How Will Alternative Tax Reform Plans Affect the Jones Family?

Download Special Report No. 49

Special Report No. 49

Executive Summary Three alternative tax reform plans have been proposed to replace the current income tax system:

• the flat tax introduced by Rep . Dick Armey (R ‘I’exas) with Richard Shelby (R-Ala.) co-sponsoring the plan in the Senate (presidential candidate Sen. Arlen Specter is offering a similar plan);
• the Unlimited Savings Allowance (USA) Tax System sponsored by Senators Pete Domenici (12-N; M.) and Sam Nunn (1)-Ga.);
• and a national retail sales tax advocated by presidential candidate Sen . Richard Lugar (Rind.).

To illustrate the different tax rules and effects for individuals under the alternative plans, the Tax Foundation assisted the Cable News Network (CNN) in calculating an actual family’s tax burden — Bob and Susan Jones” of Tennessee — under each of the reform plans and comparing these burdens with the burden under the current income tax system.

The reform plans have identical goals. They seek to eliminate the biased tax treatment of saving and investment and to simplify the process of complying with (and administering) the federal tax system. However, the flat tax and the USA Tax System differ in the approach they take to relieve the tax burden on saving and investment.

Put simply, the flat tax creates for individual taxpayers what is in effect an unlimited, back-ended individual retirement account (IRA). That is, individuals’ wage and salary income is taxed when it is earned, while any interest, dividend, and capital gains income that results from either old or new savings is never subject to tax at the individual level. And there are no tax consequences or penalties associated with drawing down one’s savings or altering the composition of a savings portfolio.

Under the USA Tax, individuals must total their wages and salaries (and also any other forms of income), but they are then allowed to deduct their new saving for the year. In effect, then, the USA Tax System operates like an unlimited, front-ended IRA. There are no tax consequences or penalties associated with altering the composition of a savings portfolio and there are no penalties associated with drawing down one’s savings. However, any new pre-tax savings that is drawn down to pay for consumption expenditures must be added to the taxpayer’s taxable income. Draw-downs of after-tax savings already accumulated under current law are not included in taxable income.

A national retail sales tax differs from the other plans in that it is collected at the point of sale. Analytically, it is similar to the USA Tax except that all expenditures are subject to tax under a sales tax —including draw-downs of existing after-tax savings and purchases with debt.