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.