealand
Venezuela
Norway
Pakistan
Peru
Office of thePhilippines
Secretary of the Treasury
March 17, 1976
Portugal
Office of Tax
Analysis
Puerto Rico
Source: PriceSingapore
Waterhouse Information Guide, Individual Income Taxes
in 80 Countries, January 1975.
1/ Lower than U.S. for incomes under $25,000.
27 Lower than U.S. for incomes under $10,000.
1/ Lower than U.S. for incomes under $20,000.
5/ Higher than U.S. for incomes of $25,000-$40,000, but lower than U.S
for other income levels.
5/ Lower than U.S. for incomes above $60,000.
6/ Lower than U.S. for incomes above $70,000.
7/ Lower than U.S. for incomes up to $10,000 and over $40,000.
8/ Lower than U.S. for incomes over $50,000.
9/ Lower than U.S. for incomes of $15,000 or less.
10/ No income tax applicable.
11/ Higher than U.S. for incomes over $80,000.
-128-
U. S. TAXATION OF ALLOWANCES PAID
TO U. S. GOVERNMENT EMPLOYEES
Marcia Field
and
Brian Gregg
-129-
T A B L E OF C O N T E N T S
Page
L Issue 131
II. Present Law 132
1. Explanation 132
(a) Foreign areas allowances
(b) Cost-of-Living allowances
(c) Peace Corps allowances
(d) Post differentials
2. Legislative history
III. Analysis 135
1. Scope of the exclusion 135
2. Justification for the exclusion
(a) Personal benefit vs. reimbursed costs
(b) Cost must be borne by employer
(c) Tax exemption vs. higher pay
(d) Practical consideration: exemption
vs. higher pay
(e) Distinguishing overseas government
employees from other employees
3. Other considerations
(a) Official expenses
(b) Education expenses
(c) Housing costs
IV. Options 149
1. Retain present law 149
2. Repeal the Section 912 exclusion entirely
3. Allow a deduction for certain costs in excess
of the costs of comparable services in the
United States
(a) Housing
(b) Tuition
4. Other statutory relief
5. Make Section 912 inapplicable to employees
serving in Alaska or Hawaii
132
132
132
132
134
139
139
141
141
142
143
144
144
144
145
149
149
149
150
150
150
-130-
LIST O F T A B L E S
Page
Table 1
Table 2
Table 3
Table 4
Table 5
Principal Categories of Allowances
of U. S. Government Employees in
Foreign Countries
133
Number of Federal Civilian Employees
Eligible for Section 912 Benefits
by Area and Agency, 1968, 1972, and
1975
136
Principal Locations of Civilian
U. S. Government Employees in
Foreign Countries, F Y 1975
137
Federal Civilian Employees Eligible
for Section 912 Benefits; Estimated
Salaries, Allowances Excludable Under
Section 912, and Associated Revenue
Loss by Area, 1968, 1972, and 1975
Examples of State Department Housing
Allowances, as of January 1976
138
146
-131L ISSUE
Under Section 912 of the Internal Revenue Code, U. S. citizens
employed outside the continental United States (and in some cases
in Alaska and Hawaii) by the U. S. Government in a civilian capacity
m a y exclude from their gross income certain allowances which supplement their base salary. The allowances in question are designed primarily to cover certain living expenses. In a number of cases, such
as moving expenses, the expenses would generally be deductible as
employee business expenses under current law. But other allowances,
notably those for housing, cost-of-living differentials, education
expenses and home leave travel, would be taxable income in the absence
of the special exclusion under Section 912.
The issue to be analyzed in this paper is whether these allowances
should be made taxable. 1/ A related consideration is the extent to
which the tax treatment 6T these allowances should parallel the treatment of income earned abroad by private sector employees.
In 1974 the Ways and Means Committee voted to phase out both
Section 912 and Section 911, which excludes certain foreign earned
income of private sector employees.
Both sections, with limited
exceptions, were to be phased out over four years. That bill (H. R.
17488) was not acted on by the House before Congress adjourned.
Many of its provisions concerning foreign source income were incorporated by the House in 1975 in H. R. 10612, including the phase out
of Section 911. However, the Ways and Means Committee deferred
consideration of Section 912 pending receipt of the report of an interagency committee which was reviewing the entire structure of overseas
government allowances. Completion of that report in final form was
expected to require another year, but in view of the Ways and Means
Committee's interest, the interagency group completed the portion of
the report dealing with tax questions and transmitted it to the Ways
and Means Committee Task Force on Foreign Income as an interim
report. 2J
While the Task Force report has not yet been issued,
it is expected to recommend changes in this area.
1/ This paper deals only with allowances paid to civilian government
employees. Military allowances are treated under different provisions of the law.
/
Interim Report of the Interagency Committee on Overseas
Allowances and
Benefits
for
U. S. Employees, (Chairman,
John M.
Thomas, Assistant Secretary of State for Administration), January 1976.
-132IL
PRESENT L A W
1. Explanation. Section 912 of the Internal Revenue Code provides
an exclusion from gross income for certain allowances paid to civilian
government employees. The section refers to three categories of
allowances, citing in each case the statutes which authorize their
payment .
(a) Foreign areas allowances. (Subsection (1) of Section 912) The
first category enumerated in Section 912 refers to the various allowances paid to government employees in foreign areas. There are about
50 such allowances, which fall into eight major groups: living quarters,
cost-of-living differentials (by comparison with Washington, D. C.),
education of dependents, travel, expenses associated with transfers,
expenses associated with separation from the foreign service, representation expenses, and residences (limited to certain officials). Table 1
gives an abbreviated description of some of the types of costs the
allowances are intended to cover.
(b) Cost-of-living allowances. (Subsection (2) of Section 912) The
second category excluded from taxable income by Section 912 is cost-ofliving allowances, if paid in accordance with regulations approved by the
President to employees stationed in the U. S. territories and possessions
or in Alaska or Hawaii. The statute refers to employees stationed outside the continental United States, which for this purpose includes only
the 48 states which were part of the United States in 1944, when the
Revenue Act of 1943 was enacted, and the District of Columbia. To
qualify for the exclusion, cost-of-living allowances paid to employees
in the territories, possessions, Alaska and Hawaii must meet the second
condition of being paid in accordance with regulations approved by the
President. Those regulations authorize the payment of allowances to
employees whose basic compensation is fixed by statute (Executive
Order 10,000, 3 C F R 1943-48 comp., 792). If the basic compensation
is paid from nonappropriated funds or is established by administrative
order, the employee m a y not exclude under Section 912 any cost-ofliving allowance he m a y receive.
(c) Peace Corps allowances. (Subsection (3) of Section 912). The
third category mentioned in Section 912 covers certain allowances paid
to Peace Corps volunteers and their families. This paragraph, added
in 1961, is essentially limited to travel expense allowances and living
allowances which do not constitute basic compensation. Termination payments and leave allowances for such individuals are specifically excluded
from Section 912.
(d) Post differentials. Section 912 specifically does not apply to
another category of allowance, namely differentials or "hardship" allowances. Post differentials are a percentage of base salary, up to 25
-133 Table 1
PRINCIPAL CATEGORIES OF ALLOWANCES
OF U.S. GOVERNMENT EMPLOYEES IN FOREIGN COUNTRIES
Housing - Quarters provided or payments to cover rent and utilities.
Extraordinary Living Costs - "Post Allowance" for higher cost of living and
"Separate Maintenance Allowance" where dependents must be living away from
post of duty.
Education - Government provided schools or payments to cover tuition.
Educational travel where appropriate schooling is not available at post of
duty.
Community Services - Commissary privileges, medical care or reimbursement
for medical expenses, after death services, personal transportation.
Hardship Incentives - "Post Differential" (presently taxable), Rest and
Recuperative Travel, Unhealthful Post Credit
Relocation - Moving expenses (including auto), temporary lodging expenses,
foreign transfer allowance for miscellaneous expenses, per diem while moving,
home leave expenses, family visitation travel, emergency visitation travel,
evacuation payments.
e:
interim Report of the Interagency Committee on Overseas Allowances
and Benefits for U.S. Employees, January 1976.
'
-134-
percent, paid to employees in locations where living conditions are
uncomfortable.
The Internal Revenue Service ruled in 1953 and 1959
that such payments were not excludable (Rev. Rul. 53-237, C.B. 1953-2
52, amplified by Rev. Rul 59-407, C.B. 1959-2, 19). That position
was incorporated into the statute in 1960. 1/
2. Legislative History. The predecessor to Section 912 (Section
116(j) of the Internal Revenue Code of 1939) was enacted in the Revenue
Act of 1943 as an amendment introduced by the Senate Finance
Committee. The exclusion covered cost-of-living allowances of
employees and officers of the Foreign Service, and cost-of-living allow
allowances of other U. S. Government employees stationed outside the
continental United States, if received in accordance with regulations
approved by the President. The reasons for excluding the allowances
were that wartime inflation was seriously reducing their value, particularly for foreign service personnel in Europe, that increases in allowances were partly nullified by the increase in tax, resulting from the
Revenue Act of 1943, and that the State Department did not have the
funds or authority to compensate the recipients for the added burden of
the tax.
The Foreign Service Act of 1946 expanded the allowances and benefits
authorized for foreign service officers and employees. The additional
allowance included amounts payable for housing, cost-of-living , representation costs, and travel expenses (for moving, home leave, and sick
leave). That Act also added Section 116(k) to the 1939 Internal Revenue
Code to provide a tax exemption for such additional allowances.
Section 912 of the Internal Revenue Code of 1954 was identical to
Section 116(j)and (k)of the 1939 Code. Ihl960, the 1954 Code was amended
to add an exemption for allowances authorized under certain other Acts
and to confirm the IRS position that post differentials were not
excludable.
In 1961, certain Peace Corps allowances were added to the list of
exclusions. The Treasury Department at that time expressed concern
at expanding the list of benefits excluded from income.
V
In 1973, a new allowance was introduced to cover the additional housing and utilities costs incurred by U. S. Government employees stationed at U. N. headquarters in N e w York City who have entertainment
responsibilities. Not more than45 employees m a y claim the allowance
at any one time. The amount is set to approximate the excess cost
of housing and utilities in the neighborhood of the U. N. headquarters
over the average of such costs in the metropolitan N e w York City
area. The tax status of this allowance is not clear.
-135IIL
ANALYSIS
!• Scope of the exclusion. As illustrated in Table 2, there are
approximately 100, 000 civilian government employees who receive one
or more allowances that are excluded from income under Section 912,
of which about 40, 000 are employed in foreign countries, 20, 000 in U. s!
territories and possessions and 40,000 in Alaska and Hawaii. Roughly
60 percent of the total are civilian employees of the Department of
Defense.
There are some 50 different allowances. The allowances for foreign
areas are administered by the State Department, while those for nonforeign areas are administered by the Civil Service Commission. However, each of the 38 participating agencies m a y make its own variations
in determining the amounts and conditions of allowances. Table 3 identifies the principal foreign countries where civilian U. S. Government
employees are located.
The aggregate amount of allowances is not reported, nor does each
agency report allowances separately in its budget. For example, the
Defense Department, the largest single employer of personnel covered
by Section 912, records some civilian allowances with those of the
military. The estimated total for all allowances increased from $244
million in 1972 to $343 million in 1975, as shown in Table 4. The
estimated revenue cost in 1975 of excluding the allowances from taxable
income was roughly $100 million, based on salary levels, location,
and assumed family size. This is a gross figure which only relates
to the revenue side of the budget; it does not take into account that the
tax exempt nature of the allowances is in part reflected in lower salaries
or lower allowances. If the allowances were subject to tax there would
have to be some offsetting increase on the expenditure side of the budget
in the amounts paid to maintain the same level of disposable income
for the employees.
Some of the allowances exempted from tax by Section 912 represent a
reimbursement of expenses which ordinarily would be deductible (e. g.,
moving expenses), or payments which are excluded from taxable income
under other sections of the Code (for example, the U. S. Government
contribution to employee health insurance plans). However, within this
group, there are several instances where the tax regulations for claiming
allowable deductions were designed with domestic employment in mind
and m a y not adequately take into account the requirements of overseas
employment. The limit under the moving expense deduction of 30 days
for household storage is one such example. Thus, if Section 912 were
repealed, equitable treatment of overseas employees would require that
present regulations be reviewed to adequately consider foreign employment circumstances.
There are four principal allowances, accounting for a substantial
portion of the total, which would become taxable income if Section 912
were repealed, those for cost-of-living differentials, housing, education,
Table 2
Number of Federal Civilian Employees Eligible for
Section 912 Benefits by Area and Agency, 1968, 1972 and 1975
Total
Overseas : —
Foreign
countries
U.S. territories
Alaska and
Hawaii 2/
1968
Dept.
of
State
Other
Agen-
Total
Dept.
of
Defense
104 ,261
62 ,413
64,791
35,587
12,259
12,259
27,211
14,567
95,626
55,082
58,652
32,145
8,733
8,733
41 887
25,671
12,240
3,976
33,134
21,817
8,732 2,585 37,167 27,515
6,985 2,667
20 _>26
9,916
19
10,591
21,948
10,328
1 11,619 20,321 7,719
12,602
41, 848
29,204
12,644
40,544
26,507
14,037 40,000 26,000
14,000
-
Total
1972
Dept.
: Dept.
of
: of
Defense : State
Total
1975
Dept.
: Dept. : Other
of
: of
: AgenDefense : State : cies
97,488
57,488
61,234
35,234
Other
Agen-
28,241
14,204
Office of the Secretary of the Treasury
Office of Tax Analysis
1/
6,985
6,985
December 1976
Calendar year averages.
2/ Figures for Alaska and Hawaii for 1968 and 1972 are as of December 31. The 1975 figures are estimates.
Source: U.S. Civil Service Commission. Federal Civilian Manpower Statistics, various (monthly) issues. For January
through March 1968, Federal Employment Statistics Bulletin, Employment and Turnover.-
29,269
15,269
- 13 7 Table 3
Principal Locations of Civilian U.S. Government
Employees in Foreign Countries, FY 1975
All foreign countries
38,592
Germany
Japan
Korea
The Philippines
The United Kingdom
Italy
Thailand
Spain
All
others
Subtotal
13,493
5,271
1,521
1,399
1,357
1,094
1,066
714
25,915
12,677
Selected other countries:
Mexico
Canada
Belgium
France
The Netherlands
Barbados
Bermuda
Office ot the Secretary ot the Treasury
Office of Tax Analysis
321
201
405
410
129
274
255
March 22, 1976
1/ Excludes about 20,000 employees in the territories and
possessions and 40,000 in Alaska and Hawaii who also
qualify for some benefits under Section 912.
Source: U.S. Department of State, Office of Personnel Reports,
U.S. Citizens Residing in Foreign Countries -FY 1975.
- 13-8 TABLE 4
Federal Civilian Employees Eligible for Section 912 Benefits;
Estimated Salaries, Allowances Excludable under Section 912,
and Associated Revenue Loss by Area, 196 8, 1972, and 1975
(Dollars Millions)
-•T9'6-$-
:
B72
r
IS 735
Salaries
Total
Overseas
Foreign countries
U.S. territories
Alaska and Hawaii
$880
577
431
146
303
$1 ,246
773
510
263
473
$1,555
1,020
740
280
535
Allowances
Total
Overseas
Foreign countries
U.S. territories
Alaska and Hawaii
179
156
131
25
23
244
209
165
44
35
343
303
256
47
40
Revenue Loss
Total
Overseas
Foreign countries
U.S. territories
Alaska and Hawaii
51
45
39
6
6
76
66
50
11
10
100
89
77
12
11
Office of the"Secretary" of the Treasury'
Office of Tax Analysis
Source:
e/
March 24, 1975
Estimates based on data from U.S. Civil Service
Commission, Pay Structure of the Federal Civil Service;
U.S. Department of State, Standardized Regulations
"
(Government Civilians, Foreign Areas); and Comptroller
General of the United States, Fundamental Changes
Needed to Achieve a Uniform Government-wide Overseas
Benefits and Allowances System for U.S. Employees,
c
September 1974.
~
— ~
—l
Estimated
-island home f leave travel. As already mentioned, post differentials or
hardship allowances are specifically excluded, from Section 912 and
would not be affected by its repeal.
. 2' c Justification for the exclusion. When it introduced the exclu?r01J ° j I T 8 a i l o w a n c e s of U.S. Government employees outside the
United States, m 1943, the Senate Finance Committee stated,
"Payment of allowances to meet the extra
cost of living at individual posts is indistinguishable from the payment of allowances
to defray expenses of operation of the
establishment... "
The Committee concluded that since the State Department had neither
the funds nor the authority to increase the allowances enough to offset
the tax on them, tax exemption was the appropriate solution.
Jhis.line of reasoning continues to serve as the justification for
the Section 912 exclusion.
m brief, the justification is as follows:
(a) the expenditures covered by the allowances do not represent a personal benefit to the recipient, but solely a reimbursement for costs
incurred as a result of the employment assignment; (b) these expenses
must, therefore, be borne by the employer; (c) the employer can either
increase the payments to cover the tax on them, or exempt them from
tax; (d) tax exemption is the only practical alternative for U. S.
Government employees, where the ability to alter compensation levels
is limited; and (e) this case is distinguishable from that of private sector
employees overseas and from U. S. Government employees in the United
States. The various elements of this reasoning are considered in the
following sections.
(a) Personal benefit vs. reimbursed costs. The general case for
exempting government allowances usually rests on the argument that
the allowances are not additional compensation to the employee, but
simply reimbursement for costs necessitated by the conditions of
employment, and therefore do not properly constitute taxable income
ot the employer. In other words, the allowances are designed to leave
the overseas government employee in the same net position in terms
ot disposable income as his counterpart in the United States.
While in general the allowances are designed to cover only extra
living costs, there are some cases where the amounts paid intentionally
go beyond that standard. The principal example is the housing allowance,
which provides free housing, including utilities, rather than just the
excess of the cost of housing and utilities at the particular post over
what the employee would have paid in the United States. The State
Department recognizes that this allowance confers a personal benefit.
+u
N
-140 As a financial inducement to overseas service, Government employees
stationed abroad are furnished
either with free Government acquired
housing or an allowance to cover the
cost of privately rented quarters.
This provides the employee with additional income, equal to what he would
have spent on housing in the United
States, that is available for spending on other goods and services. 1/
Another example of an allowance which covers more than the additional cost necessitated by overseas employment, in contrast to
domestic employment, is payment of h o m e leave travel for the whole
family to any point in the United States.
Much of the recent criticism of exempting the allowances is directed
at cases where allowances, although intended to offset necessary costs,
do confer personal benefit, leaving the recipient better off than his domestic counterpart. Two recent studies, one by the Office of Management
and Budget in 1973, and one by the General Accounting Office in 1974,
called for an overhaul of the entire system of measuring and paying
allowances to remedy the lack of unifqrmity and excessive allowances.
In some cases foreign living costs are lower than in the United
States (e. g. household help m a y be available at a low cost). If the
rationale for the tax-free allowances were merely to equalize the positions of foreign and domestic employees, there should logically also be
some provision for a reduction in base pay (a negative allowance) in
certain cases.
Some observers would argue that exclusion from income is appropriate only for those allowances'which reimburse the overseas employee
for living costs above what he would incur in the United States, and that
exemption of that part of the allowance which exceeds the living cost
differential provides a windfall to the recipients, leaving them better
off than their counterparts in either the private or the public sector.
Others would contend that, with very limited exceptions, 2/ the allowances are basically all income, whether or not they represent a reimbursement for excess costs, and that any exemption represents a windfall
to the recipient.
V
U. S. State Department, "indexes of Living Costs Abroad", April
1975, published by Labor Department, Bureau of Labor Statistics
(underscoring added).
2/ Nearly all observers would make an exception for certain allowances
such as those designed to cover evacuation and funeral expenses.
-141 -
+v,_ ^
° a S e £°r t a x e x e m P t i o n is weakest in those instances where
M J ° T ° e " / ° r C O S . S W M c h t h e e m P l o yee would incur in any event!
«_.*&• ^ « 4 e t e n c * of windfalls within the allowances structured
tne dilticulty of eradicating them may be a reason for taxing all of the
than t o ^ e d u ^ n . 6 ^ 3 7 *£"1 r e s i s t a n c e to P ^ tax on the lllowanees
than to reducing them. At the same time, the absence of tax exemption
would remove the incentive to overstate the allowance portion o? total
F
compensation.
IUICU.
b) Cos
m
l
? ustbe borne by employer. Other things being equal, an
employee will not accept the same pay for the same work in two different
places if living costs are much higher in one place than in the other.
Other things are of course seldom equal. Different work, pleasant surroundings, useful experience and other elements of "psychic * income may
induce an employee to accept a lower income in one post than he could
earn in another. Bit on the whole it is fair to say that higher living
costs must be reflected in higher compensation to attract the slrnf
quality of personnel.
nni-^fS^-ng^that g°Yernment emPloyees accept overseas assignments
t^iLLi £ d l s P° s a . b l e ^ G o m e after necessary expenses can be maintained at the same level as when they were employed in the United
States and assuming that the .allowances were revised so that they
covered only the extra living costs incurred as a consequence of employZT O U l s l d e + + t h e U n i t e d States, then taxation of the allowances would
S ^ t n ^ 6 attractlve i ne 3 s f of foreign employment and would presumably
have to be compensated by higher government salaries or allowances.lj
• ••„.u^T.aueXe^Pti0!1 VS* higher pay- ?overseas living allowances were
made taxable, the ultimate result in most cases would be an increase in
cost to the employer, the U. S. Government. Whether the increase in
compensation would be the same or less than the increase in tax cos s
m
lT°?™ tl^
***} ™ w h e t h e r t h e allowances cover the total costs of
Z?Jl
A 0 a l 0 r o° n l ? t h e e X C e S S o v e r the costs of living in the United
States. As the Senate Finance Committee noted in introducing the forerunner of Section 912 in 1943, tax exemption is one method tf bearing
the cost--a substitute for increasing the allowance directly.
Tax exemption of a particular group is a cost borne by taxpayers in
general, but when the U. S. Government is the employer, payingMgher
salaries is also a cost to taxpayers in general. Therefore! in one sense?
taxing the allowances would amount to taking money from one pocket and
putting it into another. But this argument suggests that no government
1/ Unlike private sector employees overseas, U.S. Government
employees are not subject to foreign tax on their earnings. An
increase in U. S. tax, therefore, would be felt in full by the employee,
since there is no foreign tax credit to offset the U. S. tax.
-142 -
employee should be taxed on his salary. Considered in this light, the
logic is questionable. If government salaries were generally made tax
exempt as a cost-cutting device, the result would be highly deceptive
budgeting. Government agencies would have an incentive to use more
labor than necessary because its cost would appear lower than it really
was. Moreover, the tax free status of government salaries would appear
highly inequitable to the vast majority of Americans.
These considerations also apply to the case of overseas allowances.
The exemption creates an incentive to pay higher allowances and to hire
more persons than necessary. The emphasis on allowances m a y also
be reflected in the employees being underpaid in terms of base salary.
The actual cost incurred by each agency is understated since part of
the personnel budget is reflected in lower tax collections by the Treasury
Department. In fact, as mentioned earlier, the allowances themselves
are not adequately reported, so that it is difficult to determine the
gross pay of U. S. Government employees in different locations. Moreover, the exemption of government allowances m a y seem inequitable
to persons who, for one reason or another, incur high living costs which
are not recognized in computing taxable income.
The taxation of allowances can be seen as penalizing an employee
with a substantial amount of income in addition to his government salary,
by comparison with a similar employee having no outside income. If
the allowances are viewed as marginal income, then under a progressive
structure of tax rates, the net benefit of the allowance to the employee
with outside income would be less than to the employee with no outside
income; if the allowances are not taxable, both would benefit equally.
Alternatively, however, the allowances can be viewed as the first slice
of income or as the slice on top of the salary, and the outside income
can be viewed as the marginal income taxed at a higher rate.
The difference between these two perceptions highlights the general
question of tax recognition of differences in the cost-of-living between
different locations or over time. U. S. tax law does not generally take
such differentials into account. Making such adjustments would be very
complex. To provide selective relief to certain groups raises the question of equitable treatment of those taxpayers not favored by the adjustments. (This point is considered further under Section (e) below. )
(d) Practical consideration: exemption vs. higher pay. If the
allowances now exempt under Section 91__ were to become taxable, the
gross or budgeted cost to the government agencies of maintaining their
foreign staffs would have to be increased in order to maintain a necessary level of disposable income for the employees.
Additional appropriations would be required for the employing agencies. This would
require special attention to alleviate statutory or administrative
restraints on additional spending.
-143 -
Under present appropriations procedure, Congress might not adequately take into account the offsetting additional tax on the increased
allowances.
For example, if an employee whose marginal tax rate
is 33-1/3 percent has $6,000 of allowances, and the U.S. Government
wants to reimburse him fully for the tax liability on those allowances
it would have to increase the allowances from $6, 000 to at least $9 000*
an increase of 50 percent. The net cost to the U. S. Government would
be zero m this case since the added tax of $3, 000 matches the added
allowance of $3, 000; but the tax revenue is not credited to the agency
J
which must pay the allowance.
To the extent that certain allowances tend to overcompensate the
employee (for example, housing, home leave, travel, rest and recreation), there could be a net budgetary gain if the allowance is not raised
by the full increase in the tax. In the example mentioned above, the
Government might increase the allowances from $6,000 to only $7,500
so that the after-tax amount would be $5,000 instead of $6,000; then
the increased cost of $1, 500 would be m o r e than offset by the increased
tax of $2, 500. But again the net revenue gain will not be reflected in
the employing agency's budget requests which must be approved by
J
Congress.
*^
Under present law, the personnel budgets of employing agencies are
understated since they do not reflect the appropriate tax costs. A change
irom. tax exemption of allowances to taxation as ordinary compensation
would correct this situation. But such a change should be accompanied
by adjustments in the budget process necessary to make this policy
practical.
v
J
(e) Distinguishing overseas government employees from other
employees, m e principal reason for paying th^ a llnw g n. 0 o ,o t„ ~ ? m p c n sate for increased living costs in certain locations. Differential living
costs are also encountered by private sector employees overseas and by
U. S. Government employees in the United States, and are similarly
reflected either in varying amounts of compensation or in difficulties in
tilling positions at certain locations. The argument for exempting the
allowances from tax is basically an argument that in the case of government employees outside the United States part of differential living costs
should be borne by taxpayers in general rather than by the particular
employee. This argument has fundamental shortcomings, as noted
&
earlier.
If tax adjustments for differential living costs are not made as a
matter of general policy, the question remains whether adjustments
should be made for a particular group. Part of the answer to this question
depends on whether such adjustments seem inequitable by comparison
with the tax treatment of similar groups.
-144 -
In deciding to phase out the foreign earned income exemption of private sector employees, the W a y s and Means Committee said:
Your Committee notes that some of
the same reasons for repeal of the
exclusion for private industry
employees might be equally valid
to the exclusions for governmental
employees. If
The comparison between overseas government employees and government employees stationed in the United States is in some respects better
than the comparison with private sector employees overseas. The only
relevant tax for overseas government employees is the U. S. tax, whereas
overseas private sector employees are affected by the foreign tax liability
and foreign tax credit. However, where a government and private sector
employee work side by side in a foreign country and receive the same
gross pay, it is difficult to justify exempting the living allowances of
one and not the other. The Task Force on Foreign Income of the Ways
and Means Committee studying the taxation of both private and public
sector employees overseas felt that the two groups should be treated
equitably. The Task Force Report is not yet issued. During its deliberations, the Task Force tentatively favored recommending that both the
Section 911 exclusion and the exemption of government allowances be
phased out with special relief for housing and education expenses and
for construction workers. These deliberations occurred before enactment of the Tax Reform Act of 1976.
3. Other considerations.
(a) Official expenses. Some allowances may be viewed as representing reimbursement for official expenses. As such, they m a y be
either excluded, or included in income and allowed as a deduction. However, those expenses which are business expenses under current law
would not include m a n y important allowances, such as the cost of living,
education or housing allowances. To broaden the limits of deductibility
would raise a serious problem of where to draw the line for overseas
government employees as well as for government employees based in
the United States and private sector employees based overseas.
(b) Education expenses. The situation of government employees
is parallel to that of private sector employees with respect to expenses
incurred in providing elementary and secondary schooling for dependents:
publicly financed schooling might be inadequate, and the families may
have to rely on private schooling.
The State Department regulations
1' House of Representatives Report 94-658, November 12, 1975, page
-145 provide allowances to cover the cost of transportation, room and board
tuition and other school expenses at a private school where the local
facilities are judged inadequate.
CM o™e H°USe version of a R- 10612 would have provided a deduction of
$1,200 per year per child (up to 19 years old) for tuition expenses paid
by private sector employees when both the taxpayer and the dependent
m u F e oL 0 1 ? e ° r m o r e f o r e i g n countries for 330 days in a 12 month period.
The 330 day requirement for the taxpayer m a y be strict for those
employees, both private sector and government, who have to return
*°t h e U n i t e d States on business frequently or for extended periods.
The amount of the deduction was also felt to be too low in some cases.
The Task Force on Foreign Income of the Ways and Means Committee
tentatively concluded that a higher figure, perhaps $2,000, would be
more appropriate. The problem was to balance the extra burden borne
by private and government employees abroad against the considerations
that: (a) they m a y not pay U. S. state and local taxes, which finance
most U. S. public education at the elementary and secondary levels;
(b) m a n y U. S. residents who do pay state and local taxes nevertheless
use private schools for their children without being allowed a deduction
for the added costs; and (c) some of the schools used by foreign service
employees are church-sponsored. A s enacted, the Tax Reform Act of
1976 reduces the Section 911 exemption but does not phase it out entirely
and does not contain the tuition expense deduction.
(c) Housing costs. Government and private sector employees face
the same problems of high cost housing in m a n y foreign cities. However
government employees have their full housing, including utilities, provided by their employer, and are not required to report any part of
that as taxable income. Table 5 gives some recent examples of housing
allowances in various foreign cities. Private sector employers frequently
pay part of the housing and utility costs of their overseas employees
typically the excess over the estimated U. S. cost or the excess over
some percentage of the salary, but the employer-paid portion is considered taxable income to the employee.
Some argue that housing provided by the U. S. Government for overseas employees serves the convenience of the employer and therefore
should not be taxable to the employee. The standards for determining
when employer provided housing is provided for the convenience of thl
employer are fairly stringent under current law. Section 119 of the
Internal Revenue Code sets forth a three-pronged test. The lodging
must be for the convenience of the employer, it must be on the business
premises of the employer, and the employee must accept the lodging
as a condition of his employment. The three tests must be met if the
value of the lodging furnished by the employer is to be excluded from
- 14.6 Table 5
Examples of State Department Housing Allowances,
as of January 1976
Annual allowances for an
employee with dependents
earning basic salary
of $15,000-$26,999
$4,300
Frankfurt
Tokyo, (city)
4,500
Seoul
4,400
Manila
3,800
London
5,100
Rome
7,200
Bangkok
4,400
Madrid
6,500
Mexico City
6,400
Ottawa
5,600
Brussels
8,500
Paris
9,400
the Hague
6,900
Barbados
5,500
Iran
7,400
Kuwait
7,000
Office of the Secretary of the Treasury
Office of Tax Analysis
Source:
March 26, 1976
U.S. Department of State, Allowances Staff
-147 -
the gross income of the employee. There are numerous rulings and
court cases interpreting these rules. Lodging provided to workers at
remote construction sites is excludable, for example. The A m b a s sador s residence presumably would be excludable in accordance with
Rev. Rul. 75-540, which holds that a state Governor's mansion is for
the convenience of the employer. But in their present form, the statutory
tests would be difficult for the average foreign service employee to
meet, and if section 912 were repealed, free housing of overseas
employees would in most cases be taxable income to the government
&
employee.
Congress could legislate special relief from the added burden which
would result if foreign employee housing allowances were subject to tax.
One question then would be whether such relief should be made available
to private sector employees in similar circumstances. In both cases,
the principal beneficiary would be employers with overseas staff. The
Ways and Means Committee Task Force on Foreign Income tentatively
supported the idea that both the tax exemption of government allowances
and the private sector foreign earned income exclusion should be phased
out, with special relief for added housing costs and a tuition expense
deduction for both groups.
One possibility would be to allow a deduction for the portion of housing
costs incurred for business purposes, such as official entertainment.
Such a rule, however, would be difficult to administer and complicated
for the taxpayer who would have to pro-rate rent and utilities.
Another possibility would be to allow a deduction for the cost of
foreign housing in excess of the cost incurred by employees in the United
States for comparable housing.
The standard of reference might be
expressed in terms of a percentage of income typically spent on housing
or in term of actual housing costs in a selected U. S. city. Since domestic
employees do not enjoy tax relief for high housing costs, it might be
desirable to limit any such relief to costs above a reasonably high
U. S. base, and perhaps to provide an upper limit to minimize any incentive to acquire lavish housing by Americans overseas. 2h addition to
determining the amount of such a deduction, there would have to be
rules defining its scope. What is included in housing costs: utilities,
telephone, cable T V ? W h o is eligible: government employees in the
possessions, Alaska, Hawaii, New York? If private sector taxpayers
also qualify, does this include self-employed persons, employees of
foreign firms, corporate directors? Must housing be furnished to all
employees? Rental values would have to be imputed in m a n y cases.
-148-
Such a relief provision would be complex and difficult to administer.
But the government allowances and the Section 911 exclusion are already
complex and difficult to administer. Furthermore, there is precedent
in the Code for allowing deductions for extraordinary personal expenses
(for example, medical expenses in excess of 3 percent of adjusted gross
income). A special deduction for "excess" housing costs would have the
advantage of focusing relief on a particular expense related to the location of the employment and could be limited to the portion of that
expense which exceeds the cost of comparable housing for employees
in the United States.
-149IV. OPTIONS
lu
Ret*in Present law. This alternative would put the least strain
on employing agencies and affected employees. The present system
ot exempting tax allowances paid to government employees outside the
United States, and in some cases in Alaska and Hawaii, reduces the
cost to the employing agency of maintaining U. S. citizens in those
posts. It has been argued that most allowances just offset the higher
living costs entailed by an overseas assignment. However, the exemption can amount to preferential tax treatment for a certain group of
government employees compared to government employees in other
locations and compared to private sector employees in the same
locations.
?! Repeal the Section 912 exclusion entirely. This alternative
would supject to tax all 01 the allowances now excluded under Section
91... Some of the allowances would not be taxable, due to offsetting
expense deductions permitted under other sections of the Internal
Revenue Code, but m a n y allowances, including those for education,
cost-of-living increases, and housing would become taxable. The e m ploying agencies would thus need increased appropriations.
3
* A1}ow a deduction for housing costs in excess of the costs of
comparable u. a. housing, and a special tuition expense deduction."
(a) Housing. A deduction for "excess" housing costs above those
which the employee would have incurred if employed in the United States
would deal with the principal component of extraordinary living costs
associated with foreign employment. It would significantly reduce the
added tax liability of employees in areas where desirable housing is
scarce, and would, therefore, relieve the budget burden on the employing agencies. At the same time, taxing the other allowances would
reduce the windfall element and permit more accurate accounting of
the costs of the overseas operations. On the other hand, there would
be the problems of drawing the line to avoid encouraging lavish housing
and of defining the standard so as to minimize discrimination against
employees m the United States in high cost areas.
-
^ e J a x . R e f o r m Act of 1976 reduced the Section 911 exclusion to
$15, 000 m most cases and provided that the exempt amount is taken
into account in determining the rate applicable to non-exempt
income and that foreign taxes paid on exempt income m a y not be
credited against U. S. tax on other foreign income.
-150-
The net revenue cost of such a deduction for government employees
would be small, since housing allowances in excess of the permissible
deduction would be taxable, and since in the absence of the deduction the
government would have to increase the allowances to attract the same
quality of personnel. Assuming that similar relief were made available
to private sector employees, the revenue costs of such a deduction for
the latter group would be greater, since there would usually be no offsetting effect on outlays (there could be some off set where the allowance
is a deductible expense for computing the U. S. tax of a U.S. employer).
(b) Tuition. As noted earlier, the House version ofH.R. 10612
provided a deduction for tuition expenses of employees of up to $100
per month per child, and the W a y s and Means Task Force considered
recommending an increase and extending it to public sector employees,
along with some relief to both groups for housing costs. This combination would ease the principal expense burdens on overseas employees.
A s with a housing allowance there would be difficulty in designing
an equitable tuition expense allowance.
4. Other statutory relief. Specific statutory relief should be conside red"Tor—s^veraToiTEe~lninor allowances which, though they might
be treated as taxable income in the absence of Section 912, could be
justifiably excludable from income or deductible. This category might
include allowances for emergency evacuation from a post and allowances for preparation and transportation of remains of a deceased
employee.
In addition, the rules for deductibility of certain expenses, such as
moving costs, deserve to be reviewed from the viewpoint of employment
outside the United States; special rules m a y be warranted in such
cases.
5. Make Section 912 inapplicable to employees serving in Alaska or
Hawaii. Although employees in Alaska and Hawaii constitute about 40
percent of Federal employees eligible for the Section 912 exemption,
the revenue loss attributable to their allowances is relatively small.
But the distinction between employees serving abroad and those serving
at domestic posts (both groups encounter variable living costs) is confused by continuing to exempt cost-of-living allowances paid to employees in Alaska and Hawaii when the tax law does not recognize
cost-of-living differentials for U. S.-based employees in general. H
Section 912 were replaced by special relief for housing and education
costs, this anomaly would disappear. Even if it is retained, deleting
Alaska and Hawaii from its scope deserves consideration.
- 151 -
TAX TREATMENT OF INCOME OF FOREIGN
GOVERNMENTS AND INTERNATIONAL ORGANIZATIONS
Jon Taylor
-152TABLE OF CONTENTS
Page
L Introduction 154
IL Present Law 156
1. Exemption of foreign governments from U. S. tax 156
2. Exemption from U. S. tax for compensation of employees
of foreign governments and international organizations
3. Exemption of foreign central banks from U. S. tax.
159
160
IIL Economic Scope of the Exclusion , 163
1. U. S. payments to official foreign institutions 163
2. Income receipts on U. S. government assets abroad
3. Compensation of government employees
163
163
IV. The Effect of the Exemption on Tax Revenue 171
1. General rule 171
2. Section 892: Exemption of foreign governments from U. S. tax 171
3. Section 893: Exemption from U. S. tax for compensation
of employees of foreign governments and international
organizations • • • •
. . <
172
4. Section 895: Exemption of foreign central banks from U. S. tax 172
5. Foreign government reciprocal exemptions
172
V. Issues , 174
1. Definition of "foreign governments" 174
(a) N a r r o w approach
(b) Broad approach
(c) Intermediate approach
2. Interpretation of "any other source", ,
<
174
.!..'..!!.... 174
174
174
VL Options , 176
1. Retain the exclusions in current law , , . . . . 176
2. Require reciprocal exemptions
,
3. Limit the exemption to portfolio investment income
4. Repeal the statutory exemption and rely on treaty exemptions.
5. Repeal of the statutory exemption
176
177
177
178
Appendix A: Tax E x e m p t International Organizations
179
-153-
LIST O F T A B L E S
Page
Table 1 .Payments to Official Foreign Institutions 164
Table 2 U. S. Liabilities to Official Foreign Institutions 165
Table 3 U. S. Liabilities to Official Institutions of Foreign
Countries by AreaTable 4 Income Receipts on U. S. Government Assets Abroad- •
166
16
7
Table 5 Outstanding Long-term Principle Indebtedness of
Foreign Countries on U. S. Government Credits as
of June 30, 1975, by Area
168
Table 6 Employees of Foreign Governments and International
Organizations* .»•«••
169
-154-
L
INTRODUCTION
The United States unilaterally exempts foreign governments
and international organizations from tax on certain income from
sources within the United States. This exemption includes organizations which are separate in form from a foreign government provided
the organization meets certain requirements. The exemption is
extended, on a reciprocal basis, to the compensation of alien
officers and employees of foreign governments and international
organizations.
These exemptions reflect the generally accepted principle that
one government does not tax another. While some foreign governments benefiting from these provisions of the Internal Revenue Code
have reciprocal
exemptions concerning U. S. Government income
arising from investment in their country, m a n y do not. F e w foreign
governments explicitly exempt other foreign governments from tax
on income
generated in their country. Countries that do provide
such exemptions generally do so on a reciprocal basis only. Brazil,
for example, exempts foreign governments from the provisions of
its income tax law only if an equivalent exemption is granted to
the Brazilian government by the foreign country. 1/ Foreign governments such as Sweden, France, Germany, and the United Kingdom
do not explicitly exempt foreign governments from tax on income
sourced within their respective countries. These countries do, however, provide various exemptions for diplomatic representatives,
foreign consular representives, and other official agents of foreign
governments. 2_f The principle of exempting international organizations and their employees from local income tax is the most universal tax exemption afforded m e m b e r s of the international community.
V
W . S.
Barnes,
ed., World Tax Series: Taxation in Brazil
(Boston: Little, Brown and Company, 1957), p. 92.
""
2 ' For an explanation of the tax treatment of official foreign entiti
in these countries see: W . S. Barnes, ed., World Tax Series:
Taxation in Sweden (1959); Taxation in France (1966); Taxation
in the Federal Republic of Germany (1963); ana1 Taxation in the'
United Kingdom (1957), (Boston; Tittle, Brown and Company).""
-155Similar, though less extensive, reciprocal tax exemptions are
also contained in bilateral income tax treaties between the United
States and some of its treaty partners. 1/ In addition, the United
States is a party to numerous international treaties which exempt
from taxmembers of the armed forces and certain of their auxiliary
organizations.
United States military personnel, for example,
assigned to Germany as m e m b e r s of N A T O , are exempt from tax
in Germany. 2 /
The tax exempt status of foreign governments and international
organizations has become a sensitive issue in light of the recent
increase in foreign government investment in the United States,
particularly from the O P E C countries, and the changing nature
of this investment. Changes in the extent and form of foreign
governmental organizations, and the creation of quasi-governmental
organizations, have raised important questions concerning the scope
of the existing statutory exemption. The Internal Revenue Service
has issued guidelines concerning some of the issues raised by the
exemption. 3/ This approach has not been entirely satisfactory, as
the guidelines have neither kept pace with the numerous variations
in the form of investment nor the form of the foreign governmental
organizations. Thus, the Internal Revenue Service has had to consider m a n y exemptions on a case-by-case basis--a process which
creates uncertainty and delay.
This paper examines the U.S. tax treatment of income
received by foreign governments and international organizations
from investments in the United States in stocks, bonds, or other
domestic securities, from interest on deposits in U. S. banks, and
from other sources. A related issue is the tax treatment of compensation paid to employees of foreign governments and international
organizations.
1/ For example, Article 10 (interest) of the income tax convention
between the United States and France provides that: "interest
received by one of the Contracting States, or by an instrumentality of that State not subject to income tax by such State, shall
be exempt in the State in which such interest has its source. "
The convention does not, however, exempt dividends received
by the Governments of the Contracting States. Hence, the exemption contained in the income tax convention is not as extensive
as the statutory exemption. U. S. Department of State, Treaty
Series, Income Tax Treaty Between France and the United
States, TIAS6518, July 11, 1968.
—
2] W. S. Barnes, ed., World Tax Series: Taxation in the Federal
?.e-?.ublic of Germany (Boston:
Little, i3rown and Company,
lyo3), p. 24 5.
3/ Rev. Rul. 75-298, 1975-2 C. B. 290.
-156-
IL
PRESENT L A W
1. Exemption of foreign governments from U.S. tax. Section
892 of the Internal Revenue Code provides that the income of foreign
governments or international organizations received from investments in the United States in stocks, bonds, or other domestic
securities, or
from
interest on deposits in banks in the United
States, or from any other source within the United States, will generally be exempt from U.S. tax provided the investments and
deposits are owned by the foreign governments. 1/ Any income collected by foreign governments from investments in the United States
will not be exempt from tax if the stocks, bonds, or other domestic
securities generating the income are not actually owned by, but
loaned to, the foreign governments. 2/ The exemption of foreign
government income from U. S. tax applies to their political subdivisions.
The exemption was originally enacted as part of the Revenue
Act of October 3, 1917 3/ which amended Section 30 of the Revenue
Act of September 8, 1911). The original exemption read as follows:
That nothing in Section II of the Act approved October
third, nineteen hundred and thirteen, entitled 'An Act to
reduce tariff duties and to provide revenue for the Government, and for other purposes', or in this title, shall be
construed as taxing the income of foreign governments
received from investments in the United States in stocks,
bonds, or other domestic securities, owned by such foreign governments, or from interest on deposits in banks
in the United States or moneys belonging to foreign governments.
V For purposes of Sections 892 and 893 (dealing with employee compensation), the European Communities (European Coal and Steel
Community, European Economic Community, and European Atomic
Energy Community) collectively and individually constitute a foreign government. To date these are the only supranational organizations qualifying for a Section 892 or 893 exemption. No rationale
was stated in the revenue ruling as to why these organizations qualify
for the exemptions, nor was any guidance1 provided as to the criteria which should be used to evaluate future
requests by other supranational organizations for tax exempt
status under Sections 892 and 893. Rev. Rul. 68-309, 1968-1 C. B.
338.
2 / Regulations 1. 892-1 (a).
3/ U. S. Congress, House, An Act to Provide Revenue to Defray War
Expenses, and For Other Purposes, Public Law 50, 65th Cong.,"
lstsess., iyi7, H.K. 4..8U, 'title XII (Income Tax Amendments)
Section 30.
- 157 -
The exemption was first amended in 1918. This amendment
expanded the categories of income covered by the initial statute
to include income "from any other source within the United
States Al At this juncture the first legislative history appears concerning the statutory foreign government tax exemption. This history is confined to a mere paragraph contained in the W a y s and
Means Committee report stating that the bill includes "income of
foreign governments from any other, source within the United
States .2/ The inclusion of the language " or from any other source
withm the United States" arguably broadened the scope of
Section 892. However, there was no substantive legislative comment
on the intended scope of the provision. In 1920 the Service chose
an extremely broad interpretation of the 1918 statute by ruling that
a foreign government is not subject to tax on income derived from
the operation of vessels
owned by such government through its
agents in the United States.
Neither is the foreign government
liable to tax upon the income arising from the operation for its
benefit of vessels chartered by it. "3/ This ruling was declared
obsolete m 1968, and can no longer be used as a guide. However,
the fact
that the ruling was declared obsolete provides little
guidance
in
delimitating
Section 892. 4/ The scope of
Section 892jremains unresolved, particularly in Tight of the fact that
the phrase or any other source"has yet to be satisfactorily defined.
If U.S. Congress, House, A n Act to Provide Revenue, and For
? t h f r . ^ J ? 0 8 ^ 8 ' P u b l i c L a w 254, 65th Cong., 2ndsess., 1918,
ti.ti. 12 863, Title II, Part II, Section 12 3(b)(5).
2/ U.S. Congress, House, Committee on Ways and Means, Revenue
®j11 °?.}l18'Committee;RePorton
H.R. 12863, House Report No.
767
* 65th Cong., 2nd sess., 1918. §ee~also 1939-1 Part 2,
C.B. 92.
3/ Office Decision 515, 1920-2, C.B. 96. (Declared obsolete by
y
Rev. Rul. 68-575.)
4/ The procedure of declaring rulings obsolete is a systematic
effort on the part of the Service to identify rulings which are
no longer to be considered determinative with respect to future
transactions. The public announcement that a particular ruling
is not determinative with respect tp future transactions does
not necessarily
m e a n that the conclusion or the underlying
rationale has no current applicability. " 1967-1. C.B. 578.
-158-
A second amendment, inl945, included in the exemption income
received by international organizations. V
The term "international
organization" was defined in the International Organizations
Immunities Act of 1945 (22 U. S. C. 288) as a public international
organization in which the United States participates pursuant to any
treaty or under the authority of any Act of Congress authorizing such
participation. 2 /
International
organizations qualifying for the
exemption under Section 892 are those organizations designated by
the President through Executive Order. A list of presently exempt
organizations appears as Appendix A.
The requirements for tax exempt status of foreign organizations
related to, but separate in form from, a foreign government have
changed several times since the enactment of Section 892. Currently, income earned by an organization created by a foreign
government which does not engage in commercial activities on more
than a de minimis basis in the United States qualifies for the exemption from Federal income tax provided the organization meets the
following requirements (set forth in Rev. Rul. 75-298):
1. it is wholly owned and controlled by a foreign government;
2. its assets and income are derived solely from its activities
and investments and from the foreign government;
3. its net income is credited either to itself or to the foreign
government, with no portion of its income inuring to the
benefit of any private person; and
4. its investments in the United States, if any, include only
those which produce passive income, such as currencies,
fixed interest deposits, stocks, bonds, and notes or other
securities evidencing loans.
V
U. S. Congress, House, An Act to Extend Certain Privileges,
^emptions, and Immunities to International Organizations and
to the Officers and Employees Thereof, and For Other Purposes,
Public Law __yif 79th Cong., 1st sess., 1945, H. R. 4489.
2/ Section 7701(a)(18) also defines the term "international organization to m e a n "a public international organization entitled to enjoy
privileges, exemptions, and immunities as an international
organization under the International Organization Immunities Act
(22 U. S. C. 288-288f). "
-159-
The same tests are applied for determining whether organizations are considered a "foreign government" for purposes of Section
893 (compensation of employees of foreign governments and international organizations).
2. Exemption from U.S. tax for compensation of employees of
foreign governments and international organizations. Related and
parallel to the exemption under Section 892 of the Code is the exemption contained in Section 893 which excludes from Federal income tax
the compensation of employees of foreign governments and international organizations. Specifically, the exemption provides that
wages, fees, or salary of an employee of a foreign government
or of an international organization received as compensation for
official services shall be exempt from tax provided:
1. such employee is not a citizen of the United States, or is
a citizen of the Republic of the Philippine si/ (whether or
not a citizen of the United States); and
2. in the case of an employee of a foreign government, the
services are of a character similar to those performed by
employees of the Government of the United States in foreign
countries; and
3. in the case of an employee of a foreign government, the
foreign government grants an equivalent exemption to
employees of the Government of the United States performing similar services in such foreign country.
The Secretary of State is directed to certify to the
@FedFRASER