What CPAs Can Tell Clients About Tax Reform

The tax reform fever that has hit the United States has many clients asking CPAs what changes the might face, as well as how business and investment strategies could be affected. While some of the proposals provide enough information to recompute current tax liabilities, that alone is not sufficient to evaluate them. This article provides an overview of the proposals and the factors clients should consider in reviewing them. Most plans call for replacement of the current federal income tax system with a consumption-based tax. Evaluating such a tax requires a different focus and careful study both practitioners and clients. DEJA VU? Both the press and the public are paying close attention to the proposals to revamp the tax system. While some of the same proposals were discussed in 1992 and earlier, the did not generate much interest until the past year, fueled perhaps the 1994 election and the attention being given to re-inventing government. Major reform, however, is unlikely until after the 1996 presidential election. Congressional activity means tax reform is being taken seriously. House Ways and Means Committee chairman Bill Archer (R-Tex.) has talked of pulling the income tax code out by its roots, eliminating the Internal Revenue Service from citizens' lives and even repealing the 16th amendment to the Constitution. While many of tax reform's goals can be achieved changing the current system, most sponsors believe tinkering is not enough. One benefit of changing the current system, however, is avoiding the complexities of switching to a new one. WHY TAX REFORM? Tax reform sponsors say the current system cannot be repaired, noting specific problems: * Complexity hinders compliance, allows for loopholes, imposes a heavy compliance burden and has led the public to lose confidence in the tax system. * The IRS is too large, as is the quantity of tax regulations. * Public concern over IRS audits and penalties needs to be reduced. * The current system is not visible enough. Individuals should know their tax liability as well as they know their mortgage or car payments. * The current system fails to collect all taxes owed, creating a tax gap of over $110 billion per year. * The system is inefficient; its impact on business decision making (for example, debt versus equity decisions for corporations) creates economic distortions. * It does not encourage savings; the United States has a lower savings rate than Japan and Germany. * It is incompatible with the General Agreement on Tariffs and Trade, which allows indirect taxes to be removed for exports but imposed on imports. THE PROPOSALS A consumption-based tax generally exempts investment and savings and allows businesses to currently expense the cost of physical assets, such as land, buildings and equipment. An income tax generally taxes all types of income and computes the tax base using financial reporting concepts. Such a system discourages investment, while a consumption tax does not, but the expected improvement in savings and investment is a matter of economic debate. Consumption taxes generally are considered regressive because lower-income taxpayers use a higher percentage of income for consumption. Direct grants, personal exemptions or exemptions for certain types of consumption can be used to alleviate this. Economic theory takes the driver's seat. In the tax reform debate, practitioners will soon realize that economics rather than technical or legal issues is key. There are various theories about how a consumption tax would affect the economy, what eliminating mortgage interest and property tax deductions would mean to the housing market and whether international markets and exchange rates make Gatt-compatibility unimportant. Consumption taxes can follow varying formulas. Consumption could be taxed directly such as a sales tax, allowing a deduction for savings (and taxing savings withdrawals) or exempting earnings on savings and investment. …