This Selected Issues paper on the United States explains the behavior of inflation and unemployment during 1997–98. The paper highlights that a simple Philips curve equation relating inflation to the unemployment gap has overpredicted inflation since 1993. The mean forecast error for 1994–97 is greater than zero by an amount equivalent to two-thirds of the standard deviation of the forecast error. The paper also examines the developments in the U.S. stock prices. Alternative approaches to social security reform are also discussed.


This Selected Issues paper on the United States explains the behavior of inflation and unemployment during 1997–98. The paper highlights that a simple Philips curve equation relating inflation to the unemployment gap has overpredicted inflation since 1993. The mean forecast error for 1994–97 is greater than zero by an amount equivalent to two-thirds of the standard deviation of the forecast error. The paper also examines the developments in the U.S. stock prices. Alternative approaches to social security reform are also discussed.


1. The complexity and lack of transparency in the U.S. income tax system, along with the disincentives for saving that it creates, have prompted a public debate in recent years on various reform proposals.2 The Tax Reform Act of 1986 significantly improved the structure of the U.S. personal income tax system by reducing marginal tax rates on personal income and eliminating many tax deductions and income exclusions (“tax shelters”). However, these steps toward greater efficiency, simplicity, and transparency have been largely undone over the past decade, reflecting steps taken to consolidate the fiscal position, or the introduction of new tax incentives to promote specific economic or social objectives. This paper reviews economic considerations arising from three possible approaches to reform that are commonly proposed: simplification of the income tax system along the lines of the 1986 tax reform; a shift from income to consumption taxation via a value-added tax; and a flat income tax.

2. Compliance costs under the current income tax are estimated to be substantial owing in large part to the system’s complexity. Such costs include the value of personal time spent on tax matters and expenditures on tax planning and preparation services. Slemrod and Bakija (1996) estimate that the personal and corporate income tax systems impose a compliance cost of about $75 billion (1 percent of GDP or just under 10 cents per dollar raised). They estimate that the total compliance cost of the personal income tax was $50 billion in 1995, based on an estimate of $42 billion for the value of time spent complying with tax rules and $8 billion in direct expenditures, such as payments to tax preparers. For the corporate income tax, they calculate that the value of time spent in tax compliance amounted to $20 billion plus an additional $5 billion to account for the administrative costs of the Internal Revenue Service (IRS).

3. Complexity and nontransparency of the income tax system also give rise to, and may result from, rent-seeking activities.3 Because complexity and nontransparency tend to facilitate successful lobbying by interest groups, the current tax system imposes higher rent-seeking costs than would be associated with a simpler, more transparent system. Indeed, every time the tax code undergoes a revision that favors an interest group, a signal is sent out that the tax code is up for renegotiation which, in turn, can be expected to stimulate further rent-seeking behavior. A credible commitment to maintain a simple and transparent tax system would help to contain rent seeking by reducing its expected payoff.

4. In addition to the issues that arise from the complexity of the tax system, the income tax creates a saving disincentive by subjecting investment income to the personal income tax, which effectively increases the relative price of future consumption by reducing the return to saving. The tax also does not adjust the measurement of capital income for inflation, which has the effect of raising effective marginal tax rates applied to real capital income. Moreover, corporate income taxation can exacerbate the disincentive to save by reducing the return to investment. In attempting to measure the costs imposed by these factors, however, it is important to note that the effect of changes in the net-of-tax return to saving on total saving is theoretically ambiguous because of income and substitution effects that work in opposite directions. While many economists believe that the tax system imposes a serious cost by discouraging saving, empirical studies generally have been unable to establish a strong link between saving behavior and changes in after-tax rates of return.4

A. Simplification of the Current Income Tax System

5. Modifying the present income tax system without changing its basic structure could substantially reduce compliance costs and reduce the disincentives to save. Such revisions, along the lines of the 1986 reform, would focus on reducing marginal tax rates and broadening the tax base through the elimination of deductions and credits.5 The cost of eliminating deductions and credits, however, may be a rise in inequity between rich and poor (vertical equity) and across individuals with similar incomes (horizontal equity). One reason for the existence of many deductions and credits is that they might, in principle, make the tax system fairer by adapting it to the particular needs and circumstances of individuals. Such equity considerations might be better addressed through government spending programs rather than indirectly through the tax system.

6. Altig et al (1997) use a general equilibrium model to calculate the likely economic effects of reforming the income tax in a way that produces a “clean base,” by eliminating many of the existing deductions and credits and taxing wage and capital income at a single (uniform) rate.6 They find that making these improvements to the current tax system could raise the long-run level of output by 5 percent and increase both labor supply and the capital stock. The results of their simulations show, however, that reform of this type leaves lower-income groups worse off, as these groups tend to benefit more from the system of deductions and credits under the current system.

B. Shifting to Consumption-Based Taxes

7. Alternatively, the federal tax base in the United States might be shifted from income to consumption, and thereby eliminate saving disincentives associated with the income tax, by switching to a value-added tax.7 A broad-based VAT with a single rate would achieve a high degree of efficiency and simplicity. Nevertheless, as a practical matter, the United States would have to adopt a federal VAT in the context of an array of state and local retail sales taxes.8 These retail sales taxes vary extensively by rates, exempt traders (e.g., certain service providers, charitable, religious, and educational institutions), and exempt or zero-rated items. The imposition of a federal VAT on top of state and local retail sales taxes could result in relatively high compliance costs. Traders would face separate registration requirements, separate tax forms with some items taxed only under state retail sales taxes and others taxed only under the federal VAT, multiple tax rates (owing to differences across local, state and federal rates, and within each system), different rules for settlement with the tax authorities, and the like. The resulting complexity of the overall tax scheme and the associated compliance burden would seriously undermine a principle strength of the VAT.9 In principle, this problem could be overcome by harmonization of state and local retail sales taxes and the federal VAT, so that each would cover the same set of goods and services, include the same exemptions (if any), and apply the same rates. However, harmonization is not likely to be a realistic option. Retail sales taxes are a major source of revenue for state and local governments and they would be expected to resist strongly the loss in sovereignty that harmonization would entail.10

8. Replacing the income tax system with a VAT would likely result in a significant reduction in the overall progressivity of the federal tax system. A uniform VAT applied to all goods and services with no exemptions or zero-rated items is not a progressive tax, and indeed is regressive if higher-income households are net savers and/or lower-income households are net borrowers. Attempts to achieve progressivity through exemptions, zero-rated items (e.g., food, clothing, and footwear), and multiple rates would cause significantly greater complexity, higher administrative costs, tax evasion, and distorted relative prices, in part defeating the purpose of introducing the VAT in the first place.

9. Moreover, the imposition of a VAT, because it would be fully reflected in retail prices, implies that accumulated financial assets would be subject to full federal taxation for a second time, since under the current tax system the portion of income that is saved has already been subject to taxation. Thus, those households that elected to save under the current system would be penalized relative to similarly situated households that chose not to save. This problem could in principle be alleviated through a system of VAT rebates to compensate households with accumulated financial assets during a transition period.11 However, this solution would significantly complicate tax administration and create new opportunities for evasion. It might also raise objections on equity grounds because it implies favorable treatment for wealthy households.

C. A Flat Income Tax

10. A flat income tax, along the lines proposed by Hall and Rabushka (1995),12 offers a way of reforming the income tax system that would provide the benefits of a consumption-based tax system, while avoiding the problems involved in trying to harmonize a federal VAT with state and local retail sales taxes.13 Specifically, the Hall-Rabushka approach attains the simplicity and efficiency of a clean VAT without the problem of regressivity and without penalizing past savers. In the Hall-Rabushka system, the tax base for business income is sales revenue less payments to all suppliers (both of intermediate inputs and capital goods), workers, and retirees. All wages, salaries, and pensions are then taxed directly at the household level at the same flat rate as that applied to businesses with no deductions or special tax credits. While there is no deduction for household saving, saving is effectively eliminated from the tax base since all capital expenditures by businesses are fully expensed. Progressivity in the application of this flat tax is achieved without appreciably complicating the tax system by establishing a “family allowance” and taxing only income that exceeds this threshold.14 However, the extent to which progressivity under the Hall-Rabushka flat tax can be adjusted to suit alternative views of fairness, without undermining the system, is limited to what can be achieved by changing the family allowance and/or the flat tax rate. Attempting to increase progressivity by introducing graduated rates is not recommended because it would significantly undermine the efficiency and simplicity of the system.15

11. Unlike the VAT, the Hall-Rabushka flat tax does not raise the transitional equity problem associated with the taxation of the existing stock of financial wealth because it captures only the flow of consumption from current income. Adoption of a Hall-Rabushka flat tax does, however, raise a number of transitional issues. Among these, capital gains that were unrealized during the pre-reform period would remain free of taxes after the adoption of the tax. A significant transitional equity issue also would be raised by the elimination of the household mortgage interest deduction which would entail a significant rise in taxes paid by mortgage holders and a potential decline in the value of real estate.16 Moreover, difficult transition problems could arise in conjunction with the change in corporate taxation. Firms are likely to demand transition rules for the phase-out of existing tax credits and exemptions, although this tendency might be mitigated by the right to expense capital expenditures fully under the Hall-Rabushka plan. It seems likely that the transition from the current income tax system to a flat tax would be complex and drawn out, diminishing the advantages of shifting to the system and potentially raising a barrier to its enactment.

List of References

  • Altig, David, et al., 1997, “Simulating U.S. Tax Reform,” National Bureau of Economic Research: Cambridge, Working Paper No. 6248 (October).

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  • Bernheim, Douglas, 1996, “Rethinking Saving Incentives,” in Fiscal Policy: Lessons From Economic Research, edited by Alan Auerbach, MIT Press: Cambridge.

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  • Hall, Robert E. and Alvin Rabushka, 1995, The Flat Tax, Hoover Institution Press, Stanford University: Stanford, California (second edition).

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  • International Monetary Fund, 1995, Tax Policy Handbook, Fiscal Affairs Department, Washington D.C.

  • McLure, Charles E., 1987a, The Value-Added Tax: Key to Deficit Reduction? American Enterprise Institute for Public Policy Research, Washington D.C.

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  • Shah, Saurin and Christopher Towe, 1995, “A U.S. Valued-Added Tax—A Review of the Issues,” IMF Paper on Policy Analysis and Assessment (PPAA/95/8) (June).

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  • Slemrod, Joel and Jon Bakija, 1996, “Taxing Ourselves: A Citizen’s Guide to the Great Debate Over Tax Reform,” The-MIT Press: Cambridge.

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  • Tait, Alan A., 1988, Value-Added Tax: International Practice and Problems, International Monetary Fund, Washington, D.C.


Prepared by Michael Leidy and Stephen Tokarick.


In recognition of the complexity of the income tax system, the U.S. House of Representatives in June 1998 passed the Tax Code Termination Act which would sunset the entire income tax code by 2003, but only if Congress has acted by then to adopt a new system.


“Rent seeking” refers to the activities of interest groups to influence legislation (or political directives) supportive of member incomes.


Bernheim (1996) surveys of a number of studies that examine this issue.


One obstacle to tax reform is that many of the provisions in the existing tax code have been capitalized into asset prices (e.g., the mortgage interest deduction) and cannot be removed without inflicting serious losses.


The simulations hold government spending and revenues constant. Tax rates fall as the base is widened.


For reviews of the literature on value-added taxes see IMF (1995). Tait (1988) and Shah and Towe (1995) present a brief history of recent VAT proposals in the United States.


Currently, only Alaska, Delaware, Montana, New Hampshire, and Oregon have no general broad-based retail sales taxes in place.


McLure (1987a, p. 154) concludes that a joint system of independent state retail sales taxes and a federal VAT should be eliminated from serious consideration.


The case of Canada is instructive in this regard, where efforts to harmonize provincial sales taxes with the federal VAT (the goods and services tax) have resulted so far in just three provinces reaching agreement.


Alternatively, Slemrod and Bakija (1996, p. 82–83) in describing such “transitional equity” problems, suggest that elderly people (the group with the most accumulated financial assets) might be granted an exemption from the sales tax, perhaps by way of an elderly “exemption card.” They point out, however, that “the elderly exemption card would be valuable indeed. One can imagine making sure your elderly parents buy your next car for you …”


Hall and Rabushka are senior fellows at Stanford University’s Hoover Institution, and Hall is also a professor of economics at Stanford.


The Hall-Rabushka flat tax is in fact equivalent to a pure consumption tax with one rate, and no exemptions or zero-rated items. As Hall and Rabushka (1995, p. 70) explain, “a tax on income with an exemption for saving is in effect a tax on consumption.” McLure (1987, p. 89) observes more specifically that the Hall-Rabushka flat tax is “a particularly ingenious version of the naive subtraction-method VAT.”


Under Hall and Rabushka’s 1995 proposal, a 19 percent flat tax combined with a family allowance of $25,500 for a family of four was estimated to achieve a revenue-neutral replacement of the current system of individual and corporate income taxes.


Hall and Rabushka (1995, p. 60) point out that taxation of business income at the source is merely a means of taxing income that accrues to the owners of businesses. Taxing business income at the source, however, has the advantage of greater simplicity and reduced opportunities for leakage through tax evasion, since there are far fewer businesses to monitor than households with business-related income. It is possible to tax the business income that ultimately accrues to households at the source under the Hall-Rabushka system because only one rate applies, the common flat tax. A system of graduated rates, on the other hand, would require that business income be taxed at the destination (since the tax rate would be destination specific), with all of the implied complexity, tax administration and enforcement costs, and greater leakage from the tax base associated with destination-based taxation.


In 1997, the deductibility of mortgage interest on owner-occupied homes was the single largest tax expenditure totaling $49 billion (0.6 percent of GDP).