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The Tax Lawyer

The Tax Lawyer: Winter 2022

Learning to Live Without Form 1040

Katherine Tulloch Pratt


  • A modified Graetz Plan could overcome two major challenges: (1) reconciling the Graetz Plan and existing multipurpose refundable income tax credits; and (2) the potential loss of beneficial functions that the mass income tax may serve.
  • Summarizes the Graetz Plan.
  • Identifies a new development that could facilitate adoption of the Graetz Plan while simultaneously improving the well-being of low-income Americans.
Learning to Live Without Form 1040
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A prominent tax reform proposal made by Michael Graetz in 2008 (the Graetz Plan) would replace much of the federal income tax with a Value Added Tax (VAT), a new consumption tax. If enacted, low-income and middle-income Americans would file 120 million fewer federal income tax returns annually. The Plan would convert the mass income tax into a narrow “class” income tax on high-income Americans. Adoption of the Graetz Plan would promote economic growth and reduce the compliance and administrative costs of the federal tax system. Defenders of the mass income tax nonetheless oppose adoption of the Graetz Plan. This Article argues that the Graetz Plan, modified as suggested in this Article, could overcome two major impediments to adoption of the Plan: (1) the difficulty of reconciling the Graetz Plan and existing multipurpose refundable income tax credits; and (2) the potential loss of beneficial functions that the mass income tax may serve.

Part I summarizes the relevant portions of the Graetz Plan. Part II provides context for reform of existing refundable income tax credits and critiques the Graetz Plan’s suggestion to replace existing refundable credits primarily with payroll tax cuts. This Article identifies a new development that could facilitate adoption of the Graetz Plan while simultaneously improving the well-being of low-income Americans. Specifically, the 2021 temporary expansion of the federal Child Tax Credit (CTC) and the adoption of an advance payment system signal a bipartisan shift in policy and potentially a shift in public attitudes about making transfer benefit payments to families with children. Replacing most of the Earned Income Tax Credit (EITC) with an expanded CTC would facilitate administration of the CTC outside the federal income tax system. The remaining, smaller EITC could be replaced with a payroll tax reduction smaller than Graetz assumed. Replacing large, antipoverty and pro-family transfer programs that currently are embedded in the income tax would no longer be the Achilles Heel of the Graetz Plan.

Part III responds to arguments that the mass income tax serves various beneficial functions that a class income tax plus a VAT would not serve. This Part explores various functions, some of which are newly identified in this Article, currently served by the mass income tax. Ultimately, this Article concludes that learning to live without the mass income tax could enhance social welfare. Some functions currently served by the mass income tax still could be served—and even improved—in the context of adopting a modified Graetz Plan. Also, one function currently served by the mass income tax, enabling Internal Revenue Service administration of hundreds of tax expenditures (tax subsidies and other targeted tax cuts), has made the federal tax system dysfunctional and should be curtailed, not retained. Adoption of the Graetz Plan could provide a needed catalyst for fundamental tax expenditure reform, which could significantly increase federal revenue and improve the efficiency and fairness of the federal tax system. The net benefits of enacting the Graetz Plan and learning to live without Form 1040 are significant and underappreciated.

I. Introduction

To raise federal revenue, over 160 countries worldwide—including all countries with developed economies other than the United States—impose consumption taxes on goods and services, known as Value Added Taxes (VAT) or Goods and Services Taxes (GST). Instead of imposing a federal consumption tax, the United States relies disproportionately on the federal income tax to raise revenue. Tax experts argue that the United States should adopt a federal consumption tax on goods and services to increase the efficiency of the tax system and promote growth in the American economy. Also, respected economists predict that pressing needs for new federal revenue sources eventually will lead to the enactment of a federal VAT.

Michael Graetz, former Deputy Assistant Secretary of the Treasury for Tax Policy under President George H.W. Bush, proposes a Competitive Tax Plan (the Graetz Plan or the Plan), which would pair a new federal VAT with a much narrower federal income tax. Part II summarizes the portions of the Graetz Plan that would apply to individuals and families. Parts III and IV argue that policy makers can overcome two major impediments to adoption of the Graetz Plan: (1) the difficulty of reconciling the Graetz Plan and existing refundable income tax credits administered by the Internal Revenue Service (the Service) and (2) the potential loss of beneficial functions that the mass income tax may serve. Part III provides context for reforming existing refundable income tax credits and critiques the Graetz Plan’s suggestion to replace existing refundable credits primarily with payroll tax cuts. Pairing the new VAT with regressivity offsets, via some form of transfer payments, is essential to address distributional concerns regarding the regressivity of VATs. This Article argues that recent legislative and political developments are consistent with reducing the payroll tax cut proposed by Graetz and increasing electronic transfer payments to parents. Part IV explores various functions served by a mass income tax, including the “warm glow” “fiscal citizenship” function Lawrence Zelenak identified. This Article identifies additional functions that might be served by a mass income tax and proposes alternative approaches to serve some of those functions in a world with a narrow class income tax. In addition, this Article argues that adoption of the Graetz Plan could provide a needed catalyst for fundamental tax expenditure reform, which could significantly increase federal revenue and increase the efficiency and fairness of the federal tax system.

II. The Graetz Plan to Replace the Mass Income Tax with a Class Income Tax and a Federal Value Added Tax

Under the Graetz Plan, a taxpayer whose income does not exceed a new “family allowance” no longer would need to file an annual Form 1040 income tax return. The proposed family allowance is $100,000 for couples or families or $50,000 for individuals, adjusted annually for inflation. The Plan thus would convert the “mass” income tax into a narrower “class” income tax on high-income taxpayers, albeit with a lower marginal tax rate. Graetz notes that the Plan would restore the income tax to the narrow application it originally had, over one hundred years ago, prior to the expansion of the federal income tax at the time of World War II. With the family allowances proposed by Graetz, American taxpayers would file 120 million fewer Form 1040 income tax returns each year.

Revenue from the new VAT would replace the income tax revenue that would be lost by narrowing the income tax. (The Plan thus is referred to as a “partial-replacement VAT.”) A VAT, like the retail sales taxes imposed by many state and local governments in the United States, is a tax on the consumption of goods and services. A retail sales tax imposes a consumption tax only at the point of retail sale of a good or service, whereas a VAT imposes a consumption tax at each stage of production and sale of a good or service. Each party paying the VAT receives a VAT credit for the amount of VAT already imposed on goods the party purchases, as indicated on the invoice for purchase of the goods. A VAT and a retail sales tax with the same tax rate thus collect the same amount of revenue. A VAT is harder to evade and less costly to administer than a retail sales tax or income tax, in part because of the invoice paper trail the VAT creates along the chain of production of goods and services.

Consumption taxes, including retail sales taxes and VATs, are regressive taxes, meaning that consumption taxes comprise a decreasing percentage of a taxpayer’s income as taxpayer income increases. Defenders of the mass income tax prefer the income tax, in large part, because the federal income tax rates on ordinary income (primarily labor income, as opposed to capital gain) are progressive, meaning that income tax (at least on ordinary income) comprises an increasing percentage of a taxpayer’s income as taxpayer income increases. The historical public and political consensus in the United States favors progressive income tax rates. A challenge for the Graetz Plan is to provide cash transfers to taxpayers to offset the regressive effects of the proposed VAT.

The Graetz Plan offers many benefits, including increased economic growth and reduced compliance and administrative costs, but the Plan must overcome certain impediments to enactment. One significant impediment is resistance to the potential elimination of refundable income tax credits for low-income and middle-income Americans, who no longer would file federal income tax returns. Existing refundable income tax credits include the Earned Income Tax Credit (EITC), which is often lauded as “a uniquely effective and viable antipoverty program,” and the Child Tax Credit (CTC). Together, the EITC and CTC are among the largest federal antipoverty programs. For the Graetz Plan to be viable, the Plan must replace the EITC and CTC outside the federal income tax. Part III addresses existing proposals to reform the EITC and CTC and considers whether the Graetz Plan could provide the equivalent of the existing EITC and CTC without having low-income and middle-income Americans file annual income tax returns.

III. Learning to Live with the Loss of Multipurpose Refundable Individual Income Tax Credits

This Part provides the context for current proposals to reform the EITC and CTC and considers how recent developments could facilitate replacement of the EITC and CTC outside the federal income tax, reducing an impediment to enactment of the Graetz Plan.

A. The Context for Reform of Refundable Income Tax Credits

Federal programs that benefit needy Americans include nontax programs and tax programs. For example, the federal government provides grants for nontax programs, such as the federal School Lunch Program, Temporary Assistance for Needy Families (TANF), and Supplemental Nutrition Assistance Program (SNAP). Federal income tax-transfer programs include the refundable credits that are embedded in the Internal Revenue Code (Code) and administered by the Service. The largest federal individual income tax credits are the EITC, the CTC, and the Premium Payment Tax Credit (PPTC).

The primary rationale for “integrating” transfer programs, such as the EITC, into the Code is that program eligibility turns, in part, on the potential beneficiary’s annual “income,” about which the Service typically has information due to automatic third-party information reporting. (For example, employers automatically provide the Service with information about their employees’ annual wage income.) Integration of a government transfer program, such as the EITC, into the income tax system potentially offers the following advantages: lower transfer program administrative costs; higher benefit take-up rates; reduced social stigma for recipients of benefits; and increased political support for the transfer program.

Anne Alstott observes, however, that the standard arguments for tax-transfer integration oversimplify the institutional design issues in the context of the EITC. She argues that “the tax system’s limitations render the EITC inherently inaccurate, unresponsive, and vulnerable to fraud and error in ways that traditional welfare programs are not.” Michelle Drumbl notes that the total cost of having the Service administer the EITC—including the significant cost of EITC overpayments—is similar to the costs of administering nontax-transfer programs, such as TANF and the School Lunch Program.

In addition, the annual accounting period used for the income tax system makes the EITC less responsive than nontax-transfer programs to volatility in the taxpayer’s economic circumstances. Under the existing EITC, eligibility is determined just once, on an annual basis, and the EITC is paid just once, also annually. EITC recipients may enjoy receiving a large lump-sum check at one time. At the same time, however, EITC recipients who lack access to credit on reasonable terms often resort to high-interest credit cards and “payday” loans, with onerous terms and frequent defaults, to meet monthly expenses for necessities. Also, a majority of low-income taxpayers who qualify for the EITC pay a third-party return preparer to file their annual tax returns, reducing the net tax-transfer benefit for the taxpayer’s family.

EITC experts have considered the following EITC reforms to improve the program for beneficiaries, reduce Service administrative costs, and reduce EITC overpayments: (1) redesign eligibility requirements, to reduce compliance complexity, administrative cost, and both error and fraud; (2) make eligibility determinations prospective instead of retrospective; (3) increase the frequency of eligibility determinations to make the payments more “responsive” to changes in the beneficiary’s economic circumstances; (4) redesign the EITC to allow quarterly or monthly payment intervals; (5) increase savings and liquidity to help beneficiaries deal with liquidity shocks and avoid poverty traps, such as onerous payday lending practices; and (6) coordinate phaseouts among tax and nontax means-tested benefit programs.

B. Reconciling the Graetz Plan and Reform of Refundable Income Tax Credits

Adoption of a federal partial-replacement VAT would complicate the ongoing reform of refundable income tax credits. The existing EITC balances multiple goals, including offsetting regressive payroll taxes on the wage income of low-wage workers; encouraging work though additional pay for low-wage workers; and reducing poverty among low-wage workers, primarily workers with children. If the federal government adopted a partial-replacement VAT, an additional policy goal of transfer benefits might be to offset the new, regressive VAT.

If low-income taxpayers are excluded from the narrow class income tax, as seems likely, advocates for continued transfer payments must devise non-income tax replacements for income tax transfers. For decades, the conventional wisdom has been that the political resilience of the EITC is tied inextricably to providing income “tax cuts” to low-income persons who “deserve” help because they work and have children. Removing transfer payments from the income tax system would make transfer payments more salient and eliminate the political “tax cut” “cover” for making transfer payments.

The risk—and the potential Achilles Heel of the Graetz Plan—is that existing income tax-transfer benefits might be eliminated, with no replacement benefit program or an inadequate replacement benefit program, if the United States adopted a partial-replacement VAT. Graetz concedes that “protecting low-and moderate-income workers from a tax increase or loss of the EITC without requiring them to file tax returns is probably the most challenging task for” the Plan.

Exemptions for essential goods and services are used by states and some countries to reduce the regressive effects of consumption taxes (including retail sales taxes and VATs), but Graetz opposes federal VAT exemptions. He argues VAT-reduction benefits of exemptions should not be provided to higher income taxpayers, and exemptions would drive up the VAT rate. In his view, it would be better to make the base of the VAT very broad, to minimize the VAT rate and direct VAT offsets to the taxpayers most in need of such offsets.

Graetz proposes payroll tax adjustments as the primary regressivity offset to replace the existing EITC. Such payroll adjustments would increase workers’ take-home pay—paycheck by paycheck—throughout the year, instead of providing one large annual lump-sum payment as under the current EITC or periodically as under reforms that would provide quarterly or monthly EITC payments. Incrementally higher worker paychecks may not solve the pressing problem of liquidity traps for low-income taxpayers who have no savings and volatile income and expenses, especially if low-income consumers bear some of the economic burden of the new VAT.

Tapping into payroll taxes for large regressivity offsets and antipoverty subsidies also seems politically risky. Payroll taxes historically have low political salience, and Social Security benefits have high political salience. In terms of overall satisfaction with our tax system, it would not make sense to deliver large antipoverty regressivity offsets through the payroll tax system, particularly if the payroll tax reduction completely eliminated payroll taxes for the worker. Putting a public spotlight on the enormous amount of payroll taxes that everyone—other than the payroll adjustment beneficiaries—would continue to pay seems like a recipe for a political disaster.

Also, a payroll tax cut would not provide a regressivity offset for unemployed persons, including disabled people, retirees, and many students. Graetz responds to this concern by noting that retirees’ monthly Social Security old age benefit would be increased under automatic cost-of-living-adjustment (COLA) rules, to reflect the economic effects of a new VAT on the prices of goods and services. Not all benefit programs (and funding for benefit programs) incorporate such COLAs, however. For example, TANF block grants to states do not automatically adjust for cost-of-living increases. Graetz suggests that COLAs could be added to federal programs and funding mechanisms that currently lack COLAs to address such concerns.

The original Graetz Plan also proposes the use of Electronic Benefit Transfer (EBT) cards (also known as “smart cards”) to deliver benefits, as an alternative or complement to payroll tax adjustments. EBT cards already are used widely to deliver transfer benefits to recipients. Graetz notes that EBT cards could be used to deliver regressivity offsets to unemployed low-income Americans as well as low-income workers. In his updated Plan, Graetz proposes that both types of regressivity offsets be adopted. Payroll tax adjustments for workers would replace the EITC, and distribution of EBT cards would replace the CTC.

As originally proposed, replacing the EITC with payroll tax adjustments would raise some daunting administrative issues. One problem is that a worker’s existing EITC could exceed the worker’s entire annual payroll tax liability (even including the employer’s portion of payroll taxes). For example, a single parent of two minor children who works full-time all year in a minimum-wage job earning $7.25 per hour would (1) earn about $15,000 in wages; (2) pay about $2,300 of payroll taxes (including the employer’s portion); and (3) be entitled to an EITC of $5,980. In this situation, even a complete payroll tax elimination would not replace the EITC. Graetz suggests that, in such a situation, an employer could use payroll taxes collected from the employer’s higher wage employees to pay additional amounts to the minimum-wage worker. That approach would work for some employers, but would not work for employers that disproportionately employ low-wage workers.

All is not lost, however. Recent bipartisan approaches to improve the social safety net for families with children signal a path to more easily replace the Service-administered EITC and CTC outside the income tax system. Most of the EITC could be replaced by expanding the CTC to make the credit amount larger and the credit fully refundable with no earned income phase-in. Payroll tax reductions could replace the remaining EITC and function as a wage subsidy for low-wage workers, including childless workers. The Social Security Administration (SSA) could administer the CTC and the payroll tax reduction.

A related approach, championed by Congressional Democrats and the Biden Administration, temporarily has become law for 2021. In March 2021, the American Rescue Plan Act of 2021 (ARPA) temporarily expanded refundable tax credits, in particular the CTC, for 2021. ARPA also significantly expanded the 2021 EITC for childless workers. Among other changes to the CTC, the ARPA (1) increased the annual CTC to $3,000 per child, for children ages 6-18, and $3,600, for children under the age of six; (2) made the CTC fully refundable; and (3) adopted a monthly advance payment schedule for the second half of 2021, with direct electronic payment of a monthly benefit unless the recipient elected out of the advance payment option by June 2021.

In addition, Republican Senator Mitt Romney has advanced a related proposal. Under Senator Romney’s proposed Family Security Act, most of the EITC would be replaced by a Monthly Child Tax Benefit of $250 per child per month ($3,000 per year) for children ages 6 to 17 and $350 per child per month ($4,200 per year) for children under age 6, up to a monthly maximum of $1,250 (an annual maximum of $15,000) per family. SSA—not the Service—would administer the benefit program. The Romney proposal would increase federal spending on families with minor children from the current CTC spending of around $117 billion per year to $229.5 billion per year for the proposed child benefit.

The Romney proposal signals that the payroll tax reductions to replace the EITC could be smaller than Graetz assumed, and the monthly cash benefit to replace the CTC could be larger than Graetz assumed. Under the Romney proposal, the maximum EITC would be $1,000 for unmarried taxpayers and $2,000 for married taxpayers filing jointly. The EITC would continue to require “work” and earned income. If the payroll tax adjustments were small enough that they did not eliminate payroll tax completely, the payroll tax replacement for the EITC might be more viable politically. The more difficult political issue would be preserving large monthly child benefits—especially if the monthly child benefit does not have an earned income phase-in or work requirement. If the bipartisan support for child allowances continues, that structure would facilitate moving individual refundable credits out of the income tax. The recent increase in political support for cash transfers to support families with children is a major tax policy development, with important implications for adoption of a partial-replacement VAT.

Another impediment to adoption of the Graetz Plan is the line of argument made by Lawrence Zelenak and other defenders of the mass income tax. Zelanak argues that the mass income tax serves important functions that would be lost on conversion of the mass income tax into a class income tax. Part IV responds to Zelenak’s argument, identifies additional functions the mass income tax serves, and concludes that most functions served by the mass income tax could be continued in an alternate form if the Graetz Plan were enacted. In addition, Part IV concludes that one function of the mass income tax—Service administration of hundreds of tax expenditures—should be curtailed significantly. Adoption of the Graetz Plan could provide a catalyst for fundamental tax expenditure reform, which could raise significant revenue and make the federal tax system fairer and more efficient.

IV. Learning to Live with the Potential Loss of Functions Served by the Mass Filing of Form 1040 Tax Returns

A. “Warm Glow” “Fiscal Citizenship”

Lawrence Zelenak famously defends the annual mass filing of income tax returns by Americans in his book, Learning to Love Form 1040: Two Cheers for the Return-Based Mass Income Tax. He argues that the annual filing of Form 1040—like voting in elections—could promote a “warm glow” of “fiscal citizenship.” The “high visibility and ceremonial aspect” of the annual filing of income tax returns every April 15 “calls the taxpayer’s attention to his status as a taxpayer and a purchaser of civilization.”

Zelenak withholds one cheer (out of three) because the existing income tax system is so complex that annual income tax filing is time-consuming and costly. In addition to the out-of-pocket costs of tax return preparation, taxpayers spend significant time and psychic energy on recordkeeping and tax return filing. These psychic costs are highlighted by the fact that some taxpayers whose itemized deductions exceed the standard deduction claim the standard deduction instead of their higher itemized deductions to eliminate the need to keep records of their itemized expenses or to avoid the risk of an audit.

Americans feel proud of contributing their “fair share” to the federal government, but the existing process of preparing and filing the Form 1040 often seems likely to produce more hot rage than warm glow. Zelenak nonetheless defends the mass return-based income tax system with a strong recommendation to simplify the federal income tax system. Even a simpler form of income tax filing would retain another problem with the current federal income tax return filing system, however. Filing a tax return makes the payment of income tax more salient, but provides no information about how the government spends a taxpayer’s tax payments. The disaggregation of a taxpayer’s salient income tax payments from an accounting of what the government purchases with the taxes is likely to foster resentment of the income tax.

Edward McCaffery and Jonathan Baron highlight the effects of the disaggregation of taxes and government spending on taxpayer attitudes. When survey respondents were asked their opinions about tax cuts funded by unspecified spending cuts, they were in favor of tax cuts on average. When survey respondents were asked to specify which government spending programs they would cut to fund tax cuts, survey respondents reversed their preferences for tax cuts. Respondents naively assumed that tax cuts could be funded by cutting wasteful or overly generous programs. They realized their error when faced with the need to precisely identify the federal spending program cuts that would be required to fund federal income tax cuts.

In addition, Americans significantly underestimate the extent to which they benefit from government spending. The fact that Social Security taxes are less reviled than income taxes may be attributable to the fact that Americans mentally aggregate the costs and benefits of Social Security, but disaggregate the costs of income taxes from the spending that income taxes fund. Zelenak favors adoption of Marjorie Kornhauser’s proposal to send taxpayers an annual statement of their income tax liability, much like the statements that SSA sends Americans periodically. He would extend Kornhauser’s proposal to include general information on federal spending in the annual income tax statement. An individualized version of the annual tax and spending statement could show each taxpayer approximately how much (in dollars) of their entire federal tax for the year was spent on each federal spending category. Taxpayers might feel less resentment about their taxes if tax and spending information were aggregated and provided, much like an invoice or receipt for the purchase of goods and services.

Also, to highlight that taxpayers pay taxes other than federal taxes, the statement could include a pie chart illustrating the various sources and uses of federal tax revenue and state and local tax revenue. Ideally, the statement also would include an estimate of the taxpayer’s total tax burden from all sources of tax—including payroll taxes and sales taxes—based on standard assumptions regarding consumption and savings at various income levels, as well as spending on major budget functions and programs. This information could show low-income and middle-income taxpayers that they too contribute to sharing the costs of government, contrary to the infamous assertion that 47 percent of Americans are “takers,” not “makers,” because they pay no income taxes.

Going beyond the annual provision of tax and spending information, the federal government could give Americans the opportunity to affirmatively express their preferences for various types of spending and programs. Cait Lamberton, Jan-Emmanuel De Neve, and Michael Norton posit that promoting “taxpayer agency” through such signaling of preferences could reduce taxpayer noncompliance and anti-tax sentiment. “Warm glow” and “fiscal citizenship” would be promoted better by adoption of the Graetz Plan, along with proposals to increase taxpayer voice, agency, and participation, than by continuing the current dysfunctional mass income tax.

B. Income Verification and De Facto Income Statement

The filing of Form 1040 also serves the important function of providing Form 1040 filers with a trusted form of income verification and a de facto income statement. The Form 1040 is used to verify income in a wide variety of nontax contexts, including applications for leases, bank loans, and student financial aid. If 120 million American households no longer had to file a Form 1040, how would they verify their income?

Even if millions of Form 1040s no longer needed to be filed, we could—and should—retain the current system of annual third-party information reporting to the Service and to Americans. For example employers provide Form W-2s to employees, and payors provide Form 1099s to payees. Americans could use their Form W-2 and Form 1099s to verify their income, even if they no longer are required to prepare and file a Form 1040. Also, the scope of mandatory Form 1099s could be expanded to require third-party reporting for additional sources of income. An alternative would be for the Service to send each American who does not have to file a Form 1040 an annual summary of his or her income reported by third parties. Other options would be for everyone to continue to file a very simple version of a Form 1040 or for the Service to prepare and send “ready” information returns to those who have income but do not have any income tax liability for the year due to the large family allowance.

In addition to the multitude of commercial parties that currently request taxpayers’ Form 1040 for income verification, government agencies sometimes require information from federal tax returns to establish eligibility for means-tested antipoverty benefits. Programs that require income verification with tax return information include Medicaid, the Children’s Health Insurance Program (CHIP), and other healthcare subsidies. Federal income tax returns are not required for some need-based, federal benefits, such as SNAP and low-income housing. These programs permit applicants to use other forms of income verification such as pay stubs. Form W-2s and Form 1099s could substitute for Form 1040 in this context.

An important additional issue is whether more informative household financial reporting could replace the Form 1040 or supplement the Form W-2 and Form 1099 in some contexts, such as applying for antipoverty transfer benefits. Using third-party income reporting or income tax returns to establish eligibility for antipoverty transfer benefits is fundamentally problematic. The tax definition of income does not accurately measure ability to pay for essential goods and services, which is a function of (1) income and expenses, (2) cash flows, and (3) wealth. The relevance of all three types of financial information is reflected in diverse eligibility tests for many means-tested programs. For example, “income” for the purposes of some means-tested programs is limited to liquid assets (such as cash and cash equivalents), and eligibility for some means-tested benefit programs includes wealth tests. For example, under some state-run Medicaid programs, Medicaid applicants with more than $2,000 of assets are ineligible for Medicaid, even if the applicant has zero income. These additional financial eligibility requirements impose daunting recordkeeping and documentation obligations on program applicants.

Even if eligibility for means-tested benefit programs were based solely on “income,” the stylized tax definition of income poorly reflects a taxpayer’s ability to pay for essential goods and services. The Code defines gross income broadly in section 61 to include all accessions to wealth, similar in concept to the comprehensive Haig-Simons definition of income. The Code nonetheless is rife with exclusions, deductions, and deferral mechanisms (e.g., the realization requirement) that deviate from a comprehensive definition of income. In some situations, gross income understates the ability to purchase goods and services. For example, government transfer payments are excluded from gross income under the General Welfare Doctrine, although such transfer payments increase the beneficiary’s liquid assets. In other situations, gross income overstates the ability to purchase essential goods and service. For example, discharge of indebtedness generally is included in gross income even if such debt discharge does not increase the debtor’s cash flow.

Income under the federal income tax (whether gross income under section 61, adjusted gross income under section 62, or taxable income under section 63) simply is not an accurate indicator of ability to purchase essential goods and services. To understand a person’s ability to afford subsistence goods and services, one must assess that person’s economic resources in terms of liquidity or solvency/insolvency. One notion of solvency/insolvency is “cash flow” (or “equity”) solvency/insolvency, meaning the ability to pay one’s debts as they come due. A second notion of insolvency is “balance sheet” solvency/insolvency, meaning assets less liabilities as indicated on a balance sheet. In the business context, hybrid measures also are used to reflect a combination of net worth and liquidity of assets to pay debts. An income statement alone is insufficient to reflect liquidity and equity solvency/insolvency. Combining an income statement with a statement of cash flows and a balance sheet would provide a more accurate reflection of ability to pay for essential goods and services.

Eligibility for means-tested programs would be easier to establish if the federal government standardized the financial reporting for need-based programs (including federally funded, state-run programs) to make the documentation of eligibility for need-based programs more uniform. A standardized reporting methodology could require program applicants to keep simple versions of the three basic financial statements: (1) the income statement; (2) the balance sheet; and (3) the statement of cash flows. The only financial statement that most Americans currently prepare is a Form 1040. The demise of the mass annual filing of Form 1040 could encourage American households to adopt innovative financial technologies to generate simple versions of the three basic forms of financial statements. These financial statements could be used in all of the contexts within which the Form 1040 currently is used to verify income, including applications for leases, loans, student financial aid, and means-tested antipoverty programs.

C. Tax Data Collection

The IRS Statistics of Income (SOI) program compiles, analyzes, and reports data from tax returns, including the Form 1040 returns filed by millions of households. SOI shares tax return information with other government agencies including (1) the Office of Tax Analysis (OTA) in the Treasury Department, (2) the Congressional Joint Committee on Taxation (JCT), (3) the Bureau of Economic Analysis (BEA) in the Department of Commerce, (4) the Federal Reserve Board, (5) the General Accountability Office (GAO), (6) the SSA, (7) and the Health Care Financing Administration (HCFA). Generally, agencies have access only to aggregate tax return data to protect taxpayers’ privacy, but OTA and JCT also have access to specific tax return files. SOI also provides aggregate tax return data to “[t]ax practitioners, policy researchers, demographers, economic analysts, consultants, business associations, State and local Governments, universities, public libraries, and the media.”

SOI has four branches, one of which focuses on statistical computing and three of which focus on specific types of taxpayers. One of the three taxpayer-specific branches of SOI focuses on tax return data for individuals and sole proprietorships. If the mass income tax were converted into a class income tax and 120 million households no longer file Form 1040, the Form 1040 tax return data for these households would be eliminated. SOI would continue to collect third-party income information reported on Forms W-2 and 1099 for all households. Also, the fact that the vast majority of the 120 million households that would no longer file tax returns previously took the standard deduction, not itemized deductions, would mitigate the loss of detailed Form 1040 tax data. In addition, SOI would continue to receive detailed data from the Form 1040 tax returns filed by the high-income households that would pay the narrower “class” income tax.

The loss of tax return data from low-income and middle-income Americans would impact various reports SOI currently prepares. For example, every year SOI publishes Individual Income Tax ZIP Code Data, which aggregates tax return data for taxpayers living in a specific Zip Code for a specific year. SOI makes available, by Zip Code, data on a wide array of topics. Similarly, SOI prepares an annual report, Individual Complete Report Publication, in which it compiles tax return data from a representative sample of individual tax returns. The report includes information on “sources of income, adjusted gross income, exemptions, deductions, taxable income, income tax, modified taxable income, tax credits, self-employment tax, and tax payments.” SOI would continue its data reporting for upper income taxpayers who continue to file Form 1040, supplemented by third-party information (e.g., Forms W-2 and 1099) reported for all households. The tax return information for taxpayers still filing Form 1040 might be simpler than under current law if the adoption of a partial-replacement VAT is combined with tax expenditure reform that simplifies the remaining income tax.

Income tax returns are not the only source of financial data for government agencies. Financial data also are collected and reported by various federal agencies and bureaus within federal agencies. For example, within the Department of Commerce, the Census Bureau and the BEA compile, analyze, and report comprehensive data on income, spending, savings, and production. As another example, the Office of the Assistant Secretary for Planning and Evaluation (ASPE) in the Department of Health and Human Services collects data and prepares reports on policy-relevant topics including poverty, disability, aging, health, health care, and social capital. Of course, the adoption of the Graetz Plan would provide government agencies with new forms of tax data, including data from the new federal VAT, as well as data collected by SSA regarding the payroll tax reductions and transfer benefit payments that would replace the existing Service-administered EITC and CTC.

Going forward, one or more federal agencies must be able to collect and organize the specific data that are necessary to conduct performance evaluations of tax expenditures. Performance review of spending through the Code consistently has been ignored, but a companion Article advocates for holding Congress, Treasury, and the Service to the sort of performance review standards that apply to major outlay (spending) programs. To conduct such performance review, Congress, Treasury, and the Service must be required to specify the goals and performance measures for each tax expenditure. In addition, funding for data collection and analysis is essential to conduct performance review of tax expenditures.

D. State Income Tax Return Preparation

Forty-one states and the District of Columbia impose state income taxes. The broad base for state income tax in most states is similar to the federal income tax base. In these states, a completed federal Form 1040 typically functions as the first step in preparing state income tax returns. If adoption of a partial-replacement VAT eliminates 120 million federal income tax returns, state legislators in states that piggyback state income taxes onto federal income taxes would have to decide how their state would proceed.

One choice would be for states to conform to the new federal partial-replacement VAT. Graetz notes that states could piggyback onto the new federal tax system, by adopting a state VAT like the federal VAT, and narrowing state income taxes to the high-income taxpayers who still would be required to file federal tax returns. Graetz argues that state-level administrative costs and compliance burdens could be reduced significantly if states fully conform to the new federal partial-replacement VAT system.

A second choice would be for states to refuse to conform to the new federal VAT and narrow class income tax. Heather Fields documents the extent to which states conformed—and did not conform—to the federal income tax changes enacted in 2017 as part of the Tax Cuts and Jobs Act. Fields argues that income tax simplification at the federal level shifts compliance burdens—but does not reduce compliance burdens—if state income tax systems do not conform to federal amendments that are designed to simplify the federal income tax. Similarly, adoption of a federal partial-replacement VAT could decrease administrative costs and compliance burdens at the federal level, while simultaneously increasing administrative costs and compliance burdens at the state and local levels.

For the United States to receive the full benefits of enactment of the Graetz Plan, policy makers must encourage state-level conformity to the federal plan. State conformity with the Graetz Plan creates the possibility of an economic win-win scenario for states, but partisan and local politics may preclude state conformity with the federal enactment of the Graetz Plan. The risk of state nonconformity with a federal partial-replacement VAT is nontrivial.

E. Service Administration of Tax Expenditures

The filing of Form 1040 also frequently functions as an “application” for federal tax expenditures, which are targeted tax benefits that are incorporated into the Internal Revenue Code and administered by the Service. Tax expenditures relate to many different federal budget functions, including health care, housing, and income security. The administration-of-tax-expenditures function performed by the Service as part of the mass income tax is, in fact, a dysfunction that enactment of the Graetz Plan could help to curtail. The consensus view, among tax scholars, is that ineffective tax expenditures should be eliminated. Also, effective tax expenditures might be improved.

1. The Graetz Plan Could Be a Catalyst for Fundamental Tax Expendi-ture Reform.

The elimination of the mass filing of Form 1040 could provide a catalyst for fundamental tax expenditure reform, a worthy policy goal that has eluded reformers for decades. One goal of such reform would be to integrate tax expenditures into federal budget processes, to provide fiscal transparency and contain automatic growth in the costs of tax subsidies. Another goal would be to subject tax expenditures to performance review—a critical, but long-ignored federal statutory requirement. As others have argued and a companion Article posits, ongoing performance review of tax expenditures would require (1) the specification of program goals and measurable outcomes for existing and new tax expenditures; (2) the determination whether existing tax expenditures are achieving the specified program goals based on measurable outcomes; (3) the repeal or reform of ineffective tax expenditures; (4) the introduction of periodic inter-agency functional review of related tax and “spending” programs, to better allocate responsibilities between federal agencies and improve overall functional performance of the federal government; and (5) the establishment of periodic assessment of outcomes of continuing tax expenditures.

The likely result of this process would be the repeal of numerous large tax expenditures. Consider, for example, the home mortgage interest deduction, one of the ten largest tax expenditures. The rationale offered for the deduction is that it encourages home ownership, which is equated with achieving the “American Dream.” As Dennis Ventry notes, however, the home mortgage interest deduction was not created to further the goal of home ownership. Instead, the deduction is a vestige of the deduction for personal interest, which was repealed in 1986. The “accidental” deduction continued, following general repeal of the personal interest deduction, because of lobbying by the real estate industry and concerns of existing homeowners about the economic effect of repeal on home values. The home mortgage interest deduction encourages purchases of more expensive and larger homes, rather than encouraging purchases of a first home. In addition, the deduction provides no tax benefits to taxpayers who claim the standard deduction instead of itemizing.

Dorothy Brown highlights the negative distributional effects of the home mortgage interest deduction. Although facially neutral as to income and race, the deduction is an enormous “upside-down” subsidy that disproportionately benefits high-income taxpayers, who disproportionately are white. Brown concludes that neither rent nor home mortgage interest should be deductible. We could immediately repeal the home mortgage interest deduction, gradually phase out the deduction, or replace the deduction with a fixed dollar credit that is phased out over time. Gradual phaseouts would smooth the cash flow and valuation effects of eliminating the deduction.

One part of tax expenditure reform is identifying ineffective tax expenditures, such as the home mortgage interest deduction, for the purpose of repealing, phasing out, or reforming such tax expenditures. Another part of tax expenditure reform is considering whether to amend effective tax expenditures, to improve their performance, based on measurable outcomes.

A foreseeable risk is that future legislation would create new tax expenditures that would erase the benefits of tax expenditure reform achieved during adoption of the Graetz Plan. Daniel Shaviro posits that tax policy “shuttles” between tax reform and tax instrumentalism. Just as the historic 1986 tax reform was followed by decades of instrumentalist back-sliding, future tax expenditure reform in the context of adopting the Graetz Plan may be temporary. Graetz argues that adoption of his Plan would reduce the likelihood that Congress would enact new tax expenditures that benefit only the high-income Americans who continue to file income tax returns. In addition, framework legislation proposed by Edward Kleinbard, along with mandatory performance review for tax expenditures, could deter the creation of new tax expenditures in the income tax.

Graetz advocates for a broad-based VAT, with few exemptions, but does not directly address the political risk of new tax expenditures proliferating under the VAT. The experiences of other countries show, however, that a federal consumption tax, like a federal income tax, is vulnerable to being eroded through legislation that favors specific interest groups. Again, framework legislation might limit the proliferation of tax expenditures, regardless of the tax base.

2. The Graetz Plan Would Restore the Primary Mission of the Service—Raising Revenue

Tax expenditure reform also could reduce the current heavy burden on the Service to administer federal benefits programs, freeing the Service to refocus on its historic core mission—raising and collecting federal revenue. The need to audit tax subsidy beneficiaries reduces the resources the Service can devote to auditing tax returns, including tax returns of self-employed taxpayers, who may underreport business income or overstate business deductions. For example, the Service has diverted audit resources to greater oversight of EITC compliance, in part because EITC overpayment rates are higher than overpayment rates for nontax-transfer programs. EITC audits have reduced the gross EITC overpayment rate, but the net reduction may be smaller because, following an EITC disallowance, another taxpayer may be eligible to claim the disallowed EITC.

As Gabriel Zucman and others note, in terms of total revenue lost, tax evasion is much more of a problem among self-employed taxpayers and high net-worth taxpayers than among EITC filers. Going forward, it makes little sense for the Service to spend its scarce (increasingly scarce in recent years) enforcement resources auditing low-income taxpayers who claim a few hundred dollars or few thousand dollars of EITC, instead of auditing taxpayers whose tax underpayments are likely to be orders of magnitude higher.

Relieved of some of its obligations to administer federal benefit programs, the Service could devote more resources to narrowing the so-called Tax Gap, which disproportionately is attributable to noncompliance by high-income taxpayers whose tax returns are complex and time-consuming to audit.

V. Conclusion

Adoption of the Graetz Plan would promote economic growth and reduce the compliance and administrative costs of the federal tax system. The Plan also could be modified to increase federal revenue, which will be needed due to demographic changes in the United States. Enacting a partial-replacement VAT also would bring the federal tax system in the United States—the last international VAT holdout—into conformity with the federal tax systems of 160 other developed nations.

Defenders of the mass income tax rightly are concerned about the potential regressivity of a federal VAT. To offset VAT regressivity, federal transfers to low-income Americans must be continued. The challenge for the Graetz Plan is to continue such federal transfers outside the federal income tax because low-income Americans no longer would file annual federal income tax returns. Until recently, this challenge has been the Achilles Heel of the Graetz Plan. Developments in 2021 indicate that the combined transfer benefits of the EITC and CTC could be transferred outside the income tax successfully. In addition, beneficial functions served by the mass income tax could be served—in some cases better served—by a modified Graetz Plan. One function of the mass income tax—enabling the Service to administer hundreds of tax expenditures—is at the heart of our current dysfunctional federal income tax system. Combining fundamental tax expenditure reform with adoption of the Graetz Plan could provide significant, underappreciated net benefits for Americans.

Thank you, for comments and suggestions, to Ellen Aprill, Jordan Barry, Jeremy Bearer-Friend, Neil Buchanan, Michelle Drumbl, Miranda Fleischer, J. Clifton Fleming, Calvin Johnson, Ariel Jurow Kleiman, Kirk Stark, and Lauren Willis, as well as participants at the UCLA Colloquium on Tax Policy and Public Finance and panelists and audience members at conferences of the National Tax Association, the Law and Society Association, SEALS, and the ABA Tax Section. Thanks also to Karissa Cotton, Farah Modarres, Jacob Ruvalcaba, and Rachel Smaler for research assistance.