Evaluation of Fundamental Tax Reform Proposals President’s Advisory Panel on Federal Tax Reform Leslie B. Samuels Cleary Gottlieb Steen & Hamilton LLP May 17, 2005

2 Evaluation of Fundamental Tax Reform Proposals The United States has the most complex economy and the most complex tax system. How can we do better?

3 Look at Proposals in a Real World Way  Fundamental Tax Reform – such as RST, VAT, Flat Tax – that substantially changes the existing tax system – should be evaluated using criteria that can easily be understood and explained to the public.  Who will be winners and losers?  The current hybrid tax system – imperfect as it is – has been created by Congress over a long period and is the creature of the political process.  Any new system will also be a product of the give and take of the legislative and political process.  Judging the feasibility and impact of fundamental tax reforms proposals should be made in the context of the reality of the legislative and political process and not on the basis of a theoretical model.  No other industrialized country has made a switch to a full consumption tax system.  We have no real world experiences to guide us.  Since there is a significant risk of getting it wrong, the proponents of fundamental tax reform have the burden of showing that the reform is clearly worthwhile.

4 First, Do No Harm  The current tax system has important incentives to encourage social and economic objectives that affect the everyday life of millions of families. These include:  Health care coverage provided by employers  Retirement savings provided by employers  Charitable giving  Child care  Education  Owner occupied housing  In judging any alternative tax system, the first question is how the new system will deal with the social and economic objectives that are now built into the existing system.  Will a new system reduce employer provided health insurance?  Will a new system reduce employer provided retirement savings opportunities?  Will a new system have a significant effect on the value of homes?

5 First, Do No Harm (cont’d)  How certain are, and what is the possible magnitude of, adverse social and economic consequences of a new tax system?  Who are the winners and losers?  How certain are the social and economic benefits of a new tax system, and what is the possible magnitude of the benefits?  The data on whether a consumption tax will encourage savings is mixed and the amount of new savings could be small.

6 Transition Issues: The Elephant in the Room  What are the expected consequences of a transition to a consumption-based system?  What are the consequences of the so-called stealth “tax” on existing wealth and savings and on existing business investments and capital structures?  Who will be the intended and unintended winners and losers? What happens to the elderly? What happens to businesses with substantial investments or borrowings?  Will attempts to soften the transitional dislocations create major complexity and uncertainty?

7 Consequences to Sectors of the Economy  How will a new consumption-based tax system affect different business sectors?  Financial Services and Financial Markets  The taxation of financial institutions – banks, credit unions, investment firms and insurance companies – is extremely difficult in a consumption tax system.  How are financial intermediation services imbedded in interest rates taxed?  What will be the effect on the financial markets of moving to a new system?  International  The international tax provisions of the existing tax system are still very complex. Need for guidance, simplification and training IRS agents.  How will a new system coordinate with our trading partners to avoid excessive taxation?  State and local fiscal consequences and integration with a new federal system.

8 Judge New System vs. Improved Tax System  First look at a possible revised and simplified tax system  Review all taxes: individual and corporate income taxes; employment taxes; and excise taxes  Review proposals to solve AMT problem  Estimate winners and losers  Then, compare a new, real world consumption-based tax system (not a theoretical model) against a possible revised income tax system  Estimate winners and losers  Review impact on state and local governments

9 Conclusions  In the real world of our complex economy and society, any proposal to completely eliminate the income tax in favor of a consumption-based tax is not a responsible approach and should be soundly rejected by the commission.  Any proposal to combine a revised income tax with a credit invoice VAT is a distant second to a reformed income tax because it is possible to get the worst of the two tax systems.  The Commission should focus primarily on reforming the existing system.