Amid the academic debate about whether a tax based on consumption or income is superior, it has long been recognized that the U.S. federal tax system is in reality a hybrid of an income and consumption tax, with some elements that do not fit naturally into either system. In recent decades, tax-law changes that altered the nature of the hybrid were generally not discussed as part of a plan to establish either a pure income tax or a pure consumption tax, but as attempts to establish a “level playing field” or to improve “incentives to save.” As of 2003, the outline of an explicit plan to move toward a consumption tax is emerging. Under the original Bush administration proposals in 2003, dividends would become taxexempt if corporate tax had been paid on the earnings supporting the dividends, and a new tax-exempt Lifetime Savings Account, with no restrictions on use, would be created. The proposed expansion of tax-exempt savings accounts was not passed, although it will likely be reintroduced in some form. What did become law were two provisions to expand expensing of qualified property: (i) an increase in the fraction of equipment investment that can be immediately written off from 30 percent (which became law in 2002) to 50 percent, and (ii) an increase through 2005 of the limit on the expensing of new depreciable assets by small businesses allowed under IRC Section 179. The 2003 tax law also reduced the rate of tax on dividends and realized capital gains received by an individual shareholder to be no more than 15 percent, compared to a top rate on “ordinary” income of 35 percent. The acceleration of depreciation, the reduction of personal tax on dividends, and an expansion of tax-favored savings accounts can be seen as part of a strategy to shift the tax base from income to consumption. If the ultimate destination of this set of tax reforms is a consumption tax base, then the most glaring omission from the discussion to date concerns interest deductibility. The continuation of interest deductibility, in spite of other moves toward a consumption tax base, raises two issues. The first is that interest deductibility plus expensing for businesses, plus exemption of financial returns of individuals produces not a zero tax on capital income, as under a consumption tax, but rather a subsidy. The second is that this tax structure allows a range of tax arbitrage opportunities among individuals and across corporations and individuals. For example, even under pre-2002 tax law, when high-tax-bracket investors borrowed from those in low (or zero) tax brackets they generated an arbitrage gain equal to the difference between the tax rates. Reducing the tax rate on interest income, but not interest deductions, to zero vastly expands this opportunity. These tax arbitrage opportunities reduce tax revenue without necessarily providing * Gordon: Department of Economics, University of California–San Diego, 9500 Gilman Drive, La Jolla, CA 92093 (e-mail:
[email protected]); Kalambokidis: Department of Applied Economics, University of Minnesota, 217f Classroom-Office Building, 1994 Buford Avenue, St. Paul, MN 55108-6040 (e-mail:
[email protected]); Rohaly: Urban Institute, 2100 M Street N.W., Washington, DC 20037 (e-mail:
[email protected]); Slemrod: Office of Tax Policy Research, University of Michigan, 701 Tappan Street, Rm. A2120, Ann Arbor, MI 48109-1234 (e-mail:
[email protected]). 1 The Tax Reform Act of 1986, which in many ways moved the definition of taxable income closer to economic income, may be an exception (see Charles E. McLure, Jr., 1988). 2 Jonathan Weisman (2003) reported that the Bush administration was debating whether to push “a plan for stealth tax reform in ‘five easy pieces’—lower marginal income tax rates, including capital gains tax rates; eliminate taxes on dividends; accelerate the speed with which businesses can write investment expenses off their tax bills [ultimately to the point of 100 percent first-year expensing of business capital investment]; expand the Roth individual retirement account to all personal saving; and exclude export and other foreign trade income of American companies from taxation.”