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1、flat taxes and effective tax planningmichael calegari *abstract - stiglitz (1985) shows that income deferral opportunities and differentially taxed economic activities provide incentives for investors to engage in tax avoidance strategies. in this paper, i describe several tax avoidance strategies t

2、hat can be used by taxpayers in a hallrabushka flat tax system to reduce or eliminate their tax liabilities. effective tax planning continues to be viable in a flat tax regime because the idealized environment envisioned by the proposal does not consider taxpayers strategic response to the new syste

3、m. these tax planning techniques can affect economic behavior, compliance and enforcement costs, and the distribution of the tax burden.introductionhall and rabushka (1995) present a simple flat tax regime that eliminates many current sources of income and deductions. their proposal has been embrace

4、d by many politicians and has been introduced as legislation in the u.s. congress by representative dick armey and senator richard shelby. its proponents claim that replacing the current income tax system with the flat tax will increase personal savings and business investment, reduce interest rates

5、 and compliance costs, and curtail incentives and opportunities for tax evasion and tax avoidance (e.g., armey,1996; national commission on economic growth and tax reform, 1996).in the current income tax system, taxpayers can successfully reduce their tax liabilities by engaging in effective tax pla

6、nning. according to stiglitz (1985), effective tax planning is based on three general principles: postponing taxes from the current period into future periods, arbitraging across different income streams facing different tax treatment (source-based arbitrage), and shifting income from high tax brack

7、ets to low tax brackets (rate-based arbitrage). by flattening tax rates, eliminating double taxation, removing distinctions between ordinary and capital gain income, and denying any offsets to compensation or retirement income, the flat tax proposal removes several popular techniques that have tradi

8、tionally been used to avoid income taxes. hall and rabushka claim that their system is “airtight” in the sense that individuals and businesses would be unable to escape taxation by taking advantage of exclusions, deductions, or credits. some supporters of the proposal suggest that tax specialists su

9、ch as lawyers and accountants will become superfluous in a flat tax system (e.g., hoven, 1995; sease and herman, 1996).notwithstanding the claim that the flat tax system is airtight, however, the hallrabushka proposal continues to provide taxpayers with opportunities to engage in effective tax plann

10、ing. in this paper, i describe several simple tax avoidance strategies that can be used by taxpayers to reduce or eliminate their tax liabilities in a flat tax regime. these strategies exist because taxpayers can apply the three principles of tax avoidance in the proposed flat tax system. some of th

11、ese strategies exist because the hallrabushka flat tax removes barriers that congress has enacted over the years to forestall certain tax avoidance behavior. other tax avoidance strategies take advantage of new opportunities that are not available under the current tax regimethe analysis in this art

12、icle can affect inferences drawn from prior studies that do not consider the opportunities for effective tax planning in a flat tax system. for example, studies that examine the distributional effects of a flat tax without regard to tax avoidance strategies (e.g., gravelle, 1995; u.s. department of

13、the treasury, 1996; gale, hauser, and scholz 1996; dunbar and pogue, 1998) probably overstate the tax burden placed on high-income taxpayers who are best able to make effective use of these strategies. it is also likely that existing studies overstate the negative effect of a flat tax on charitable

14、contributions because they do not incorporate taxpayers incentives to engage in tax avoidance strategies involving exempt organizations.in addition to analyzing and describing some of the tax planning opportunities that are available in the proposed hallrabushka flat tax system, i also describe seve

15、ral possible modifications to the proposal that can reduce or eliminate these tax avoidance opportunities. unfortunately, many of these modifications introduce more complexity into the system. for example, some of the tax strategies that involve exempt organizations and retirement plans can be conta

16、ined by including limitations on their use and imposing taxes on certain activities and transactions. although these modifications detract from the beauty of the original proposal, they are, i believe, a necessary step in the process of transforming the theoretical flat tax model to a practical alte

17、rnative to the current income tax system.the remainder of the paper is organized into eight sections. the first section summarizes the hallrabushka flat tax proposal. the second section defines the analytical framework and identifies assumptions that are used in analyzing the tax avoidance strategie

18、s. the third, fourth, and fifth sections describe, in turn, tax postponement strategies, source-based arbitrage strategies, and rate-based arbitrage strategies, which are available in the hallrabushka proposal. the sixth section discusses the effect of these strategies on tax compliance. the seventh

19、 section presents some suggestions for modifying the flat tax proposal to reduce tax planning opportunities described in this paper. the final section offers some concluding remarks.the flat tax proposalthe hallrabushka flat tax proposal imposes a 19 percent tax rate on all individual and business t

20、axable income. the tax is administered at two levels. first, an individual wage tax is imposed on individuals with compensation and retirement earnings in excess of a personal allowance. the personal allowance is a standard deduction that increases with the number of dependents. other types of perso

21、nal expenses (e.g., alimony, medical, taxes, interest, donations, and employee business expenses) are not deductible.the business tax is imposed on all businesses with positive taxable income. when business taxable income is negative, the resulting negative tax is carried forward as a credit against

22、 future year taxes. the amount of the carryover is augmented by an interest rate determined by the average daily yield on three-month treasury bills.each sole proprietorship, partnership, and corporation constitutes a business. a business may file any number of business tax returns for its various s

23、ubsidiaries or other units, provided that all business receipts are reported in the aggregate and that each expenditure for allowable business deductions is reported on no more than one return. if an individual operates as both an employee and a business owner, then the taxpayer files two separate r

24、eturns. individual taxpayers who pay business taxes on their proprietorship income can take advantage of the personal allowance by paying themselves a “wage,” which is deductible for business tax purposes. for individual wage tax purposes, however, compensated individuals cannot carry forward losses

25、 from tax years with negative taxable income.business taxable income is defined as business receipts less allowable deductions. business receipts include sales revenue, gross rents, royalties, and gross proceeds from the sale of property used in a business. business receipts also include the market

26、value of property and services that the business provides to its owners or employees. allowable business deductions include compensation paid to employees, the cost of property used for business purposes, travel and entertainment expenses, and other expenditures incurred in carrying on a business. b

27、usinesses cannot deduct the cost of charitable donations, interest, dividends, payroll taxes, or employee fringe benefits (other than pension contributions).under the armeyshelby plan, businesses must include as income the market value of property or services received in connection with an exchange

28、of property or services. this provision would require some businesses to recognize income upon the reorganization or incorporation of an existing business. for example, corporations would be required to report as income the market value of business-use property transferred to a subsidiary in exchang

29、e for stock. in the hallrabushka proposal, it is not clear whether the transfer of business-use property to a corporation for corporate stock is a taxable event (feld, 1995).businesses are allowed to deduct the cost of all contributions to pension and retirement plans. since discrimination rules and

30、 contribution limits are absent, businesses can target their retirement plans to fit the special needs of each employee. similar to current law, employees are not required to recognize income from pension contributions until they receive distributions from the retirement plan. however, individuals a

31、re not allowed to deduct contributions made to individual retirement plans.income from investments and personal activities is excluded from taxable income. likewise, gains and losses from sales of investment and personal-use property are tax exempt. estate and gift tax provisions are eliminated. sin

32、ce businesses are responsible for paying their own taxes, owners of partnerships, s corporations, and limited liability companies will no longer report the income and losses of these entities on their separate returns. instead, each entity files a separate return.each employer is required to withhol

33、d flat taxes from the wages, salaries, and pensions of its employees and to remit the withheld amounts to the internal revenue service (irs). the balance of the individual wage tax liability is calculated and paid in the following year. on the other hand, businesses do not pay any estimated taxes du

34、ring the tax year; instead, businesses pay their entire flat tax liabilities in the year following the tax year. the due dates of the individual wage tax return and the business tax return are not specified in the proposal.analytical frameworkthe primary goal of effective tax planning is to reduce t

35、he total tax bill of the taxpayer. stiglitz (1985) identifies three basic principles of tax avoidance that can be used by taxpayers in an income tax system. these basic principles are (1) postponing taxes from the current period into future periods (e.g., deferring compensation income until retireme

36、nt or postponing realization of capital gains); (2) using source-based arbitrage techniques to take advantage of differential treatment afforded to different types of income (e.g., arbitraging between short-term and long-term capital gains tax rates or deducting interest on borrowed funds used to fi

37、nance tax-exempt investments); and (3) taking advantage of rate-based arbitrage opportunities that occur because tax rates change over time or differ across taxpayers (e.g., timing capital gain realizations to coincide with periods of lower income or using intrafamily transfers to move income from h

38、igh-tax-rate members to low-tax-rate members).according to stiglitz (1985), opportunities for tax avoidance depend on the extent to which a tax system allows taxpayers to exploit these three principles. the availability of these tax avoidance principles also depends on different aspects of the tax s

39、ystem. the first principle, postponing taxes, depends on the method of accounting used in measuring the tax base and the timing of the tax payment. stiglitz observes that tax postponement opportunities are a concomitant of cash basis tax systems. in a cash basis flat rate consumption tax, which sett

40、les taxes on a daily basis (e.g., a retail sales tax), shifting income and deductions for a few days has little benefit. in the hallrabushka flat tax system, however, businesses that defer cash receipts across tax years are able to postpone taxes for at least one year. consistent use of this strateg

41、y in a stable or growing business is the same as a permanent deferral of the tax.the second principle, source-based arbitrage, depends on legislated exclusions or preferences. the flat tax system is especially vulnerable to sourcebased arbitrage strategies because it excludes several sources of inco

42、me from taxation. for example, sales of investment property or personal-use property do not result in taxable income. consequently, incentives exist for taxpayers to convert business income to either investment or personal-use income.the third principle, rate-based arbitrage, depends on the availabi

43、lity of differing marginal tax rates. in a flat tax system, individuals have two tax brackets: the flat rate and zero. retirement plans and exempt organizations are also not taxed on their business or investment income. therefore, individuals who are subject to a high marginal tax rate (i.e., with c

44、ompensation or retirement income in excess of their personal allowance) have an incentive to move their income into years in which they are subject to low tax rates (i.e., with compensation or retirement income below their personal allowance) or engage in transactions with individuals or entities th

45、at are subject to the zero tax rate.however, effective tax planning and tax avoidance are not the same thing. scholes and wolfson(1988) show that the pursuit of a myopic tax avoidance strategy can introduce significant nontax costs. for example, businesses that attempt to postpone their tax liabilit

46、ies in a flat tax system by borrowing to purchase equipment may inadvertently lock themselves into suboptimal investments that are costly to reverse. market frictions may also impose additional costs on a tax avoidance strategy (stiglitz, 1985; scholes and wolfson, 1988). stiglitz also points out th

47、at the effect of a tax avoidance strategy cannot be analyzed by looking at its effects on a single taxpayer. transactions that reduce one taxpayers tax liability may increase the tax liability of others. for example, in a flat tax regime, the proceeds of the sale of business-use property must be rec

48、ognized as income by the seller, which offsets the tax benefits of the deduction taken by the buyer (hall and rabushka, 1995). as long as the buyer and the seller are in the same marginal tax bracket and the seller recognizes income in the same tax year that the buyer deducts the payment, the govern

49、ment would be indifferent to a tax strategy that defers taxes through postponing sales or accelerating purchases. in fact, buyers that engage in this form of tax avoidance may be merely replacing explicit flat taxes with implicit taxes in the form of higher asset prices.in contrast to the myopic goa

50、l of tax minimization, scholes and wolfson(1992) suggest that effective tax planning requires taxpayers to consider (1) the tax implications of a proposed transaction for all parties to the transaction; (2) explicit taxes, implicit taxes, and tax clienteles; and (3) the costs of implementing various

51、 tax-planning strategies. for example, in pursuing a tax avoidance strategy based on acquiring additional assets, the buyer should attempt to contract with a seller who is not subject to flat taxes (e.g., an exempt organization or a seller of personal-use property). if the expected costs of identify

52、ing a tax-exempt seller and negotiating a sales contract exceed the tax benefits, however, the buyer should pursue a different strategy.the tax avoidance strategies described in this paper generally follow these guidelines. for example, tax strategies that involve sales contracts consider both parti

53、es to the transaction. in order to facilitate the analysis, however, i make several simplifying assumptions.assumption 1: given a choice between two different contracts for the purchase of the same good, a consumer will choose the contract with the lowest present value of cash payments.assumption 2:

54、 when determining the optimal contract, business managers and consumers will consider the tax consequences of the contract provisions.these first two assumptions concern taxpayer behavior. the first assumption indicates that the structure of the transaction does not affect the consumers decision. fo

55、r example, in considering whether to lease or buy property, the consumer is not concerned with intangible preferences such as pride of ownership. the first assumption also shows that the consumer is not affected by framing effects or other behavioral anomalies. the second assumption ensures that ind

56、ividuals and business managers correctly understand the tax consequences of their behavior.assumption 3: there are no taxes other than the flat tax.in the current economic environment, there exist several taxes other than the federal income tax that can provide potential obstacles to the implementat

57、ion of effective tax planning in a flat tax regime. for example, transfer taxes present an additional cost to flat tax minimizing strategies and state and local governments may continue to tax investment income and restrict the immediate deduction of property acquisitions. on the other hand, the tax

58、 benefits that result from using tax planning strategies in a federal flat tax regime will be enhanced by state and local governments that convert their current income tax system to a flat tax structure. social security taxes may also confound or magnify the benefits of the tax strategies (calegari,

59、 key, and smith, 1996). the third assumption eliminates the confounding effects of these additional taxes.assumption 4: the form of the transaction determines the tax consequences of the transaction.the fourth assumption is necessary to avoid the lengthy and tedious boilerplate that tax planners use to achieve a favorable interpretation of the statutes. in the interest of brevity, the strategies described in this paper are necessarily simple and crude. e