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Digitized from Box 35 of the James M. Cannon Files at the Gerald R. Ford Presidential Library
GERALD
Chapter 5. Transition Rules Under Basic Tax Reform
1.
Introduction
2.
Wealth Changes and Their Equity Aspects
3.
Instruments for Ameliorating Transition Problems
4.
Proposed Solutions to Selected Problems in
the Transition to an Accretion Tax
5.
Transition to a Cash Flow Tax System
Chapter 5
TRANSITION RULES UNDER BASIC TAX REFORM
1. Introduction
Major changes in the tax code such as would accompany a
switch to either an accretion or cash flow base may lead to
substantial and sudden changes in current wealth and future
after-tax income flows for some individuals. Transition
rules need to be designed to minimize unfair losses, or
undeserved windfalls, to individuals whose investment decisions
were influenced by the provisions of the existing code.
This chapter discusses the major issues in transition
and proposes transition rules for both the comprehensive
income tax and the cash flow tax. Section 2 outlines the
major wealth changes that can be expected under a switch to
either a comprehensive accretion income tax or a compre-
ehensive cash flow tax, and discusses the relevant equity
criteria to be applied in the design of transition rules.
In Section 3, instruments for amelioration of transition
problems, including phasing-in provisions of the new law and
grandfathering, or exempting, existing assets from the new
rules are discussed. The effects of applying these transition
instruments to different types of changes in the tax law are
outlined. Section 4 presents a series of specific proposals
5-2
for transition rules to be applied to changes in the tax law
that would result from adoption of the accretion tax proposal
in Chapter 3. Finally, in Section 5, special problems of
transition to a cash flow tax are discussed and a plan is
presented for transition to the cash flow proposal in
Chapter 4.
2. Wealth Changes and Their Equity Aspects
Two separate problems requiring special transition
rules can be identified: carryover and price changes.
Carryover problems would occur to the extent that changes in
the tax code affect the taxation of income earned in the
past but not yet subject to tax or, conversely, income taxed
in the past that may be subject to a second tax. Price
changes would occur in those instances where changes in the
tax code alter the expected flow of after tax income from
existing investments in the future.
Carryover Problems
Under the present tax system, income is not always
taxed at the time it is earned. For example, accretion that
occurs in the form of capital gains is not taxed prior to
realization. A change in the tax rate on realized capital
gains, therefore, would alter the tax liability on gains
accrued but not realized before the effective date of the
tax reform. Application of the new rules to past capital
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gains would either raise or lower the applicable tax on that
portion of past income, depending on whether the increase in
tax from including all capital gains in the income base
exceeded the reduction in tax caused by any allowance of
a basis adjustment for inflation.
The problem of changes in the timing of tax liability
is especially severe if the current tax system is changed to
a consumption base. Under a consumption base, purchases of
capital assets are tax deductible and sales of capital
assets that are not reinvested are fully taxable. Under the
current tax system, both the income used to purchase capital
assets and the capital gain are subject to tax, the latter,
however, at a reduced rate. Recovery of the original
investment is not taxed. An immediate change to a con-
sumption base would penalize individuals who have saved in
the past and who are currently selling assets for consumption
purposes. Having already paid a tax on the income used to
purchase the asset under the old rules, they would also be
required to pay an additional tax on the entire proceeds
from the sale of the asset. On the other hand, if owners of
capital assets are allowed to treat those assets as tax-
prepaid, they would receive a gain to the extent they plan
to use them for future consumption or bequest. Income on
past accumulated wealth would then be free from future
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taxes, and the government would have to make up the difference
by raising the tax rate on the remaining consumption regarded
as non-pre-taxed.
Other carryover problems include excess deductions or
credits unused in previous years and similar special tech-
nical features of the tax law. In general, carryover can be
viewed as being conceptually separate from changes in the
price of assets. In the case of capital gains tax, for
example, the change in tax liability to an individual for
past accrued earnings does not affect the tax liability of
another individual purchasing an asset from him; in general,
the asset price depends only on future net-of-tax earnings.
However, the new tax law and the transition rules, by
altering future net-of-tax earnings, would change the price
of capital assets.
In most cases, carryover problems could be handled by
special rules that define the amount of income earned but
not realized before the effective date of implementation of
the new law. Changes in the definition of an individual's
past income will alter asset prices only if they provide an
incentive for pre-effective date sales of existing assets.
For example, if, under the new system, past capital gains
are taxed at a higher rate than under the old system, an
incentive may be created for sales of assets prior to the
effective date.
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Price Changes
Adoption of a broadly based tax system would change
prices of some assets by changing the taxation of future
earnings. Under an accretion base system, for example, the
following changes in the tax code would alter tax rates on
income from existing assets: integration of the corporate
and personal income taxes; taxation of all realized capital
gains at the full rate; adjustment of capital taxation for
inflation losses; inclusion of interest on State and local
government bonds in the tax base; elimination of accelerated
depreciation provisions that lower the effective rate of tax
on income arising in special sectors, including minerals
extraction, real estate, and some agricultural activities;
and elimination of the deductibility of property taxes by
homeowners. Adoption of these and other changes in the tax
code would change both the average rate of tax on income
from all assets and the relative rates imposed among types
of financial claims, legal entities, and investments in
different industries.
The effects of changes in taxation on asset values
differ for changes in the average level of taxation of the
associated returns and changes in the relative rates of tax
on different assets. A change in the average rate of taxation
on all income from investment, while it will affect the
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future net return from wealth or accumulated past earnings,
is not likely in itself to change individual asset prices
significantly. For any single asset, a change in the average
rate of taxation of returns would reduce net after-tax
earnings roughly in proportion to the reduction in net
after-tax earnings on alternative assets. Thus, the market
value of the asset, which is equal to the ratio of returns
net of depreciation to the interest rate (after tax), will
not tend to change. On the other hand, an increase in the
relative rate of taxation on any single asset generally will
lead to a fall in the price of that asset, because net
after-tax earnings will fall relative to the interest rate.
The opposite holds for a decrease in the relative rate of
taxation.
The behavior of the price of any single asset in
response to a change in the relative rate of taxation of its
returns depends on the characteristics of the asset and the
nature of the financial claim to it. For example, suppose
the asset is a share in an apartment project. In the long
run, the price of the asset will depend on the costs of
building apartments; if unit construction costs are inde-
pendent of volume, they will not be altered by changes in
the tax rate on real estate profits. Now, suppose the
effective rate of tax on profits from real estate is increased.
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The increase in tax will drive down the after-tax rents
received by owners; as the value of the asset to buyers
depends on the stream of annual after-tax profits, the price
a purchaser is willing to pay also will fall. With the
price of the structure now lower than the cost of production,
apartment construction will decline, making rental housing
more scarce and driving up the before-tax rentals charged to
tenants. In final equilibrium, the before-tax rentals will
have risen sufficiently to restore after-tax profits to a
level at which the price buyers are willing to offer for
the asset is again equal to its cost of production.
Thus, the immediate effect of the tax is to lower the
price of equity claims to real estate. The wealth loss to
owners of those shares at the time of the tax change depends
both on the time period required for adjustment to final
equilibrium and the extent to which future increases in the
gross rentals (from the decline in housing supply) are
anticipated in the market place. The faster the adjustment
to equilibrium and the larger the percent of gross rentals
change that is anticipated, the smaller the fall in asset
price will be for any given increase in the tax on the
returns.
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If the asset is a claim to a fixed stream of future
payments (e.g., a bond), a change in the rate of taxation
will alter its price by lowering the present value of the
future return flow. For example, if interest from municipal
bonds becomes subject to tax, the net after-tax earnings of
holders of municipal bonds will fall, lowering the value of
those claims. New purchasers of municipal bonds will demand
an after-tax rate of return on their investment comparable
to the after-tax return on other assets of similar risk and
liquidity. The proportional decline in value for a given
tax change will be greater for bonds with a longer time to
maturity.
The effect of corporate integration on the price of
assets is less certain. Viewing the corporate income tax as
a tax on the earnings of corporate equity shareholders,
integration will increase the rate of tax on income from
investment of high bracket shareholders and lower the rate
of tax on such income of low bracket shareholders. 1/ In
addition, many assets owned by corporations also can be used
in the noncorporate sector. To the extent that relative tax
rates on income arising in the two sectors are altered by
integration, those assets can easily move from one sector to
the other, changing relative before-tax earnings and output
prices in the two sectors, but keeping relative after-tax
earnings and asset prices the same.
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In conclusion, raising the relative tax on capital
income in industries and for types of claims currently
receiving relatively favorable tax treatment is likely to
cause some changes in asset prices. Immediate asset price
changes generally will be greater for long-term fixed claims,
such as State and local bonds, than for equity investments;
greater for assets specific to a given industry (e.g.,
apartment buildings) than for assets that can be shifted
among industries; and greater for assets whose supply can
only be altered slowly (e.g., buildings and some mineral
investments) than for those the supply of which can be
changed quickly.
The effect of integration on capital values is not
likely to be large. On the other hand, changes in the
special tax treatment currently afforded in certain in-
dustries, for example in real estate and in mineral resources,
and changes in the treatment of State and local bond interest
are likely to cause significant changes in asset values.
Equity
Considerations of equity associated with changes in tax
laws are different from equity considerations associated
with the overall design of a tax system. Changes in the tax
code create potential inequities to the extent that indi-
viduals who made commitments in response to provisions of
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the existing law suffer windfall losses (or receive windfall
gains) as a result of the change. These gains (and losses)
can be of two types: (1) wealth changes to individuals
resulting from changes in tax liabilities on income accrued
in the past but not yet recognized for tax purposes, and (2)
changes in the price of assets or the value of employment
contracts brought about by changes in future after-tax
earnings. These two types of problems, carryover and price
change, pose somewhat different equity issues.
Carryover poses the problem of how to tax equitably
income earned while a different set of tax laws was in
effect. For example, consider one aspect of the proposed
change in the tax treatment of corporations under the
accretion income tax. Presently, capital gains are subject
to lower tax rates than dividends, especially when realization
is deferred for long periods of time. Individuals owning
shares of corporations paying high dividend rates relative
to total earnings pay more tax than individuals owning
shares of corporations with low dividends relative to total
earnings. As both tpyes of investments are available to
everyone, individuals purchasing shares in high-dividend
corporations presumably are receiving something (possibly
less risk or more liquidity) in exchange for the higher tax
5-11
liability they had to assume. To subject the shareholders
of low-dividend corporations to the same rate of tax on
income accumulated in the form of capital gains prior to the
effective date as they would have paid had the earnings been
distributed would be unfair.
Carryover poses another equity problem: some taxpayers
may be assessed at unusually high or low rates on past
income because of changes in the timing of accrual of tax
liability. The above example can be used to illustrate this
point too. Under current law, the special tax treatment of
capital gains in part compensates shareholders for the extra
tax on their income at the corporate level. Under integration,
the separate corporate income tax would be eliminated but
shareholders would be required to pay a full tax on their
attributed share of the corporation's income, whether or not
distributed. Now, suppose integration is introduced and a
shareholder has to pay the full tax on appreciation of his
shares which occurred before the effective date.
The
taxpayer is, in effect, being too heavily taxed on that
income as it was subject to taxation at the corporate level
before being taxed at the full individual income tax rate.
Before integration, he would in effect have paid the corporate
tax plus the reduced capital gains rate; after integration,
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he would be liable for the full tax rate on ordinary income.
However, in the absence of transition rules, he is in fact
subject to a higher tax on income which accrued before but
not recognized until after the effective date of the new
law.
The most desirable solution to the problem of equity
raised by carryover is to design a set of transition rules
that insure that, to the maximum extent consistent with
other objectives, tax liabilities on income earned before
the effective date are computed according to the old law and
tax liabilities on income earned after the effective date
are computed according to the new law.
Changes in future after-tax income brought about by tax
reform raise a different set of equity issues. A radical
tax reform that is to a large extent unexpected will cause
capital losses to owners of assets in previously tax-favored
sectors. Imposition of such capital losses may be viewed as
unfair, especially since past government policy explicitly
encouraged investment in those assets. For example, if two
individuals in a given tax bracket are indifferent between
holding subsidized State and local bonds and unsubsidized
Treasury bonds before the tax change, it seems reasonable to
compensate the holder of State and local bonds for the loss
suffered upon removal of the subsidy so that he ends up in
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the same position as the holder of Treasury bonds. Note
that this concept of distributive justice does not imply
that a third taxpayer, who earns higher after-tax income
from tax-free bonds than from Treasury bonds because he is
in a higher tax bracket than the other two, should retain
the privilege of earning tax-free interest. Equity does not
require that the tax system maintain loopholes; it does
require some limitation on wealth losses imposed on individuals
because they took advantage of legal tax incentives.
The counterargument to the view that compensation for
such wealth changes is required by principles of justice is that
all changes in public policy alter the relative incomes of
individuals and frequently asset values. For example, a
government decision to reduce the defense budget will lower
relative asset prices in defense companies and their principal
supplying firms and also lower relative wages of individuals
with skills specialized to defense activities (e.g., many
engineers and physicists). Although some special adjustment
assistance programs exist, it is not common practice to
compensate individuals for changes in the value of physical
and human assets caused by changes in government policies.
In addition, it can be argued that, because investors in
tax-favored industries know that the tax subsidy may end,
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the risk of a public policy change is reflected in asset
prices and rates of return. If, for example, it is believed
that the continuing debate over ending remaining special
tax treatment of the oil industry assets poses a real
threat, it can be argued that investors in oil are already
receiving a risk premium in the form of higher than normal
net after-tax returns, and further compensation for capital
losses upon end of the subsidy is unwarranted.
The discussion above suggests that cases can be made
both for and against compensation of individuals for capital
losses caused by radical changes in tax policy. As the
capital value changes resulting from the tax change alone
are virtually impossible to measure precisely, designing a
method to determine the appropriate amount of compensation
would be difficult on both theoretical and practical grounds.
However, it would be desirable to design transition rules so
that capital losses and windfall gains resulting from
adoption of a comprehensive tax base would be moderated to
some degree. Two possible design features, grandfathering
existing assets and phasing in the new rules slowly, are
discussed in section 3.
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3. Instruments for Ameliorating Transition Problems
The main criteria that transition rules should satisfy
are: (1) simplicity, (2) minimizing incentive problems, and
(3) minimizing undesirable wealth effects.
Simplicity. The transition rules in themselves should
not introduce any major new complexity in the tax law. To
the extent possible, transition rules should not require
that corporations or individuals supply additional data on
financial transactions or asset values.
Minimizing Incentive Problems. The transition rules
should be designed to minimize the probability of action in
response to special features of the change from one set of
tax rules to another. In particular, there should not be
special inducements to either buy or sell particular kinds
of assets just before or after the effective date of the new
law.
Minimizing Undesirable Wealth Effects. Transition
rules should moderate wealth losses to individuals holding
assets that lose their tax advantages under basic tax reform
as well as gains to those whose assets are relatively favored.
At the same time, special transition rules to protect asset
from loss holders should not give them the opportunity to
earn windfall gains.
5-16
Alternatives
Two alternative methods of reducing capital value
changes are discussed here: grandfathering existing assets
and phasing in the new law.
Grandfathering. The grandfather clause was originally
used by some southern States as a method for disfranchising
black voters following the Civil War. It exempted from the
high literacy and property qualifications only those voters
or their lineal descendants who had voted before 1867. More
recently, grandfather clauses have been used to exempt
present holders of positions from new laws applicable to
those positions, e.g., setting a mandatory age of retire-
ment. In the context of tax reform, a grandfather clause
could be used either to exempt existing assets from the new
law as long as they are held by the current owner or to
exempt existing assets from the new law regardless of who
holds them. A grandfather clause also could be applied to
capital gains accrued but not yet realized at the time the
new law went into effect.
Consider, for example, the effect of eliminating the
special depreciation rules that result in a low rate of tax
on income arising from real estate investments. A grand-
father clause that exempted existing buildings only as long
as they are held by the current owner (s) would mean that
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current owners could depreciate their buildings to zero
according to the old rules, but that new owners could not do
the same. Grandfathering the buildings independently of
their owners would allow subsequent purchasers to depreciate
according to the old rules. This would have the effect
of raising the value of the buildings. Elimination of tax-
incentives in real estate would discourage new construction,
reducing the supply of housing and raising gross rentals
before tax. Thus, grandfathering, by making existing
property more valuable, would give a windfall gain to
investors in real estate tax shelters. On the other hand,
grandfathering the buildings only for current owners would
not prevent a wealth loss to real estate investors because
the value to new buyers would decline. The loss would be
mititgated by the anticipated increase in after-tax profits
to current investors (because of the decline in housing
supply).
Grandfathering existing buildings unconditionally
would be simpler than grandfathering them only as long as
they are owned by their existing owners. The new law could
be made to apply only to ownership of buildings constructed
after a certain effective date; proof of the date of purchase
would not be required.
5-18
The effect of grandfathering on asset prices for fixed-
interest securities, is less certain. For example, if
existing municipal bonds are grandfathered, annual interest
received net of tax will be unchanged. However, the value
of the tax saving from owning municipal bonds will change
for two reasons. First, there will be no new tax-exempt
municipal bond issues under the new rules; with fewer
available tax-exempt bonds, the marginal bracket of the
buyer who is indifferent between tax exempt and other securities
will rise, driving up the price of the tax exempt securities.
Second, the other changes in the tax system would probably
lower all marginal tax rates by widening the base, thereby
reducing the tax advantage and the price of tax-exempt
securities. It is not clear in what direction the price of
the grandfathered securities would change, though the price
change is likely to be much smaller than the price change if
the new rules were immediately adopted for all tax-exempt
securities.
The main danger of grandfathering is that it can
provide a windfall gain to current owners of assets subject
to favorable tax treatment. These owners would receive a
gain because the new tax law would reduce the supply of
previously favored assets, thus raising before-tax profits.
5-19
Grandfathering probably should be limited to cases
where gross returns are not likely to be altered signi-
ficantly by the tax. For example, changes in the tax
treatment of pensions are not likely to affect before-tax
labor compensation significantly, assuming the supply of
labor to the economy is relatively fixed. While grand-
fathering tax treatment of pensions in current employment
contracts is not likely to raise significantly the value of
those contracts relative to their value under the old law,
an immediate shift to the new law would reduce the value of
previously negotiated pension rights.
Phasing In. An alternative method of avoiding drastic
changes in capital values is to introduce the new rules
gradually. For example, taxation of interest on currently
tax-exempt State and local bonds can be introduced slowly by
including an additional 10 percent of interest in the tax
base every year for 10 years. Phasing in the new rules
would not alter the direction of capital value changes, but
it would reduce their magnitude by delaying tax liability
changes and making them occur more slowly.
5-20
Assuming that the market incentives under the new law
are preferable to the incentives under the current law,
phasing in poses a distinct disadvantage. Phasing in delays
application of the new rules, thus reducing the present
value of the economic changes that would be encouraged.
The length of the phase-in period would depend on the
desired balance of the gains from changing the tax system
against the costs of imposing capital value changes on some
investors.
Combination of Phase in and Grandfathering. A possible
variant of the two approaches outlined above is to adopt the
new rules immediately for new assets, while phasing in the
new rules for existing assets. In many cases, grandfathering
existing asests when new assets are taxed more heavily under
the new tax law will raise the market price of the old
assets. By phasing in the new rule for the old assets, it
is possible to moderate the increase in present value of
future tax liabilities, while at the same time the immediate
effects on supply of new assets are raising before tax
returns. The two effects may roughly cancel out, leaving
asset prices almost the same throughout the early transition
period. For example, a gradual introduction of new, and
more appropriate, depreciation schedules for existing residential
real
estate with a concurrent adoption of the new rules
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for new buildings, would have the same incentive effects on
new buildings as immediate adoption of the new law. Before-
tax rentals on existing real estate would rise gradually, as
supply growth is reduced, while tax liabilities on existing
real estate also would rise. It is likely that, for an
appropriate phase-in period, the asset value change to
existing owners will be small. However, tax shelters on new
construction will be totally eliminated immediately.
4. Proposed Solutions to Selected Problems in the
Transition to an Accretion Tax
As described in Chapter 3, a change over to an accretion
income tax system would have significant impact on the
taxation of capital gains, corporate income, business and
investment income, and personal income. The following
discussion examines the problems that these changes present
for transition. In most cases possible solutions to these
problems are suggested.
Capital Gains
Under an accretion income tax system, the deduction and
alternative tax with respect to capital gains will be
discontinued. The transition mechanism proposed is to allow
capital gains (or losses) that have accrued as of the
general effective date of the proposal to continue to
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qualify for capital gains treatment upon a sale or other
taxable disposition for 10 years following such date. This
"capital gain account" inherent in each capital asset could
be determined in either of two ways:
(1) By actual valuation on the general effective date
of enactment of the proposal (or on an elective alternative
valuation date to avoid temporary distortions in market
value) , or
(2) By regarding the gain (or loss) recognized on a
sale or exchange of the asset as having accrued ratably
over the period the seller held the asset. The portion of
the gain (or loss) thus regarded as having accrued prior to
the effective date would be taxed at capital gain rates (or
be subject to the limitation on capital losses) provided
that the asset continues to meet the current requirements
for such treatment. Recognition of capital gain (or loss)
on the asset after the effective date will extinguish the
capital gain (or loss) potential of the asset. Thus, gains
on sale or exchange of an asset purchased after the effective
date would not receive any special tax treatment.
A number of technical rules relating to transfers and
subsequent adjustments to basis will have to be provided.
In general, the account should carry over to the transferee
in certain tax-free transfers that refelct a change in the
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transferor's form of ownership of, or interest in, the
asset, such as contributions to a controlled corporation
(under section 351) or partnership (section 721) or a
complete liquidation of certain controlled subsidiaries
(section 332). In the case of a transfer of an asset to a
controlled corporation or partnership, it may be appropriate
to allow the shareholder or partner to elect to transfer the
capital gain account of the asset to his stock or partner-
ship interest, and have the asset lose its capital gain
character in the hands of the corporation or partnership.
Also, in the case of a sale or exchange where the seller is
allowed nonrecognition of gain on the transaction because he
acquires an asset similar to the asset disposed of, the
capital gain account should attach to the newly acquired
asset. For example, if a taxpayer is to be allowed non-
recognition treatment on the sale of a personal residence,
where another residence is acquired within a specified time,
the capital gain account would attach to the new residence.
Rules also will be needed to take into account an
increase or decrease in the basis of the property after the
effective date. An increase in the basis of the property
generally should not decrease the capital gain account,
since the increase in basis generally will be accompanied by
an increase in the fair market value of the asset (for
5-24
example, where a shareholder contributes cash to a corpo-
ration); the increased fair market value due to the increase
in basis will, when recognized, represent a return of the
investment increasing the basis. On the other hand, a
decrease in basis resulting from a deduction against ordinary
income should reduce the capital gain account (i.e., code
sections 1245, 1250, and other recapture provisions currently
in the code that prevent the conversion of ordinary income
into capital gain because of excess depreciation deductions
or other means should continue to apply). The capital gain
account should follow an allocation of the basis of the
asset, such as is required with respect to a nontaxable
stock dividend.
Special rules also would be needed for section 1231
property, since net gains from the sale of such assets
qualify for capital gains treatment. A workable rule
would be to apply section 1231 to assets that are section
1231 assets in the hands of the taxpayer on the general
effective date, and continue to so qualify as of the date of
sale or other taxable disposition. Such property would have
a "section 1231 account" similar to the capital gain account
attaching to each asset. Similar rules relating to transfers,
basis adjustments, etc., also would apply.
5-25
Since a capital asset may be held for an indefinite
period, a cutoff date for capital gains treatment is needed;
otherwise, the complexity of the capital gains provisions in
the code will continue for at least a generation. (Under
the proposal, donors and decedents will be required to
recognize gain or loss on the assets transferred, subject to
certain exceptions, and thus the capital gain account will
not carry over to a doneee or heir.) Accordingly, at the
end of a specified period (say, 10 years), the capital gains
deduction and the alternative tax treatment would expire.
Admittedly, some of the problems described in section 2 of this
chapter will exist if the complete repeal is delayed 10
years as would be present if the capital gain provisions
were completely repealed when the proposal is enacted. The
10-year phase-out period, however, will allow gradual market
adjustments and help protect the interests of investors who
purchased assets in reliance on the current capital gains
provisions.
An alternative to the capital gain account (and section
1231 account) procedure would be to phase out the deduction
for capital gains (and the alternative tax) ratably over a
specified number of years. For example, the 50 percent
deduction for capital gains could be reduced five percentage
points a year, SO that at the end of 10 years the deduction
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would be eliminated. The simplicity of this alternative is
the best argument for its adoption, since no valuation as of
a particular date would be required.
Corporate Integration. Transition problems related to
the foreign area are discussed in Section 11 of Chapter 3
Under an accretion income tax system, corporations will
not be subject to tax. Instead shareholders will be taxable
on their pro-rata share of corporate income or will be
allowed to deduct their pro-rata share of corporate loss.
(See the discussion in section 8 of Chapter 3.)
The most significant transitional problems involve the
question of timing and the treatment of income, deductions,
credits, and accumulated earnings and profits that are
earned or accrued before the effective date of the change-
over to integration, but that would be taken into account
for tax purposes after such date.
Pre-effective Date Retained Earnings
Perhaps the most difficult transitional problem posed
by corporate integration is the treatment of corporate
earnings and profits that are undistributed as of the
effective date of integration. Such earnings would have
been taxed to the shareholders as dividends if distributed
before the effective date, or taxed at capital gains rates
5-27
if recognized by means of sale or exchange of the stock
(provided the stock was a capital asset in the hands of the
seller). Under corporate integration, distributions made by
a corporation to its shareholders will be tax-free to the
extent of the shareholder's basis; distributions in excess
of the shareholder's basis in his stock will be taxable.
However, corporate earnings and profits accumulated before
the effective date but distributed afterward should not be
accorded tax-free treatment: to do so would discriminate
against corporations that distributed (rather than accumulated)
their earnings and profits in pre-integration taxable years.
(In the case of the shareholders who are content to leave
the accumulated earnings and profits in corporate solution,
however, the effect of corporate integration on the income
generated by such earnings may give the same result as if
such earnings had been distributed tax free, since such
income will be taxed directly to the shareholders, without
the interposition of corporate tax, and will then be available
to the shareholders as a tax-free dividend.)
The problem of accumulated earnings can be addressed by
continuing to apply current law to corporate distributions
that are made within 10 years after the effective date of
integration and that (1) are made to persons who held the
shares on such effective date with respect to which the
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distribution is made, and (2) are made out of earnings and
profits accumulated before such date. Thus, a distribution
to such shareholders out of earnings and profits accumulated
by the corporation before the first taxable year to which
corporate integration applies would be a dividend, taxable
as ordinary income, unless the distribution would qualify
for different treatment under current law. For example, a
distribution received pursuant to a redemption of stock that
is not essentially equivalent to a dividend under current
law would be treated as a distribution in part or full
payment in exchange for the stock. On the other hand, an
attempt to bail out the pre-effective date earnings and
profits by means of a partial redemption of stock that would
be treated as a dividend distribuiton under current law
would continue to be SO treated. The provisions of current
law relating to electing small business (subchapter S)
corporations would be helpful as a model in drafting this
particular transition proposal. For purposes of determining
how much of a distribution that is treated as a sale or
exchange under current law would qualify for special capital
gains treatment, the shareholder would have to take into
account the transition rules with respect to repeal of the
capital gains provisions.
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In general, distributions with respect to stock acquired
in a taxable transaction after the effective date would be
subject to the new rules, and would reduce basis and not
constitute income (unless such distributions exceeded the
shareholder's basis). However, in those cases where the
transferee acquired the stock after the effective date
without recognition of gain by the transferor, current law
will continue to apply to distributions from pre-effective
date accumulated earnings and profits.
Distributions after the effective date would be deemed
to be made first from the shareholder's distributable share
of the corporation's post-effective date income and then
from pre-effective date earnings and profits. Distributions
in excess of these amounts would be applied against and
reduce the shareholder's basis in his stock. Amounts in
excess of the shareholder's basis generally would be considered
income.
In order to avoid indefinite retention of such a dual
system of taxation, the special treatment of pre-effective
date earnings and profits would cease after a specified
number of years following the effective date of integration.
Distributions received after such date, regardless of
source, first would be applied against basis and would be
income to the shareholder to the extent they exceed basis.
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Pre-integration accumulated earnings and profits remaining
after this date may not escape taxation completely at the
shareholder level, since such earnings may be reflected in
the gain recognized on a subsequent taxable transfer of the
stock, (such as a sale or a transfer by gift or at death),
or may be taxed as a distribution in excess of basis. Before
fixing the cut-off date for this provision an effort should
be made to determine quantitatively the extent of the benefit
to the shareholders of the deferral of such taxation.
An alternative proposal was considered in an attempt to
preserve the ordinary income character of distributions from
pre-effective date earnings. This proposal would treat a
shareholder as receiving a "deemed dividend" (spread ratably
over a 10-year or longer period) in an amount equal to the
lesser of the excess of the fair market value of the share
of stock as of the effective date over its adjusted basis,
or the share's pro-rata portion of undistributed earnings
and profits as of such date. This proposal was rejected
because of its complexity and because of the likelihood of
substantial liquidity problems for certain shareholders.
Carryovers and Carrybacks
The carryover or carryback of items of income, deduction,
and credit between taxable years to which the corporate
income tax applies, and taxable years to which it does not,
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must be considered for purposes of the transition rules. To
the extent practicable, an attempt should be made to treat
such items in a manner that reflects the impact of the
corporate income tax as in effect when such items are earned
or incurred. In following this approach, however, no
attempt should be made to depart from the general rules
requiring that an item of income or loss be recognized
before it is taken into account in computing gross income.
Accordingly, unrecognized appreciation or decline in value
of corporate assets (or stock of the corporation) attrib-
utable to the pre-effective date period should not be
"triggered" or recognized solely by reason of the shift to
full integration.
In general, certain deductions and credits may carry-
back to a preceding taxable year or carryover to a subse-
quent taxable year because of a limitation on the amount of
such deduction or credit that the taxpayer may claim for the
taxable year in which the deduction is incurred or the
credit earned. Thus, for example, a net operating loss
carryback or carryover arises because the taxpayer's de-
ductions exceed his gross income. Capital loss deductions
are limited to capital gains, deductions for charitable
contributions are limited to a certain percentage of income,
and the investment tax credit is limited to a percentage of
the tax due. Also, the recapture as ordinary income, after
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the effective date, of deductions allowed and other amounts
of income upon which tax has previously been deferred in
pre-effective date years, has the effect of shifting that
income to post-effective date years.
If income sheltered by a deduction (or income that
would have been sheltered had the deduction been utilized in
an earlier year) had been distributed as a taxable dividend,
the net after-tax effect on the shareholder of the deferral
or acceleration of a deduction will vary, depending on his
marginal tax bracket. In general, if the shareholder is in
a lower bracket, he may realize more total after-tax income
if the deduction is utilized at the corporate level in a
pre-effective date year to which the corporate tax applies
and the tax savings at the corporate level is distributed as
a dividend; if the taxpayer is in a higher bracket he may
realize more total after-tax income if the deduction is
utilized in computing his distributable share of taxable
income after integration. In order to best approximate the
net result that would occur if such items could be used in
the year incurred or earned, unused deductions and credits
incurred or earned in pre-effective date years should be
given an unlimited carryback to earlier years of the
corporation. In order to avoid windfalls from receiving
refunds earlier than under current law, interest could be
charged on the refund.
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Deductions that could not be absorbed in pre-effective
date years would be allowed to be carried in full to post-
effective date years, subject to current limits on the
number of succeeding taxable years to which the item may be
carried. In general, however, deductions carried over from
a pre-effective date year should not flow through to the
shareholders, either directly or indirectly, for use in
offsetting the shareholder's income from other sources, but
should be available only as deductions at the corporate
level in order to determine the shareholder's pro-rata share
of corporate income. This will avoid retroactive integration
with respect to such deductions, since the deduction would
not flow through when incurred, and will also avoid possible
abuses by means of trafficking in loss corporations. Ordinary
income upon which tax was deferred in pre-effective years
should continue to be subject to recapture as ordinary
income.
Generally, the carryover to a post-integration year of
a tax credit earned in a pre-effective date taxable year
will result in a windfall for the shareholder. If the
credit had been used to offset corporate income tax in the
year in which it was earned, the amount representing the tax
at the corporate level offset by the credit would have been
taxable to the shareholder, either when distributed as a
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dividend or when realized by means of sale of the stock.
Accordingly, a rule should be devised by which the tax
benefit of a credit carryover approxiamtes the benefit that
would result if the amount of the credit first offset a
hypothetical corporate tax and then was distributed to the
shareholder as a taxable dividend (or, perhaps, realized as
capital gain).
In general, no losses incurred or available credits
earned in post-effective date years will carry back to pre-
effective date years, since such items will flow through to
the shareholders after the effective date of integration.
Under present law, certain taxpayers, such as regulated
investment companies, real estate investment trusts, and
personal holding companies, receive a dividends-paid de-
duction for a taxable year even though the distribution is
actually made in a subsequent year. Such distributions in
post-effective date years should be allowed to relate back
to the extent provided by current law, for the purpose of
determining the corporate tax liability for the appropriate
pre-effective date year. The distribution would be con-
sidered to be out of pre-effective date earnings and profits
(whether or not it exceeds the amount in such account) and
taxable to the shareholders as a dividend from that source.
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Rules will have to be provided to insure that, if an
investment tax credit earned by a corporation in a pre-
effective date taxable year is subject to recapture because
of an early disposition of the property, the credit also is
recaptured, either from the corporation or the shareholders.
This could be accomplished at the corporate level by im-
posing an excise tax on the transfer or other recapture
event in an amount equal to the appropriate income tax
recapture.
Flow-Through of Corporate Capital Gains
During the phase-out period for capital gains, the net
capital gain or net capital loss for taxable years after the
effective date of corporate integration should be computed
at the corporate level with respect to sales or exchanges of
capital assets or section 1231 property by the corporation.
The character of such net capital gain or net capital loss
should be flowed through to the shareholders.
Flow-Through of Tax-Exempt Interest
If the character of capital gains is to flow through to
shareholders, consistency would require that the character
of any remaining tax-exempt interest received or accrued by
a corporation after the effective date of corporate inte-
gration from any State or municipal bonds that are grand-
fathered should also flow through as tax-exempt interest to
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the shareholders. (Since corporate distributions will be
tax-free, the tax-free character of the interest would be
preserved by not reducing the shareholder's basis by the
amount of the distribution attributable to such interest.)
Generally, under present law, State and municipal bond
interest is received tax-free by the corporation but is
taxable as a dividend when distributed to shareholders. The
1976 Tax Reform Act, however, provides that, in certain
cases, the character of tax-exempt interest distributed by a
regulated investment company flows through as tax-exempt
interest to its shareholders. 7/ In the event that it is
determined that the tax-exempt character of State and
municipal bond interest received by all corporations should
not flow-through to shareholders (i.e., that distributions
of such amounts should reduce basis), an exception should be
made for regulated investment companies that have relied on
the flow-through provisions of the 1976 Tax Reform Act.
Unique Corporate Taxpayers
The provisions of the tax code relating to taxation of
insurance companies and other unique corporate taxpayers
will have to be examined to determine what adjustments, if
any, are required to take into account the effect of corporate
integration on the special rules applying to such taxpayers.
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The determination of appropriate transitional rules will
depend on the nature of any changes made to the basic
provisions.
Business and Investment Income, Both Individual and Corporate
In general, the repeal of code provisions that provide
an incentive for certain business-related expenditures or
investments in specific assets should be structured to
minimize the losses to persons who made such expenditures or
investments prior to the effective date of the new law. The
principal technique to effectuate this policy would be to
grandfather actions taken under current law. For example,
any repeal of a tax credit (such as the investment tax
credit) and any requirement that an expenditure that is
currently deductible (such as soil and water conservation
expenditures) must be capitalized should be prospective
only. Subject to the rules prescribed above for cor-
porations, unused tax credits earned in pre-effective date
years should be available as a carryover to taxable years
after the effective date to the extent allowed under current
law. The repeal of special provisions allowing accelerated
amortization or depreciation of certain assets generally
should apply only with respect to expenditures made or
assets placed in service after a specific cutoff date. The
revision of the general depreciation and depletion rules
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should apply to property placed in service, or expenditure
made, after an effective date. Thus, for example, buildings
would continue to be depreciable in the manner prescribed by
current law only in the hands of their current owners. A
taxpayer who acquires a building and places it in service
after the effective date would be subject to the new rules.
Although this could result in capital losses for the current
owners, the grandfathering of the asset itself could,
particularly in the case of buildings, delay the effect of
the new rules for an unacceptable period.
The deduction for local property taxes on personal
residences should be phased out, by allowing deduction of a
percentage of such taxes which declines over a period of
years.
The exclusion from gross income of interest on State
and municipal bonds and certain earnings on life insurance
policies should continue to apply to such interest and
earnings on bonds and insurance policies that are outstanding
as of the effective date.
If the adoption of the accretion income tax system
results in the repeal of certain provisions of current law
that allow the non-recognition of gain (or loss) on sales or
exchanges of particular assets, such repeal should be
effective immediately, with no grandfather clause. It is
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unlikely that the original decision to invest in such assets
depended on an opportunity to make a subsequent tax-free
change in investment. An exception may be appropriate,
however, with respect to a repeal of the provision that
excludes from gross income the value of a building constructed
by a lessee that becomes the property of the lessor upon a
termination of the lease. A grandfather clause should apply
current law to the termination of a lease entered into
before the effective date.
The proposal will allow an adjustment to the basis of
an asset to prevent the taxation of "gain" which is at-
tributable to inflation, and does not reflect an increase in
real value of the asset sold by the taxpayer. The inflation
adjustment should be applied with respect to inflation
occurring in taxable years after the effective date. Making
such an adjustment retroactive would result in a substantial
windfall for taxpayers.
Other Individual Income
Under an accretion income tax system, several kinds of
compensation and other items previously excluded would be
included in gross income, and deductions for a number of
expenditures that can be considered personal in nature would
be disallowed.
Employee Compensation
Such items as earnings on pension plan reserves al-
locable to the employee, certain health and life insurance
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premiums paid by the employer, certain disability benefits,
unemployment benefits, and subsidized compensation would be
included in gross income.
It may be presumed that existing employment contracts
were negotiated on the basis that such items (other than
unemployment compensation) would be excluded from the employee's
gross income, particularly in those cases where the ex-
clusion reflects a policy of encouraging that particular
type of compensation. The inclusion of such items in income
in the absence of special transitional rules could create
cash flow problems or other hardships for employees under
such contracts. For example, a worker who is required to
include in income the amount of his employer's health
insurance plan contribution may have to pay the tax on this
amount from what was previously "take home" pay if he cannot
renegotiate his contract.
This problem can best be solved by an effective date
provision that would apply the new rules to compensation
paid in taxable years beginning after the effective date of
the basic tax reform program. However, the tax-free status
of items paid pursuant to binding employment contracts in
effect on the date of enactment would continue for the life
of the contract or a specified period, such as three years,
whichever is less. The length of this period should reflect
5-41
the general length of industry-wide contracts. Special
rules for military personnel could be devised to grandfather
servicemen through their current enlistment or term of
service. Earnings of a qualified pension plan allocable to
the employee that are attributable to periods before the
effective date would not be included in the gross income of
the employee until such time as they would be included under
present law (i.e., generally, upon distribution to the
employee). Earnings attributable to periods after the
effective date (as extended with respect to binding contracts)
would be included in gross income when paid or accrued. As
under present law, payments from the pension plan made to an
employee after the effective date will be allocated between
the employee's tax-paid basis in the plan, which will be
returned to him tax-free, and amounts not previously taxed,
which will be included in gross income.
Generally, unemployment compensation that will be
included in gross income under the proposal will not rep-
resent a return of a tax-paid basis to the recipient, since
the "premiums", or employer contributions, with respect to
such compensation were not included in his gross income.
Thus, it would not be inequitable to include the full amount
of such compensation in gross income after the general
effective date.
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Nonbusiness Expenditures
Under an accretion income tax system, certain non-
business expenditures such as small casualty losses, medical
and dental expenses, and political contributions will cease
being deductible. Generally, the repeal of the deduct-
ibility of these expenses can be effective immediately. If
the deduction for alimony is repealed pursuant to the
enactment of an accretion tax, alimony payable under court
decrees or agreements currently in effect could be grand-
fathered. If the medical expense deduction is to be replaced
by a catastrophic insurance program, repeal of the deduction
should coincide with the effective date of the program.
Other Items Previously Excluded
The inclusion in gross income of social security retire-
ment benefits (OASI payments) presents significant transition
problems, since such payments will represent to some extent
a return of previous after-tax contributions by persons
currently (or formerly) employed, and will also effectively
reduce the anticipated retirement income of many persons.
Persons currently receiving benefits (and possibly persons
with only a specified number of years remaining before
eligibility) should be grandfathered, i.e., the receipt of
their benefits should continue to be tax free. Such persons
would very likely be unable to make alternative arrangements
5-43
to supplement their retirement income in order to maintain
their anticipated level of disposable income. For other
persons who retire in the future, a statutory formula will
have to be devised to allocate benefits between after-tax
employee contributions, which would be returned tax free,
and employer and post-effective date employee contributions,
which portion would be taxable.
The inclusion in gross income of scholarships, fellow-
ships and means tested cash and in-kind government grants,
does not appear to present any transitional problems, since,
generally, the amounts of these items were not bargained for
by the recipient, and do not represent a return of a tax
paid basis.
Treatment of Gifts and Transfers at Death as Recognition Events
Under the proposal, gifts and transfers at death will
be treated as recognition events. Thus, in general, the
excess of the fair market value of the asset transferred
over its adjusted basis in the hands of the donor or decedent
will be included in the gross income of the donor or decedent.
There appear to be no transition problems if this rule is
made to apply only to transfers after an effective date.
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5. Transition to a Cash Flow Tax System
Introduction
This section presents a proposal for transition from
the current system to a cash flow expenditure tax of the
type discussed in Chapter 4. The problems involved in a
transition to a cash flow tax would be considerable, and all
of the alternative methods considered have major short-
comings. Presentation of this proposal includes discussion
of administrative difficulties and some possible distributive
inequities, and an explanation of why certain alternative
plans were rejected.
In summary, the proposed transition scheme would
maintain both an income tax and a cash flow tax for 10 years
before total conversion to the cash flow tax. During the
transition period, individuals would compute their tax
liability under both systems and would be required to pay
the higher of the two taxes. The corporat e income tax
would be retained for the interim and would be discontinued
immediately after the effective date. Unrealized capital
gains earned prior to full adoption of the cash flow tax
would be "flushed" out of the system through a recognition
date at the end of the 10-year period when they would be
taxed at the current capital gains rates. Payment of taxes
on past capital gains could be deferred with a low interest
charge to prevent forced liquidation of small business.
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The transition program outlined here would not fully
realize the goals of transition presented below. It would,
however, mitigate the redistribution of wealth that would
result from immediate adoption of a cash flow tax and would
simplify the tax system by eliminating, within a reasonable
period of time, the need to keep the personal and business
income tax records currently required.
Goals of Transition
The main objectives of a program of transition to a
cash flow tax are: (1) prevention of immediate or long-term
redistribution of economic welfare and (2) simplicity and
administrative ease. Although some changes in consumption
opportunities would be inevitable in a tax change as major
as the one proposed, the proper transition program should be
able to minimize large redistributions among taxpayers in
ability to consume immediately and in the future. In parti-
cular, this program should prevent heavy additional tax
liabilities (in present value terms) for any clearly identi-
fiable group of taxpayers. For purposes of simplicity,
transition rules should eliminate the present income tax
system and its recordkeeping requirements as soon as pos-
sible and, if possible, avoid measuring current accumulated
wealth and and annual changes in individuals' total wealth
positions in the transition period, as well as afterwards.
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Under a fully operative cash flow tax system, the principal
records for tax purposes consist only of cash flow trans-
actions for business activities, net deposit and withdrawal
in each qualified account plus the usual wage and salary
data.
Distribution Issues
Two distribution issues are important in a transition
to the cash flow tax: (1) treatment of untaxed income before
the effective date, and (2) changes in the distribution of
after-tax consumption.
Equitable treatment of income untaxed before the
effective date would require that an individual who had
unrealized capital gains at the time of the adoption of the
new system be treated in the same way as the individual who
realized the capital gain before the effective date. The
practical problems involved in realizing this goal influence
the specifics of the transition proposal discussed below.
The treatment of past accumulated income that has been
taxed poses a more difficult problem of equity. Because a
cash flow tax is equivalent to exempting income from capital
from tax, a higher tax rate on income from labor would be
required under a cash flow tax system in order to maintain
the same tax revenue. Thus, the short-term effect of a cash
flow tax would be a higher after-tax rate of return from
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ownership of monetary or physical assets and a lower after-
tax wage rate. The exact distributive consequences of this
change would depend upon how past accumulated wealth is
allowed to enter the system.
There are two alternative ways, both consistent with
the logic of a cash flow tax, to allow past accumulated
wealth to enter the system. The most generous to owners of
capital is to define existing wealth as tax prepaid assets
under the new system. All future returns from such assets,
as well as return of principal, would not be reported as
income or subject to tax. The second way is to define
existing wealth as current, untaxed income. In this case,
the return of principal would be taxed, but the present
value of tax liability would not increase as assets earn
accrued interest. The tax liability, although increasing in
nominal value with future earnings, would be deferred until
the gains were realized.
Table 6-1 illustrates the tax treatment, under an
income tax and under the two alternative methods of transition
to a cash flow tax, of consumption out of $100 of past
accumulated assets for different times at which wealth is
withdrawn for consumption. Time 1 represents potential
consumption in the first year after the effective date.
Time 2 represents potential consumption at a time in the
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future when the asset has doubled in value if untaxed. Time
3 represents potential consumption at a time in the future
when the asset has quadrupled in value if untaxed. A tax
rate of 50 percent is assumed.
Table 6-1
Potential Consumption Out of Accumulated
Wealth Under Different Tax Rules
Initial Wealth = $100
Assets Double in Value Between Each Pair of Time
Periods if Untaxed
Cash Flow Tax;
Cash Flow Tax;
Income Tax
Asset Prepaid
Asset in Initial
Income
Time 1
$100
$100
$50
Time 2
$150
$200
$100
Time 3
$200
$400
$200
Under an income tax, the asset could be withdrawn and
consumed tax free, but future accumulation would be taxed.
Under the cash flow tax, with the asset defined as tax prepaid,
the asset would be allowed to accumulate tax free and could
also be withdrawn and consumed tax free. Under the cash
flow tax, with the asset value initially included in the tax
base, consumption from the asset would be taxed upon withdrawal,
but the rate of accumulation of the asset would not be
affected by the tax.
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A transition to a cash flow tax with assets initially
defined as prepaid would increase the welfare of owners of
capital assets. The after-tax consumption of these taxpayers
would increase under the new system unless they consumed
all of their wealth within the first year after the effective
date, in which case consumption would be unchanged. If
assets were initially included in the tax base, however, the
after-tax consumption of owners of capital assets would
decrease if they chose to consume a large portion of their
wealth in the early years after the effective date. Inclusion
of assets in the base would increase after-tax consumption
relative to an income tax for owners of capital assets who
deferred consumption out of accumulated wealth for a long
period. 10,
As Table 6-1 illustrates, initial definition of assets
as prepaid or included in the base would make a big difference
in tax liability.
Inclusion of accumulated assets in the tax base seems
very unfair to older persons who are about to consume out of
accumulated wealth during the retirement period. On the
other hand, prepaid designation would greatly benefit all
owners of monetary and physical assets by redistributing
after-tax dollars from labor to capital. Although returns
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from capital would be nontaxable under a fully operational
cash flow tax, past accumulation of capital occurred under a
different tax system, where individuals did not anticipate a
sharp rise in the after-tax return to capital. Thus, tax
prepaid treatment of capital assets may be viewed as
inequitable.
The distribution problem caused by defining existing
captital assets as prepaid would be reduced over time. The
incentive to savings under a cash flow tax should raise the
rate of capital formation, increasing the amount of invest-
ment and eventually lowering before-tax returns to capital
and raising before-tax wages. However, in the first few
years after transition, higher tax rates on labor income
would not be matched by a corresponding increase in before-
tax wages.
For certain types of capital assets, the appropriate
rule for transition definition is clear. Investments in
owner-occupied houses and other consumer durables are
treated very similarly to prepaid investments under the
current system, and they should be defined as prepaid assets
for purposes of transition to a cash flow tax. The accrued
value of employer funded pension plans should be treated in
the same manner as qualified accounts becuase the contribu-
tions were exempt from tax under the old system and the
receipts were fully taxable.
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Designation of past accumulated assets as prepaid
assets would be the easier transition to administer. There
would be no need to measure existing wealth, and the only
change to the present system would be to eliminate capital
income from the tax base. Prepaid assets could be freely
converted to qualified assets to enable the individual to
average his tax base over time. An individual converting a
prepaid to a qualified asset would be able to take an
immediate tax deduction, but would become liable for taxes
upon withdrawal of principal and subsequent earnings from
the qualified account. 11/ If assets were initially defined
to be part of an individual's tax base, it would be necessary
to value them on the effective date. Individuals would have
an incentive to understate their initial asset positions.
Assets not initailly accounted for could be deposited in
qualified accounts in subsequent years, enabling an individual
to take a deduction against other income.
A Preliminary Transition Proposal
All assets would be defined initially as prepaid
assets. For a period of 10 years, the existing income tax
would be maintained, and individuals would file returns for
both systems and would pay the higher of the two computed
taxes.
12/
For most taxpayers, the cash flow tax would be
higher. However, for persons with large amounts of capital
income relative to labor income, the income tax would be
higher.
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The corporate profits tax would be retained throughout
the transition period. Theoretically, stockholders paying
the cash flow tax should receive their corporate earnings
gross of corporate tax during the interim period. However,
without full corporate integration, whereby all earnings
would be attributed to individual stockholders, it would be
practically impossible to determine what part of a corporation's
earnings should be attributed to individuals paying the
consumption tax and what part, to individuals paying the
income tax. It is likely that ownership of corporate shares
would be concentrated among individuals who would be subject
to the income tax during the interim period. For reasons of
simplicity, therefore, the corporate tax would be retained
for the transition period and would be eliminated immediately
afterward.
All sales of corporate stock purchased before the
beginning of the transition period, by individuals paying
under either tax base, would be subject to a capital gains
tax at the existing favorable rates. The reason for this
provision is that capital gains earned but not realized
before the interim period should be taxed as if they were
income realized at the effective date. 13/
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A recognition date would be required at the end of the
transition period to account for all remaining untaxed
capital gains. Under a fully operational cash flow tax
system, under which assets would be defined as prepaid and
no records of current and past corporate earnings and
profits would be kept, it would be impossible to distinguish
between distributions that were dividends out of current
income and distributions that were réturn of accumulated
capital. The dividends would not be subject to tax under
the new law. Distributing past earnings would be a way of
returning to the individual his accumulated capital gains
tax free. In order to eliminate the need for corporate
records for income tax purposes on the final day of the
transition period, it would be necessary to have a single
day of recognition for past gains.
It would be possible to develop a method of final
capital gains tax assessed on the recognition date be paid
over a long period at a low interest rate, to avoid forced
liquidation of small firms with few owners.
The advantage of the transition proposal outlined here
are the following: 1. It would enable all of the simplifying
features of cash flow tax to be in full operation after 10
years, including elimination of required income tax records.
5-54
2. It would allow consumption out of past accumulated
earnings to be exactly the same as it would have been under
the income tax during the first years after the effective
date. 3. It would provide for appropriate and consistent
taxation of income earned before the effective date. 4. By
gradual elimination of taxes on income earned from past
accumulated capital, this proposal would mitigate the redis-
tribution of wealth to current asset owners that would occur
after immediate full adoption of a cash flow tax. The major
disadvantages of this transition program are that it would
require a recognition date that would impose a large one-
time administrative cost on the system, and it would require
some taxpayers to fill out two sets of tax forms for a
period of 10 years, a temporary departure from the long-term
goal of low administrative costs.
Alternative Transition Plans
One alternative plan would be to adopt the new tax
system immediately, designating all assets as prepaid,
without a recognition date to "flush out" past capital
gains. Although this plan would be the simplest one, it
would give too great an economic advantage to individuals
with unrealized capital gains and would cause too large a
transfer of future after-tax consumption to present asset
owners.
5-55
Another transition plan would be to adopt the cash flow
tax immediately and designate all assets as current income.
This would require valuing all wealth on the effective date
and imposition of an effective one-time wealth tax. Such an
approach would be harsh on older persons planning to live
off accumulated capital in the early years after the effec-
tive date.
A second, more complicated option would allow prepaid
treatment of assets but, in exchange for the elimination of
taxes on future capital income, would impose an initial
wealth tax related to an individual's personal circumstances.
For example, the initial tax could be based on age and
wealth, with higher rates for persons with more wealth and
lower rates for older people. 14/ Although it might provide
a transition program that approximates distributive neutrality,
such a plan would be even greater departure from the goal of
simplicity.
A third option would allow three types of assets:
prepaid, as defined above, qualified, as defined above, and
a Type 3, which would treat assets as defined under the
current system. In principle, we would like people to be
able to consume out of Type 3 assets tax free and to invest
in prepaid and qualified assets only out of savings from
current income. In effect, this plan would initiate cash
5-56
flow taxation on current earnings only and would treat pre-
effective date earnings exactly as they are treated under
the current system, including the same treatment of post-
effective date capital accumulation from pre-effective date
wealth. This plan would be extremely difficult to administer.
Not only would individuals have to keep books for three
types of assets, but also total annual wealth changes would
have to be measured (valuation of unsold assets would not be
a problem because even if too high a value were imputed,
raising both measured wealth and saving, consumption would
remain unchanged) in order to arrive at a measure of annual
consumption. Treatment of corporate income under this
system would also be complicated, because some investments
in corporate stock would come from all three types of assets.
Under this transition alternative, Type 3 assets would
be subject to a transfer tax and converted to prepaid assets
at death. Eventually, Type 3 assets would disappear from
the system, and the complete cash flow tax would be in
operation. Alternatively, all Type 3 assets could be
designated prepaid after a fixed number of years.
Although the three asset plan has the advantage of
treating owners of capital exactly as they would have been
treated under the income tax and changing the rules only for
new capital, 15/ its administrative complexity is so great
as to discourage serious consideration.
5-57
Footnotes
1/
The exact change in the rate of tax on capital income
earned in corporations by different individuals will
depend on the fraction of corporate income currently
paid out in dividends, the current average holding
period of assets before realizing capital gains, and
the individual's tax brackets. While the current
corporate income tax does not distinguish between
owners in different tax brackets, integration, which
attributes all corporate earnings to the individual
owners would tax all earnings from corporate capital
at each individual owner's marginal tax rate.
2/
The taxpayer can, in fact, avoid this problem by selling
his shares before the effective date at the current
lower capital gains rate and then buying them back.
However, one other objective of transition rules,
discussed in the next section, should be to avoid
encouraging market transactions just prior to the
effective date.
For example, workers damaged by employment reductions
in industries with increasing imports due to trade
5-58
liberalization are eligible for trade adjustment
assistance.
Note that is is not clear just what is meant by
an "existing asset" in this context; a building is
greatly affected by, e.g., maintenance and improvement
expenditures over time.
5/
The appropriate rule may be to allow no depreciation at
all.
6/
Section 1231 property is generally certain property
used in the taxpayer's trade or business. If gains
exceed losses for a taxable year, the net gains
from section 1231 property are taxed at capital gains
rates; if losses from section 1231 property exceed
gains, the net losses are treated as ordinary losses.
7/
In the case of a subchapter S corporation, the
character of net capital gains flow through to the
shareholder. The character of tax-exempt interest
does not.
5-59
Expenditures made pursuant to binding contracts
entered into before the effective date should also
be grandfathered.
9/
The income tax computation assumes a full accretion
tax, under which all returns to capital are taxed as
accrued at full rates. Thus, the rate of accumulation
under the income tax would be cut in half. Under the
present law, taxation of capital gains is deferred
until realization and then taxed at only one-half the
regular rate. For example, if the asset is realized at
time 3, after-tax income would be $325. It should be
noted, however, that if the asset is corporate stock,
profits are taxed at a rate of 48 percent every year.
If the corporation is not reducing its tax base sub-
stantially through accelerated depreciation or the
investment tax credit, then, combining the corporate
and personal taxes, the capital income of the corporate
shareholder may be taxed under current law at an even
higher rate than the rate on ordinary income.
10/ For example, if the before-tax interest rate were 10
percent, wealth would quadruple in 15 years. With the
50 percent tax rate used in Table 1, wealth holders
5-60
would be better off under the consumption tax, even if
their assets were initially defined as income, if they
deferred consumption out of wealth for at least 15
years.
11/ A wealthy person could appear to "shelter" his current
labor income by converting prepaid assets into qualified
assets, deducting the deposits in qualified assets from
current labor income. However, this practice would not
reduce the present value of his tax base, because he
would have to pay a tax on the principal and accumulated
interest whenever the qualified asset is liquidated for
consumption.
12/ It is possible that only wealthy people should be
required to fill out an income tax return. The main
reason for retaining the income tax would be to tax
accumulated past capital for an interim period of time,
to mitigate the inequitable distribution effects of a
transiotn to prepaid treatments of assets. It is
likely that only people with significant amounts of
past accumulated capital would have a higher liability
under the income tax. The requirement to file an
income tax return might be limited to taxpayers reporting
5-61
an adjusted gross income above a certain minimum level
(for example, $20,000 or more) in any of several years
before the effective date.
13/ Technically speaking, individuals paying the cash flow
tax during the interim period should not have to pay
capital gains tax between the first day of the interim
period and the time an asset is sold. One way to avoid
this would be to adjust the basis upwards to conform to
interest that would have been earned on a typical
investment after the beginning of the interim period.
By doing this, the present value of capital gains tax
paid, for assets growing at that interest rate, would
be the same as if the gain were realized on the effective
date.
14/ Because the wealth of older persons would be subject to
the accessions tax sooner, it would not be necessary
for equity to tax it on the effective date.
15/ The three asset plan can be viewed as a sophisticated
form of "gradfathering."
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"ocrText": "The original documents are located in Box 35, folder \"Taxes - Tax Reform Report (4)\" of\nthe James M. Cannon Files at the Gerald R. Ford Presidential Library.\nCopyright Notice\nThe copyright law of the United States (Title 17, United States Code) governs the making of\nphotocopies or other reproductions of copyrighted material. Gerald Ford donated to the United\nStates of America his copyrights in all of his unpublished writings in National Archives collections.\nWorks prepared by U.S. Government employees as part of their official duties are in the public\ndomain. The copyrights to materials written by other individuals or organizations are presumed to\nremain with them. If you think any of the information displayed in the PDF is subject to a valid\ncopyright claim, please contact the Gerald R. Ford Presidential Library.\nDigitized from Box 35 of the James M. Cannon Files at the Gerald R. Ford Presidential Library\nGERALD\nChapter 5. Transition Rules Under Basic Tax Reform\n1.\nIntroduction\n2.\nWealth Changes and Their Equity Aspects\n3.\nInstruments for Ameliorating Transition Problems\n4.\nProposed Solutions to Selected Problems in\nthe Transition to an Accretion Tax\n5.\nTransition to a Cash Flow Tax System\nChapter 5\nTRANSITION RULES UNDER BASIC TAX REFORM\n1. Introduction\nMajor changes in the tax code such as would accompany a\nswitch to either an accretion or cash flow base may lead to\nsubstantial and sudden changes in current wealth and future\nafter-tax income flows for some individuals. Transition\nrules need to be designed to minimize unfair losses, or\nundeserved windfalls, to individuals whose investment decisions\nwere influenced by the provisions of the existing code.\nThis chapter discusses the major issues in transition\nand proposes transition rules for both the comprehensive\nincome tax and the cash flow tax. Section 2 outlines the\nmajor wealth changes that can be expected under a switch to\neither a comprehensive accretion income tax or a compre-\nehensive cash flow tax, and discusses the relevant equity\ncriteria to be applied in the design of transition rules.\nIn Section 3, instruments for amelioration of transition\nproblems, including phasing-in provisions of the new law and\ngrandfathering, or exempting, existing assets from the new\nrules are discussed. The effects of applying these transition\ninstruments to different types of changes in the tax law are\noutlined. Section 4 presents a series of specific proposals\n5-2\nfor transition rules to be applied to changes in the tax law\nthat would result from adoption of the accretion tax proposal\nin Chapter 3. Finally, in Section 5, special problems of\ntransition to a cash flow tax are discussed and a plan is\npresented for transition to the cash flow proposal in\nChapter 4.\n2. Wealth Changes and Their Equity Aspects\nTwo separate problems requiring special transition\nrules can be identified: carryover and price changes.\nCarryover problems would occur to the extent that changes in\nthe tax code affect the taxation of income earned in the\npast but not yet subject to tax or, conversely, income taxed\nin the past that may be subject to a second tax. Price\nchanges would occur in those instances where changes in the\ntax code alter the expected flow of after tax income from\nexisting investments in the future.\nCarryover Problems\nUnder the present tax system, income is not always\ntaxed at the time it is earned. For example, accretion that\noccurs in the form of capital gains is not taxed prior to\nrealization. A change in the tax rate on realized capital\ngains, therefore, would alter the tax liability on gains\naccrued but not realized before the effective date of the\ntax reform. Application of the new rules to past capital\n5-3\ngains would either raise or lower the applicable tax on that\nportion of past income, depending on whether the increase in\ntax from including all capital gains in the income base\nexceeded the reduction in tax caused by any allowance of\na basis adjustment for inflation.\nThe problem of changes in the timing of tax liability\nis especially severe if the current tax system is changed to\na consumption base. Under a consumption base, purchases of\ncapital assets are tax deductible and sales of capital\nassets that are not reinvested are fully taxable. Under the\ncurrent tax system, both the income used to purchase capital\nassets and the capital gain are subject to tax, the latter,\nhowever, at a reduced rate. Recovery of the original\ninvestment is not taxed. An immediate change to a con-\nsumption base would penalize individuals who have saved in\nthe past and who are currently selling assets for consumption\npurposes. Having already paid a tax on the income used to\npurchase the asset under the old rules, they would also be\nrequired to pay an additional tax on the entire proceeds\nfrom the sale of the asset. On the other hand, if owners of\ncapital assets are allowed to treat those assets as tax-\nprepaid, they would receive a gain to the extent they plan\nto use them for future consumption or bequest. Income on\npast accumulated wealth would then be free from future\n5-4\ntaxes, and the government would have to make up the difference\nby raising the tax rate on the remaining consumption regarded\nas non-pre-taxed.\nOther carryover problems include excess deductions or\ncredits unused in previous years and similar special tech-\nnical features of the tax law. In general, carryover can be\nviewed as being conceptually separate from changes in the\nprice of assets. In the case of capital gains tax, for\nexample, the change in tax liability to an individual for\npast accrued earnings does not affect the tax liability of\nanother individual purchasing an asset from him; in general,\nthe asset price depends only on future net-of-tax earnings.\nHowever, the new tax law and the transition rules, by\naltering future net-of-tax earnings, would change the price\nof capital assets.\nIn most cases, carryover problems could be handled by\nspecial rules that define the amount of income earned but\nnot realized before the effective date of implementation of\nthe new law. Changes in the definition of an individual's\npast income will alter asset prices only if they provide an\nincentive for pre-effective date sales of existing assets.\nFor example, if, under the new system, past capital gains\nare taxed at a higher rate than under the old system, an\nincentive may be created for sales of assets prior to the\neffective date.\n5-5\nPrice Changes\nAdoption of a broadly based tax system would change\nprices of some assets by changing the taxation of future\nearnings. Under an accretion base system, for example, the\nfollowing changes in the tax code would alter tax rates on\nincome from existing assets: integration of the corporate\nand personal income taxes; taxation of all realized capital\ngains at the full rate; adjustment of capital taxation for\ninflation losses; inclusion of interest on State and local\ngovernment bonds in the tax base; elimination of accelerated\ndepreciation provisions that lower the effective rate of tax\non income arising in special sectors, including minerals\nextraction, real estate, and some agricultural activities;\nand elimination of the deductibility of property taxes by\nhomeowners. Adoption of these and other changes in the tax\ncode would change both the average rate of tax on income\nfrom all assets and the relative rates imposed among types\nof financial claims, legal entities, and investments in\ndifferent industries.\nThe effects of changes in taxation on asset values\ndiffer for changes in the average level of taxation of the\nassociated returns and changes in the relative rates of tax\non different assets. A change in the average rate of taxation\non all income from investment, while it will affect the\n5-6\nfuture net return from wealth or accumulated past earnings,\nis not likely in itself to change individual asset prices\nsignificantly. For any single asset, a change in the average\nrate of taxation of returns would reduce net after-tax\nearnings roughly in proportion to the reduction in net\nafter-tax earnings on alternative assets. Thus, the market\nvalue of the asset, which is equal to the ratio of returns\nnet of depreciation to the interest rate (after tax), will\nnot tend to change. On the other hand, an increase in the\nrelative rate of taxation on any single asset generally will\nlead to a fall in the price of that asset, because net\nafter-tax earnings will fall relative to the interest rate.\nThe opposite holds for a decrease in the relative rate of\ntaxation.\nThe behavior of the price of any single asset in\nresponse to a change in the relative rate of taxation of its\nreturns depends on the characteristics of the asset and the\nnature of the financial claim to it. For example, suppose\nthe asset is a share in an apartment project. In the long\nrun, the price of the asset will depend on the costs of\nbuilding apartments; if unit construction costs are inde-\npendent of volume, they will not be altered by changes in\nthe tax rate on real estate profits. Now, suppose the\neffective rate of tax on profits from real estate is increased.\n5-7\nThe increase in tax will drive down the after-tax rents\nreceived by owners; as the value of the asset to buyers\ndepends on the stream of annual after-tax profits, the price\na purchaser is willing to pay also will fall. With the\nprice of the structure now lower than the cost of production,\napartment construction will decline, making rental housing\nmore scarce and driving up the before-tax rentals charged to\ntenants. In final equilibrium, the before-tax rentals will\nhave risen sufficiently to restore after-tax profits to a\nlevel at which the price buyers are willing to offer for\nthe asset is again equal to its cost of production.\nThus, the immediate effect of the tax is to lower the\nprice of equity claims to real estate. The wealth loss to\nowners of those shares at the time of the tax change depends\nboth on the time period required for adjustment to final\nequilibrium and the extent to which future increases in the\ngross rentals (from the decline in housing supply) are\nanticipated in the market place. The faster the adjustment\nto equilibrium and the larger the percent of gross rentals\nchange that is anticipated, the smaller the fall in asset\nprice will be for any given increase in the tax on the\nreturns.\n5-8\nIf the asset is a claim to a fixed stream of future\npayments (e.g., a bond), a change in the rate of taxation\nwill alter its price by lowering the present value of the\nfuture return flow. For example, if interest from municipal\nbonds becomes subject to tax, the net after-tax earnings of\nholders of municipal bonds will fall, lowering the value of\nthose claims. New purchasers of municipal bonds will demand\nan after-tax rate of return on their investment comparable\nto the after-tax return on other assets of similar risk and\nliquidity. The proportional decline in value for a given\ntax change will be greater for bonds with a longer time to\nmaturity.\nThe effect of corporate integration on the price of\nassets is less certain. Viewing the corporate income tax as\na tax on the earnings of corporate equity shareholders,\nintegration will increase the rate of tax on income from\ninvestment of high bracket shareholders and lower the rate\nof tax on such income of low bracket shareholders. 1/ In\naddition, many assets owned by corporations also can be used\nin the noncorporate sector. To the extent that relative tax\nrates on income arising in the two sectors are altered by\nintegration, those assets can easily move from one sector to\nthe other, changing relative before-tax earnings and output\nprices in the two sectors, but keeping relative after-tax\nearnings and asset prices the same.\n5-9\nIn conclusion, raising the relative tax on capital\nincome in industries and for types of claims currently\nreceiving relatively favorable tax treatment is likely to\ncause some changes in asset prices. Immediate asset price\nchanges generally will be greater for long-term fixed claims,\nsuch as State and local bonds, than for equity investments;\ngreater for assets specific to a given industry (e.g.,\napartment buildings) than for assets that can be shifted\namong industries; and greater for assets whose supply can\nonly be altered slowly (e.g., buildings and some mineral\ninvestments) than for those the supply of which can be\nchanged quickly.\nThe effect of integration on capital values is not\nlikely to be large. On the other hand, changes in the\nspecial tax treatment currently afforded in certain in-\ndustries, for example in real estate and in mineral resources,\nand changes in the treatment of State and local bond interest\nare likely to cause significant changes in asset values.\nEquity\nConsiderations of equity associated with changes in tax\nlaws are different from equity considerations associated\nwith the overall design of a tax system. Changes in the tax\ncode create potential inequities to the extent that indi-\nviduals who made commitments in response to provisions of\n5-10\nthe existing law suffer windfall losses (or receive windfall\ngains) as a result of the change. These gains (and losses)\ncan be of two types: (1) wealth changes to individuals\nresulting from changes in tax liabilities on income accrued\nin the past but not yet recognized for tax purposes, and (2)\nchanges in the price of assets or the value of employment\ncontracts brought about by changes in future after-tax\nearnings. These two types of problems, carryover and price\nchange, pose somewhat different equity issues.\nCarryover poses the problem of how to tax equitably\nincome earned while a different set of tax laws was in\neffect. For example, consider one aspect of the proposed\nchange in the tax treatment of corporations under the\naccretion income tax. Presently, capital gains are subject\nto lower tax rates than dividends, especially when realization\nis deferred for long periods of time. Individuals owning\nshares of corporations paying high dividend rates relative\nto total earnings pay more tax than individuals owning\nshares of corporations with low dividends relative to total\nearnings. As both tpyes of investments are available to\neveryone, individuals purchasing shares in high-dividend\ncorporations presumably are receiving something (possibly\nless risk or more liquidity) in exchange for the higher tax\n5-11\nliability they had to assume. To subject the shareholders\nof low-dividend corporations to the same rate of tax on\nincome accumulated in the form of capital gains prior to the\neffective date as they would have paid had the earnings been\ndistributed would be unfair.\nCarryover poses another equity problem: some taxpayers\nmay be assessed at unusually high or low rates on past\nincome because of changes in the timing of accrual of tax\nliability. The above example can be used to illustrate this\npoint too. Under current law, the special tax treatment of\ncapital gains in part compensates shareholders for the extra\ntax on their income at the corporate level. Under integration,\nthe separate corporate income tax would be eliminated but\nshareholders would be required to pay a full tax on their\nattributed share of the corporation's income, whether or not\ndistributed. Now, suppose integration is introduced and a\nshareholder has to pay the full tax on appreciation of his\nshares which occurred before the effective date.\nThe\ntaxpayer is, in effect, being too heavily taxed on that\nincome as it was subject to taxation at the corporate level\nbefore being taxed at the full individual income tax rate.\nBefore integration, he would in effect have paid the corporate\ntax plus the reduced capital gains rate; after integration,\n5-12\nhe would be liable for the full tax rate on ordinary income.\nHowever, in the absence of transition rules, he is in fact\nsubject to a higher tax on income which accrued before but\nnot recognized until after the effective date of the new\nlaw.\nThe most desirable solution to the problem of equity\nraised by carryover is to design a set of transition rules\nthat insure that, to the maximum extent consistent with\nother objectives, tax liabilities on income earned before\nthe effective date are computed according to the old law and\ntax liabilities on income earned after the effective date\nare computed according to the new law.\nChanges in future after-tax income brought about by tax\nreform raise a different set of equity issues. A radical\ntax reform that is to a large extent unexpected will cause\ncapital losses to owners of assets in previously tax-favored\nsectors. Imposition of such capital losses may be viewed as\nunfair, especially since past government policy explicitly\nencouraged investment in those assets. For example, if two\nindividuals in a given tax bracket are indifferent between\nholding subsidized State and local bonds and unsubsidized\nTreasury bonds before the tax change, it seems reasonable to\ncompensate the holder of State and local bonds for the loss\nsuffered upon removal of the subsidy so that he ends up in\n5-13\nthe same position as the holder of Treasury bonds. Note\nthat this concept of distributive justice does not imply\nthat a third taxpayer, who earns higher after-tax income\nfrom tax-free bonds than from Treasury bonds because he is\nin a higher tax bracket than the other two, should retain\nthe privilege of earning tax-free interest. Equity does not\nrequire that the tax system maintain loopholes; it does\nrequire some limitation on wealth losses imposed on individuals\nbecause they took advantage of legal tax incentives.\nThe counterargument to the view that compensation for\nsuch wealth changes is required by principles of justice is that\nall changes in public policy alter the relative incomes of\nindividuals and frequently asset values. For example, a\ngovernment decision to reduce the defense budget will lower\nrelative asset prices in defense companies and their principal\nsupplying firms and also lower relative wages of individuals\nwith skills specialized to defense activities (e.g., many\nengineers and physicists). Although some special adjustment\nassistance programs exist, it is not common practice to\ncompensate individuals for changes in the value of physical\nand human assets caused by changes in government policies.\nIn addition, it can be argued that, because investors in\ntax-favored industries know that the tax subsidy may end,\n5-14\nthe risk of a public policy change is reflected in asset\nprices and rates of return. If, for example, it is believed\nthat the continuing debate over ending remaining special\ntax treatment of the oil industry assets poses a real\nthreat, it can be argued that investors in oil are already\nreceiving a risk premium in the form of higher than normal\nnet after-tax returns, and further compensation for capital\nlosses upon end of the subsidy is unwarranted.\nThe discussion above suggests that cases can be made\nboth for and against compensation of individuals for capital\nlosses caused by radical changes in tax policy. As the\ncapital value changes resulting from the tax change alone\nare virtually impossible to measure precisely, designing a\nmethod to determine the appropriate amount of compensation\nwould be difficult on both theoretical and practical grounds.\nHowever, it would be desirable to design transition rules so\nthat capital losses and windfall gains resulting from\nadoption of a comprehensive tax base would be moderated to\nsome degree. Two possible design features, grandfathering\nexisting assets and phasing in the new rules slowly, are\ndiscussed in section 3.\n5-15\n3. Instruments for Ameliorating Transition Problems\nThe main criteria that transition rules should satisfy\nare: (1) simplicity, (2) minimizing incentive problems, and\n(3) minimizing undesirable wealth effects.\nSimplicity. The transition rules in themselves should\nnot introduce any major new complexity in the tax law. To\nthe extent possible, transition rules should not require\nthat corporations or individuals supply additional data on\nfinancial transactions or asset values.\nMinimizing Incentive Problems. The transition rules\nshould be designed to minimize the probability of action in\nresponse to special features of the change from one set of\ntax rules to another. In particular, there should not be\nspecial inducements to either buy or sell particular kinds\nof assets just before or after the effective date of the new\nlaw.\nMinimizing Undesirable Wealth Effects. Transition\nrules should moderate wealth losses to individuals holding\nassets that lose their tax advantages under basic tax reform\nas well as gains to those whose assets are relatively favored.\nAt the same time, special transition rules to protect asset\nfrom loss holders should not give them the opportunity to\nearn windfall gains.\n5-16\nAlternatives\nTwo alternative methods of reducing capital value\nchanges are discussed here: grandfathering existing assets\nand phasing in the new law.\nGrandfathering. The grandfather clause was originally\nused by some southern States as a method for disfranchising\nblack voters following the Civil War. It exempted from the\nhigh literacy and property qualifications only those voters\nor their lineal descendants who had voted before 1867. More\nrecently, grandfather clauses have been used to exempt\npresent holders of positions from new laws applicable to\nthose positions, e.g., setting a mandatory age of retire-\nment. In the context of tax reform, a grandfather clause\ncould be used either to exempt existing assets from the new\nlaw as long as they are held by the current owner or to\nexempt existing assets from the new law regardless of who\nholds them. A grandfather clause also could be applied to\ncapital gains accrued but not yet realized at the time the\nnew law went into effect.\nConsider, for example, the effect of eliminating the\nspecial depreciation rules that result in a low rate of tax\non income arising from real estate investments. A grand-\nfather clause that exempted existing buildings only as long\nas they are held by the current owner (s) would mean that\n5-17\ncurrent owners could depreciate their buildings to zero\naccording to the old rules, but that new owners could not do\nthe same. Grandfathering the buildings independently of\ntheir owners would allow subsequent purchasers to depreciate\naccording to the old rules. This would have the effect\nof raising the value of the buildings. Elimination of tax-\nincentives in real estate would discourage new construction,\nreducing the supply of housing and raising gross rentals\nbefore tax. Thus, grandfathering, by making existing\nproperty more valuable, would give a windfall gain to\ninvestors in real estate tax shelters. On the other hand,\ngrandfathering the buildings only for current owners would\nnot prevent a wealth loss to real estate investors because\nthe value to new buyers would decline. The loss would be\nmititgated by the anticipated increase in after-tax profits\nto current investors (because of the decline in housing\nsupply).\nGrandfathering existing buildings unconditionally\nwould be simpler than grandfathering them only as long as\nthey are owned by their existing owners. The new law could\nbe made to apply only to ownership of buildings constructed\nafter a certain effective date; proof of the date of purchase\nwould not be required.\n5-18\nThe effect of grandfathering on asset prices for fixed-\ninterest securities, is less certain. For example, if\nexisting municipal bonds are grandfathered, annual interest\nreceived net of tax will be unchanged. However, the value\nof the tax saving from owning municipal bonds will change\nfor two reasons. First, there will be no new tax-exempt\nmunicipal bond issues under the new rules; with fewer\navailable tax-exempt bonds, the marginal bracket of the\nbuyer who is indifferent between tax exempt and other securities\nwill rise, driving up the price of the tax exempt securities.\nSecond, the other changes in the tax system would probably\nlower all marginal tax rates by widening the base, thereby\nreducing the tax advantage and the price of tax-exempt\nsecurities. It is not clear in what direction the price of\nthe grandfathered securities would change, though the price\nchange is likely to be much smaller than the price change if\nthe new rules were immediately adopted for all tax-exempt\nsecurities.\nThe main danger of grandfathering is that it can\nprovide a windfall gain to current owners of assets subject\nto favorable tax treatment. These owners would receive a\ngain because the new tax law would reduce the supply of\npreviously favored assets, thus raising before-tax profits.\n5-19\nGrandfathering probably should be limited to cases\nwhere gross returns are not likely to be altered signi-\nficantly by the tax. For example, changes in the tax\ntreatment of pensions are not likely to affect before-tax\nlabor compensation significantly, assuming the supply of\nlabor to the economy is relatively fixed. While grand-\nfathering tax treatment of pensions in current employment\ncontracts is not likely to raise significantly the value of\nthose contracts relative to their value under the old law,\nan immediate shift to the new law would reduce the value of\npreviously negotiated pension rights.\nPhasing In. An alternative method of avoiding drastic\nchanges in capital values is to introduce the new rules\ngradually. For example, taxation of interest on currently\ntax-exempt State and local bonds can be introduced slowly by\nincluding an additional 10 percent of interest in the tax\nbase every year for 10 years. Phasing in the new rules\nwould not alter the direction of capital value changes, but\nit would reduce their magnitude by delaying tax liability\nchanges and making them occur more slowly.\n5-20\nAssuming that the market incentives under the new law\nare preferable to the incentives under the current law,\nphasing in poses a distinct disadvantage. Phasing in delays\napplication of the new rules, thus reducing the present\nvalue of the economic changes that would be encouraged.\nThe length of the phase-in period would depend on the\ndesired balance of the gains from changing the tax system\nagainst the costs of imposing capital value changes on some\ninvestors.\nCombination of Phase in and Grandfathering. A possible\nvariant of the two approaches outlined above is to adopt the\nnew rules immediately for new assets, while phasing in the\nnew rules for existing assets. In many cases, grandfathering\nexisting asests when new assets are taxed more heavily under\nthe new tax law will raise the market price of the old\nassets. By phasing in the new rule for the old assets, it\nis possible to moderate the increase in present value of\nfuture tax liabilities, while at the same time the immediate\neffects on supply of new assets are raising before tax\nreturns. The two effects may roughly cancel out, leaving\nasset prices almost the same throughout the early transition\nperiod. For example, a gradual introduction of new, and\nmore appropriate, depreciation schedules for existing residential\nreal\nestate with a concurrent adoption of the new rules\n5-21\nfor new buildings, would have the same incentive effects on\nnew buildings as immediate adoption of the new law. Before-\ntax rentals on existing real estate would rise gradually, as\nsupply growth is reduced, while tax liabilities on existing\nreal estate also would rise. It is likely that, for an\nappropriate phase-in period, the asset value change to\nexisting owners will be small. However, tax shelters on new\nconstruction will be totally eliminated immediately.\n4. Proposed Solutions to Selected Problems in the\nTransition to an Accretion Tax\nAs described in Chapter 3, a change over to an accretion\nincome tax system would have significant impact on the\ntaxation of capital gains, corporate income, business and\ninvestment income, and personal income. The following\ndiscussion examines the problems that these changes present\nfor transition. In most cases possible solutions to these\nproblems are suggested.\nCapital Gains\nUnder an accretion income tax system, the deduction and\nalternative tax with respect to capital gains will be\ndiscontinued. The transition mechanism proposed is to allow\ncapital gains (or losses) that have accrued as of the\ngeneral effective date of the proposal to continue to\n5-22\nqualify for capital gains treatment upon a sale or other\ntaxable disposition for 10 years following such date. This\n\"capital gain account\" inherent in each capital asset could\nbe determined in either of two ways:\n(1) By actual valuation on the general effective date\nof enactment of the proposal (or on an elective alternative\nvaluation date to avoid temporary distortions in market\nvalue) , or\n(2) By regarding the gain (or loss) recognized on a\nsale or exchange of the asset as having accrued ratably\nover the period the seller held the asset. The portion of\nthe gain (or loss) thus regarded as having accrued prior to\nthe effective date would be taxed at capital gain rates (or\nbe subject to the limitation on capital losses) provided\nthat the asset continues to meet the current requirements\nfor such treatment. Recognition of capital gain (or loss)\non the asset after the effective date will extinguish the\ncapital gain (or loss) potential of the asset. Thus, gains\non sale or exchange of an asset purchased after the effective\ndate would not receive any special tax treatment.\nA number of technical rules relating to transfers and\nsubsequent adjustments to basis will have to be provided.\nIn general, the account should carry over to the transferee\nin certain tax-free transfers that refelct a change in the\n5-23\ntransferor's form of ownership of, or interest in, the\nasset, such as contributions to a controlled corporation\n(under section 351) or partnership (section 721) or a\ncomplete liquidation of certain controlled subsidiaries\n(section 332). In the case of a transfer of an asset to a\ncontrolled corporation or partnership, it may be appropriate\nto allow the shareholder or partner to elect to transfer the\ncapital gain account of the asset to his stock or partner-\nship interest, and have the asset lose its capital gain\ncharacter in the hands of the corporation or partnership.\nAlso, in the case of a sale or exchange where the seller is\nallowed nonrecognition of gain on the transaction because he\nacquires an asset similar to the asset disposed of, the\ncapital gain account should attach to the newly acquired\nasset. For example, if a taxpayer is to be allowed non-\nrecognition treatment on the sale of a personal residence,\nwhere another residence is acquired within a specified time,\nthe capital gain account would attach to the new residence.\nRules also will be needed to take into account an\nincrease or decrease in the basis of the property after the\neffective date. An increase in the basis of the property\ngenerally should not decrease the capital gain account,\nsince the increase in basis generally will be accompanied by\nan increase in the fair market value of the asset (for\n5-24\nexample, where a shareholder contributes cash to a corpo-\nration); the increased fair market value due to the increase\nin basis will, when recognized, represent a return of the\ninvestment increasing the basis. On the other hand, a\ndecrease in basis resulting from a deduction against ordinary\nincome should reduce the capital gain account (i.e., code\nsections 1245, 1250, and other recapture provisions currently\nin the code that prevent the conversion of ordinary income\ninto capital gain because of excess depreciation deductions\nor other means should continue to apply). The capital gain\naccount should follow an allocation of the basis of the\nasset, such as is required with respect to a nontaxable\nstock dividend.\nSpecial rules also would be needed for section 1231\nproperty, since net gains from the sale of such assets\nqualify for capital gains treatment. A workable rule\nwould be to apply section 1231 to assets that are section\n1231 assets in the hands of the taxpayer on the general\neffective date, and continue to so qualify as of the date of\nsale or other taxable disposition. Such property would have\na \"section 1231 account\" similar to the capital gain account\nattaching to each asset. Similar rules relating to transfers,\nbasis adjustments, etc., also would apply.\n5-25\nSince a capital asset may be held for an indefinite\nperiod, a cutoff date for capital gains treatment is needed;\notherwise, the complexity of the capital gains provisions in\nthe code will continue for at least a generation. (Under\nthe proposal, donors and decedents will be required to\nrecognize gain or loss on the assets transferred, subject to\ncertain exceptions, and thus the capital gain account will\nnot carry over to a doneee or heir.) Accordingly, at the\nend of a specified period (say, 10 years), the capital gains\ndeduction and the alternative tax treatment would expire.\nAdmittedly, some of the problems described in section 2 of this\nchapter will exist if the complete repeal is delayed 10\nyears as would be present if the capital gain provisions\nwere completely repealed when the proposal is enacted. The\n10-year phase-out period, however, will allow gradual market\nadjustments and help protect the interests of investors who\npurchased assets in reliance on the current capital gains\nprovisions.\nAn alternative to the capital gain account (and section\n1231 account) procedure would be to phase out the deduction\nfor capital gains (and the alternative tax) ratably over a\nspecified number of years. For example, the 50 percent\ndeduction for capital gains could be reduced five percentage\npoints a year, SO that at the end of 10 years the deduction\n5-26\nwould be eliminated. The simplicity of this alternative is\nthe best argument for its adoption, since no valuation as of\na particular date would be required.\nCorporate Integration. Transition problems related to\nthe foreign area are discussed in Section 11 of Chapter 3\nUnder an accretion income tax system, corporations will\nnot be subject to tax. Instead shareholders will be taxable\non their pro-rata share of corporate income or will be\nallowed to deduct their pro-rata share of corporate loss.\n(See the discussion in section 8 of Chapter 3.)\nThe most significant transitional problems involve the\nquestion of timing and the treatment of income, deductions,\ncredits, and accumulated earnings and profits that are\nearned or accrued before the effective date of the change-\nover to integration, but that would be taken into account\nfor tax purposes after such date.\nPre-effective Date Retained Earnings\nPerhaps the most difficult transitional problem posed\nby corporate integration is the treatment of corporate\nearnings and profits that are undistributed as of the\neffective date of integration. Such earnings would have\nbeen taxed to the shareholders as dividends if distributed\nbefore the effective date, or taxed at capital gains rates\n5-27\nif recognized by means of sale or exchange of the stock\n(provided the stock was a capital asset in the hands of the\nseller). Under corporate integration, distributions made by\na corporation to its shareholders will be tax-free to the\nextent of the shareholder's basis; distributions in excess\nof the shareholder's basis in his stock will be taxable.\nHowever, corporate earnings and profits accumulated before\nthe effective date but distributed afterward should not be\naccorded tax-free treatment: to do so would discriminate\nagainst corporations that distributed (rather than accumulated)\ntheir earnings and profits in pre-integration taxable years.\n(In the case of the shareholders who are content to leave\nthe accumulated earnings and profits in corporate solution,\nhowever, the effect of corporate integration on the income\ngenerated by such earnings may give the same result as if\nsuch earnings had been distributed tax free, since such\nincome will be taxed directly to the shareholders, without\nthe interposition of corporate tax, and will then be available\nto the shareholders as a tax-free dividend.)\nThe problem of accumulated earnings can be addressed by\ncontinuing to apply current law to corporate distributions\nthat are made within 10 years after the effective date of\nintegration and that (1) are made to persons who held the\nshares on such effective date with respect to which the\n5-28\ndistribution is made, and (2) are made out of earnings and\nprofits accumulated before such date. Thus, a distribution\nto such shareholders out of earnings and profits accumulated\nby the corporation before the first taxable year to which\ncorporate integration applies would be a dividend, taxable\nas ordinary income, unless the distribution would qualify\nfor different treatment under current law. For example, a\ndistribution received pursuant to a redemption of stock that\nis not essentially equivalent to a dividend under current\nlaw would be treated as a distribution in part or full\npayment in exchange for the stock. On the other hand, an\nattempt to bail out the pre-effective date earnings and\nprofits by means of a partial redemption of stock that would\nbe treated as a dividend distribuiton under current law\nwould continue to be SO treated. The provisions of current\nlaw relating to electing small business (subchapter S)\ncorporations would be helpful as a model in drafting this\nparticular transition proposal. For purposes of determining\nhow much of a distribution that is treated as a sale or\nexchange under current law would qualify for special capital\ngains treatment, the shareholder would have to take into\naccount the transition rules with respect to repeal of the\ncapital gains provisions.\n5-29\nIn general, distributions with respect to stock acquired\nin a taxable transaction after the effective date would be\nsubject to the new rules, and would reduce basis and not\nconstitute income (unless such distributions exceeded the\nshareholder's basis). However, in those cases where the\ntransferee acquired the stock after the effective date\nwithout recognition of gain by the transferor, current law\nwill continue to apply to distributions from pre-effective\ndate accumulated earnings and profits.\nDistributions after the effective date would be deemed\nto be made first from the shareholder's distributable share\nof the corporation's post-effective date income and then\nfrom pre-effective date earnings and profits. Distributions\nin excess of these amounts would be applied against and\nreduce the shareholder's basis in his stock. Amounts in\nexcess of the shareholder's basis generally would be considered\nincome.\nIn order to avoid indefinite retention of such a dual\nsystem of taxation, the special treatment of pre-effective\ndate earnings and profits would cease after a specified\nnumber of years following the effective date of integration.\nDistributions received after such date, regardless of\nsource, first would be applied against basis and would be\nincome to the shareholder to the extent they exceed basis.\n5-30\nPre-integration accumulated earnings and profits remaining\nafter this date may not escape taxation completely at the\nshareholder level, since such earnings may be reflected in\nthe gain recognized on a subsequent taxable transfer of the\nstock, (such as a sale or a transfer by gift or at death),\nor may be taxed as a distribution in excess of basis. Before\nfixing the cut-off date for this provision an effort should\nbe made to determine quantitatively the extent of the benefit\nto the shareholders of the deferral of such taxation.\nAn alternative proposal was considered in an attempt to\npreserve the ordinary income character of distributions from\npre-effective date earnings. This proposal would treat a\nshareholder as receiving a \"deemed dividend\" (spread ratably\nover a 10-year or longer period) in an amount equal to the\nlesser of the excess of the fair market value of the share\nof stock as of the effective date over its adjusted basis,\nor the share's pro-rata portion of undistributed earnings\nand profits as of such date. This proposal was rejected\nbecause of its complexity and because of the likelihood of\nsubstantial liquidity problems for certain shareholders.\nCarryovers and Carrybacks\nThe carryover or carryback of items of income, deduction,\nand credit between taxable years to which the corporate\nincome tax applies, and taxable years to which it does not,\n5-31\nmust be considered for purposes of the transition rules. To\nthe extent practicable, an attempt should be made to treat\nsuch items in a manner that reflects the impact of the\ncorporate income tax as in effect when such items are earned\nor incurred. In following this approach, however, no\nattempt should be made to depart from the general rules\nrequiring that an item of income or loss be recognized\nbefore it is taken into account in computing gross income.\nAccordingly, unrecognized appreciation or decline in value\nof corporate assets (or stock of the corporation) attrib-\nutable to the pre-effective date period should not be\n\"triggered\" or recognized solely by reason of the shift to\nfull integration.\nIn general, certain deductions and credits may carry-\nback to a preceding taxable year or carryover to a subse-\nquent taxable year because of a limitation on the amount of\nsuch deduction or credit that the taxpayer may claim for the\ntaxable year in which the deduction is incurred or the\ncredit earned. Thus, for example, a net operating loss\ncarryback or carryover arises because the taxpayer's de-\nductions exceed his gross income. Capital loss deductions\nare limited to capital gains, deductions for charitable\ncontributions are limited to a certain percentage of income,\nand the investment tax credit is limited to a percentage of\nthe tax due. Also, the recapture as ordinary income, after\n5-32\nthe effective date, of deductions allowed and other amounts\nof income upon which tax has previously been deferred in\npre-effective date years, has the effect of shifting that\nincome to post-effective date years.\nIf income sheltered by a deduction (or income that\nwould have been sheltered had the deduction been utilized in\nan earlier year) had been distributed as a taxable dividend,\nthe net after-tax effect on the shareholder of the deferral\nor acceleration of a deduction will vary, depending on his\nmarginal tax bracket. In general, if the shareholder is in\na lower bracket, he may realize more total after-tax income\nif the deduction is utilized at the corporate level in a\npre-effective date year to which the corporate tax applies\nand the tax savings at the corporate level is distributed as\na dividend; if the taxpayer is in a higher bracket he may\nrealize more total after-tax income if the deduction is\nutilized in computing his distributable share of taxable\nincome after integration. In order to best approximate the\nnet result that would occur if such items could be used in\nthe year incurred or earned, unused deductions and credits\nincurred or earned in pre-effective date years should be\ngiven an unlimited carryback to earlier years of the\ncorporation. In order to avoid windfalls from receiving\nrefunds earlier than under current law, interest could be\ncharged on the refund.\n5-33\nDeductions that could not be absorbed in pre-effective\ndate years would be allowed to be carried in full to post-\neffective date years, subject to current limits on the\nnumber of succeeding taxable years to which the item may be\ncarried. In general, however, deductions carried over from\na pre-effective date year should not flow through to the\nshareholders, either directly or indirectly, for use in\noffsetting the shareholder's income from other sources, but\nshould be available only as deductions at the corporate\nlevel in order to determine the shareholder's pro-rata share\nof corporate income. This will avoid retroactive integration\nwith respect to such deductions, since the deduction would\nnot flow through when incurred, and will also avoid possible\nabuses by means of trafficking in loss corporations. Ordinary\nincome upon which tax was deferred in pre-effective years\nshould continue to be subject to recapture as ordinary\nincome.\nGenerally, the carryover to a post-integration year of\na tax credit earned in a pre-effective date taxable year\nwill result in a windfall for the shareholder. If the\ncredit had been used to offset corporate income tax in the\nyear in which it was earned, the amount representing the tax\nat the corporate level offset by the credit would have been\ntaxable to the shareholder, either when distributed as a\n5-34\ndividend or when realized by means of sale of the stock.\nAccordingly, a rule should be devised by which the tax\nbenefit of a credit carryover approxiamtes the benefit that\nwould result if the amount of the credit first offset a\nhypothetical corporate tax and then was distributed to the\nshareholder as a taxable dividend (or, perhaps, realized as\ncapital gain).\nIn general, no losses incurred or available credits\nearned in post-effective date years will carry back to pre-\neffective date years, since such items will flow through to\nthe shareholders after the effective date of integration.\nUnder present law, certain taxpayers, such as regulated\ninvestment companies, real estate investment trusts, and\npersonal holding companies, receive a dividends-paid de-\nduction for a taxable year even though the distribution is\nactually made in a subsequent year. Such distributions in\npost-effective date years should be allowed to relate back\nto the extent provided by current law, for the purpose of\ndetermining the corporate tax liability for the appropriate\npre-effective date year. The distribution would be con-\nsidered to be out of pre-effective date earnings and profits\n(whether or not it exceeds the amount in such account) and\ntaxable to the shareholders as a dividend from that source.\n5-35\nRules will have to be provided to insure that, if an\ninvestment tax credit earned by a corporation in a pre-\neffective date taxable year is subject to recapture because\nof an early disposition of the property, the credit also is\nrecaptured, either from the corporation or the shareholders.\nThis could be accomplished at the corporate level by im-\nposing an excise tax on the transfer or other recapture\nevent in an amount equal to the appropriate income tax\nrecapture.\nFlow-Through of Corporate Capital Gains\nDuring the phase-out period for capital gains, the net\ncapital gain or net capital loss for taxable years after the\neffective date of corporate integration should be computed\nat the corporate level with respect to sales or exchanges of\ncapital assets or section 1231 property by the corporation.\nThe character of such net capital gain or net capital loss\nshould be flowed through to the shareholders.\nFlow-Through of Tax-Exempt Interest\nIf the character of capital gains is to flow through to\nshareholders, consistency would require that the character\nof any remaining tax-exempt interest received or accrued by\na corporation after the effective date of corporate inte-\ngration from any State or municipal bonds that are grand-\nfathered should also flow through as tax-exempt interest to\n5-36\nthe shareholders. (Since corporate distributions will be\ntax-free, the tax-free character of the interest would be\npreserved by not reducing the shareholder's basis by the\namount of the distribution attributable to such interest.)\nGenerally, under present law, State and municipal bond\ninterest is received tax-free by the corporation but is\ntaxable as a dividend when distributed to shareholders. The\n1976 Tax Reform Act, however, provides that, in certain\ncases, the character of tax-exempt interest distributed by a\nregulated investment company flows through as tax-exempt\ninterest to its shareholders. 7/ In the event that it is\ndetermined that the tax-exempt character of State and\nmunicipal bond interest received by all corporations should\nnot flow-through to shareholders (i.e., that distributions\nof such amounts should reduce basis), an exception should be\nmade for regulated investment companies that have relied on\nthe flow-through provisions of the 1976 Tax Reform Act.\nUnique Corporate Taxpayers\nThe provisions of the tax code relating to taxation of\ninsurance companies and other unique corporate taxpayers\nwill have to be examined to determine what adjustments, if\nany, are required to take into account the effect of corporate\nintegration on the special rules applying to such taxpayers.\n5-37\nThe determination of appropriate transitional rules will\ndepend on the nature of any changes made to the basic\nprovisions.\nBusiness and Investment Income, Both Individual and Corporate\nIn general, the repeal of code provisions that provide\nan incentive for certain business-related expenditures or\ninvestments in specific assets should be structured to\nminimize the losses to persons who made such expenditures or\ninvestments prior to the effective date of the new law. The\nprincipal technique to effectuate this policy would be to\ngrandfather actions taken under current law. For example,\nany repeal of a tax credit (such as the investment tax\ncredit) and any requirement that an expenditure that is\ncurrently deductible (such as soil and water conservation\nexpenditures) must be capitalized should be prospective\nonly. Subject to the rules prescribed above for cor-\nporations, unused tax credits earned in pre-effective date\nyears should be available as a carryover to taxable years\nafter the effective date to the extent allowed under current\nlaw. The repeal of special provisions allowing accelerated\namortization or depreciation of certain assets generally\nshould apply only with respect to expenditures made or\nassets placed in service after a specific cutoff date. The\nrevision of the general depreciation and depletion rules\n5-38\nshould apply to property placed in service, or expenditure\nmade, after an effective date. Thus, for example, buildings\nwould continue to be depreciable in the manner prescribed by\ncurrent law only in the hands of their current owners. A\ntaxpayer who acquires a building and places it in service\nafter the effective date would be subject to the new rules.\nAlthough this could result in capital losses for the current\nowners, the grandfathering of the asset itself could,\nparticularly in the case of buildings, delay the effect of\nthe new rules for an unacceptable period.\nThe deduction for local property taxes on personal\nresidences should be phased out, by allowing deduction of a\npercentage of such taxes which declines over a period of\nyears.\nThe exclusion from gross income of interest on State\nand municipal bonds and certain earnings on life insurance\npolicies should continue to apply to such interest and\nearnings on bonds and insurance policies that are outstanding\nas of the effective date.\nIf the adoption of the accretion income tax system\nresults in the repeal of certain provisions of current law\nthat allow the non-recognition of gain (or loss) on sales or\nexchanges of particular assets, such repeal should be\neffective immediately, with no grandfather clause. It is\n5-39\nunlikely that the original decision to invest in such assets\ndepended on an opportunity to make a subsequent tax-free\nchange in investment. An exception may be appropriate,\nhowever, with respect to a repeal of the provision that\nexcludes from gross income the value of a building constructed\nby a lessee that becomes the property of the lessor upon a\ntermination of the lease. A grandfather clause should apply\ncurrent law to the termination of a lease entered into\nbefore the effective date.\nThe proposal will allow an adjustment to the basis of\nan asset to prevent the taxation of \"gain\" which is at-\ntributable to inflation, and does not reflect an increase in\nreal value of the asset sold by the taxpayer. The inflation\nadjustment should be applied with respect to inflation\noccurring in taxable years after the effective date. Making\nsuch an adjustment retroactive would result in a substantial\nwindfall for taxpayers.\nOther Individual Income\nUnder an accretion income tax system, several kinds of\ncompensation and other items previously excluded would be\nincluded in gross income, and deductions for a number of\nexpenditures that can be considered personal in nature would\nbe disallowed.\nEmployee Compensation\nSuch items as earnings on pension plan reserves al-\nlocable to the employee, certain health and life insurance\n5-40\npremiums paid by the employer, certain disability benefits,\nunemployment benefits, and subsidized compensation would be\nincluded in gross income.\nIt may be presumed that existing employment contracts\nwere negotiated on the basis that such items (other than\nunemployment compensation) would be excluded from the employee's\ngross income, particularly in those cases where the ex-\nclusion reflects a policy of encouraging that particular\ntype of compensation. The inclusion of such items in income\nin the absence of special transitional rules could create\ncash flow problems or other hardships for employees under\nsuch contracts. For example, a worker who is required to\ninclude in income the amount of his employer's health\ninsurance plan contribution may have to pay the tax on this\namount from what was previously \"take home\" pay if he cannot\nrenegotiate his contract.\nThis problem can best be solved by an effective date\nprovision that would apply the new rules to compensation\npaid in taxable years beginning after the effective date of\nthe basic tax reform program. However, the tax-free status\nof items paid pursuant to binding employment contracts in\neffect on the date of enactment would continue for the life\nof the contract or a specified period, such as three years,\nwhichever is less. The length of this period should reflect\n5-41\nthe general length of industry-wide contracts. Special\nrules for military personnel could be devised to grandfather\nservicemen through their current enlistment or term of\nservice. Earnings of a qualified pension plan allocable to\nthe employee that are attributable to periods before the\neffective date would not be included in the gross income of\nthe employee until such time as they would be included under\npresent law (i.e., generally, upon distribution to the\nemployee). Earnings attributable to periods after the\neffective date (as extended with respect to binding contracts)\nwould be included in gross income when paid or accrued. As\nunder present law, payments from the pension plan made to an\nemployee after the effective date will be allocated between\nthe employee's tax-paid basis in the plan, which will be\nreturned to him tax-free, and amounts not previously taxed,\nwhich will be included in gross income.\nGenerally, unemployment compensation that will be\nincluded in gross income under the proposal will not rep-\nresent a return of a tax-paid basis to the recipient, since\nthe \"premiums\", or employer contributions, with respect to\nsuch compensation were not included in his gross income.\nThus, it would not be inequitable to include the full amount\nof such compensation in gross income after the general\neffective date.\n5-42\nNonbusiness Expenditures\nUnder an accretion income tax system, certain non-\nbusiness expenditures such as small casualty losses, medical\nand dental expenses, and political contributions will cease\nbeing deductible. Generally, the repeal of the deduct-\nibility of these expenses can be effective immediately. If\nthe deduction for alimony is repealed pursuant to the\nenactment of an accretion tax, alimony payable under court\ndecrees or agreements currently in effect could be grand-\nfathered. If the medical expense deduction is to be replaced\nby a catastrophic insurance program, repeal of the deduction\nshould coincide with the effective date of the program.\nOther Items Previously Excluded\nThe inclusion in gross income of social security retire-\nment benefits (OASI payments) presents significant transition\nproblems, since such payments will represent to some extent\na return of previous after-tax contributions by persons\ncurrently (or formerly) employed, and will also effectively\nreduce the anticipated retirement income of many persons.\nPersons currently receiving benefits (and possibly persons\nwith only a specified number of years remaining before\neligibility) should be grandfathered, i.e., the receipt of\ntheir benefits should continue to be tax free. Such persons\nwould very likely be unable to make alternative arrangements\n5-43\nto supplement their retirement income in order to maintain\ntheir anticipated level of disposable income. For other\npersons who retire in the future, a statutory formula will\nhave to be devised to allocate benefits between after-tax\nemployee contributions, which would be returned tax free,\nand employer and post-effective date employee contributions,\nwhich portion would be taxable.\nThe inclusion in gross income of scholarships, fellow-\nships and means tested cash and in-kind government grants,\ndoes not appear to present any transitional problems, since,\ngenerally, the amounts of these items were not bargained for\nby the recipient, and do not represent a return of a tax\npaid basis.\nTreatment of Gifts and Transfers at Death as Recognition Events\nUnder the proposal, gifts and transfers at death will\nbe treated as recognition events. Thus, in general, the\nexcess of the fair market value of the asset transferred\nover its adjusted basis in the hands of the donor or decedent\nwill be included in the gross income of the donor or decedent.\nThere appear to be no transition problems if this rule is\nmade to apply only to transfers after an effective date.\n5-44\n5. Transition to a Cash Flow Tax System\nIntroduction\nThis section presents a proposal for transition from\nthe current system to a cash flow expenditure tax of the\ntype discussed in Chapter 4. The problems involved in a\ntransition to a cash flow tax would be considerable, and all\nof the alternative methods considered have major short-\ncomings. Presentation of this proposal includes discussion\nof administrative difficulties and some possible distributive\ninequities, and an explanation of why certain alternative\nplans were rejected.\nIn summary, the proposed transition scheme would\nmaintain both an income tax and a cash flow tax for 10 years\nbefore total conversion to the cash flow tax. During the\ntransition period, individuals would compute their tax\nliability under both systems and would be required to pay\nthe higher of the two taxes. The corporat e income tax\nwould be retained for the interim and would be discontinued\nimmediately after the effective date. Unrealized capital\ngains earned prior to full adoption of the cash flow tax\nwould be \"flushed\" out of the system through a recognition\ndate at the end of the 10-year period when they would be\ntaxed at the current capital gains rates. Payment of taxes\non past capital gains could be deferred with a low interest\ncharge to prevent forced liquidation of small business.\n5-45\nThe transition program outlined here would not fully\nrealize the goals of transition presented below. It would,\nhowever, mitigate the redistribution of wealth that would\nresult from immediate adoption of a cash flow tax and would\nsimplify the tax system by eliminating, within a reasonable\nperiod of time, the need to keep the personal and business\nincome tax records currently required.\nGoals of Transition\nThe main objectives of a program of transition to a\ncash flow tax are: (1) prevention of immediate or long-term\nredistribution of economic welfare and (2) simplicity and\nadministrative ease. Although some changes in consumption\nopportunities would be inevitable in a tax change as major\nas the one proposed, the proper transition program should be\nable to minimize large redistributions among taxpayers in\nability to consume immediately and in the future. In parti-\ncular, this program should prevent heavy additional tax\nliabilities (in present value terms) for any clearly identi-\nfiable group of taxpayers. For purposes of simplicity,\ntransition rules should eliminate the present income tax\nsystem and its recordkeeping requirements as soon as pos-\nsible and, if possible, avoid measuring current accumulated\nwealth and and annual changes in individuals' total wealth\npositions in the transition period, as well as afterwards.\n5-46\nUnder a fully operative cash flow tax system, the principal\nrecords for tax purposes consist only of cash flow trans-\nactions for business activities, net deposit and withdrawal\nin each qualified account plus the usual wage and salary\ndata.\nDistribution Issues\nTwo distribution issues are important in a transition\nto the cash flow tax: (1) treatment of untaxed income before\nthe effective date, and (2) changes in the distribution of\nafter-tax consumption.\nEquitable treatment of income untaxed before the\neffective date would require that an individual who had\nunrealized capital gains at the time of the adoption of the\nnew system be treated in the same way as the individual who\nrealized the capital gain before the effective date. The\npractical problems involved in realizing this goal influence\nthe specifics of the transition proposal discussed below.\nThe treatment of past accumulated income that has been\ntaxed poses a more difficult problem of equity. Because a\ncash flow tax is equivalent to exempting income from capital\nfrom tax, a higher tax rate on income from labor would be\nrequired under a cash flow tax system in order to maintain\nthe same tax revenue. Thus, the short-term effect of a cash\nflow tax would be a higher after-tax rate of return from\n5-47\nownership of monetary or physical assets and a lower after-\ntax wage rate. The exact distributive consequences of this\nchange would depend upon how past accumulated wealth is\nallowed to enter the system.\nThere are two alternative ways, both consistent with\nthe logic of a cash flow tax, to allow past accumulated\nwealth to enter the system. The most generous to owners of\ncapital is to define existing wealth as tax prepaid assets\nunder the new system. All future returns from such assets,\nas well as return of principal, would not be reported as\nincome or subject to tax. The second way is to define\nexisting wealth as current, untaxed income. In this case,\nthe return of principal would be taxed, but the present\nvalue of tax liability would not increase as assets earn\naccrued interest. The tax liability, although increasing in\nnominal value with future earnings, would be deferred until\nthe gains were realized.\nTable 6-1 illustrates the tax treatment, under an\nincome tax and under the two alternative methods of transition\nto a cash flow tax, of consumption out of $100 of past\naccumulated assets for different times at which wealth is\nwithdrawn for consumption. Time 1 represents potential\nconsumption in the first year after the effective date.\nTime 2 represents potential consumption at a time in the\n5-48\nfuture when the asset has doubled in value if untaxed. Time\n3 represents potential consumption at a time in the future\nwhen the asset has quadrupled in value if untaxed. A tax\nrate of 50 percent is assumed.\nTable 6-1\nPotential Consumption Out of Accumulated\nWealth Under Different Tax Rules\nInitial Wealth = $100\nAssets Double in Value Between Each Pair of Time\nPeriods if Untaxed\nCash Flow Tax;\nCash Flow Tax;\nIncome Tax\nAsset Prepaid\nAsset in Initial\nIncome\nTime 1\n$100\n$100\n$50\nTime 2\n$150\n$200\n$100\nTime 3\n$200\n$400\n$200\nUnder an income tax, the asset could be withdrawn and\nconsumed tax free, but future accumulation would be taxed.\nUnder the cash flow tax, with the asset defined as tax prepaid,\nthe asset would be allowed to accumulate tax free and could\nalso be withdrawn and consumed tax free. Under the cash\nflow tax, with the asset value initially included in the tax\nbase, consumption from the asset would be taxed upon withdrawal,\nbut the rate of accumulation of the asset would not be\naffected by the tax.\n5-49\nA transition to a cash flow tax with assets initially\ndefined as prepaid would increase the welfare of owners of\ncapital assets. The after-tax consumption of these taxpayers\nwould increase under the new system unless they consumed\nall of their wealth within the first year after the effective\ndate, in which case consumption would be unchanged. If\nassets were initially included in the tax base, however, the\nafter-tax consumption of owners of capital assets would\ndecrease if they chose to consume a large portion of their\nwealth in the early years after the effective date. Inclusion\nof assets in the base would increase after-tax consumption\nrelative to an income tax for owners of capital assets who\ndeferred consumption out of accumulated wealth for a long\nperiod. 10,\nAs Table 6-1 illustrates, initial definition of assets\nas prepaid or included in the base would make a big difference\nin tax liability.\nInclusion of accumulated assets in the tax base seems\nvery unfair to older persons who are about to consume out of\naccumulated wealth during the retirement period. On the\nother hand, prepaid designation would greatly benefit all\nowners of monetary and physical assets by redistributing\nafter-tax dollars from labor to capital. Although returns\n5-50\nfrom capital would be nontaxable under a fully operational\ncash flow tax, past accumulation of capital occurred under a\ndifferent tax system, where individuals did not anticipate a\nsharp rise in the after-tax return to capital. Thus, tax\nprepaid treatment of capital assets may be viewed as\ninequitable.\nThe distribution problem caused by defining existing\ncaptital assets as prepaid would be reduced over time. The\nincentive to savings under a cash flow tax should raise the\nrate of capital formation, increasing the amount of invest-\nment and eventually lowering before-tax returns to capital\nand raising before-tax wages. However, in the first few\nyears after transition, higher tax rates on labor income\nwould not be matched by a corresponding increase in before-\ntax wages.\nFor certain types of capital assets, the appropriate\nrule for transition definition is clear. Investments in\nowner-occupied houses and other consumer durables are\ntreated very similarly to prepaid investments under the\ncurrent system, and they should be defined as prepaid assets\nfor purposes of transition to a cash flow tax. The accrued\nvalue of employer funded pension plans should be treated in\nthe same manner as qualified accounts becuase the contribu-\ntions were exempt from tax under the old system and the\nreceipts were fully taxable.\n5-51\nDesignation of past accumulated assets as prepaid\nassets would be the easier transition to administer. There\nwould be no need to measure existing wealth, and the only\nchange to the present system would be to eliminate capital\nincome from the tax base. Prepaid assets could be freely\nconverted to qualified assets to enable the individual to\naverage his tax base over time. An individual converting a\nprepaid to a qualified asset would be able to take an\nimmediate tax deduction, but would become liable for taxes\nupon withdrawal of principal and subsequent earnings from\nthe qualified account. 11/ If assets were initially defined\nto be part of an individual's tax base, it would be necessary\nto value them on the effective date. Individuals would have\nan incentive to understate their initial asset positions.\nAssets not initailly accounted for could be deposited in\nqualified accounts in subsequent years, enabling an individual\nto take a deduction against other income.\nA Preliminary Transition Proposal\nAll assets would be defined initially as prepaid\nassets. For a period of 10 years, the existing income tax\nwould be maintained, and individuals would file returns for\nboth systems and would pay the higher of the two computed\ntaxes.\n12/\nFor most taxpayers, the cash flow tax would be\nhigher. However, for persons with large amounts of capital\nincome relative to labor income, the income tax would be\nhigher.\n5-52\nThe corporate profits tax would be retained throughout\nthe transition period. Theoretically, stockholders paying\nthe cash flow tax should receive their corporate earnings\ngross of corporate tax during the interim period. However,\nwithout full corporate integration, whereby all earnings\nwould be attributed to individual stockholders, it would be\npractically impossible to determine what part of a corporation's\nearnings should be attributed to individuals paying the\nconsumption tax and what part, to individuals paying the\nincome tax. It is likely that ownership of corporate shares\nwould be concentrated among individuals who would be subject\nto the income tax during the interim period. For reasons of\nsimplicity, therefore, the corporate tax would be retained\nfor the transition period and would be eliminated immediately\nafterward.\nAll sales of corporate stock purchased before the\nbeginning of the transition period, by individuals paying\nunder either tax base, would be subject to a capital gains\ntax at the existing favorable rates. The reason for this\nprovision is that capital gains earned but not realized\nbefore the interim period should be taxed as if they were\nincome realized at the effective date. 13/\n5-53\nA recognition date would be required at the end of the\ntransition period to account for all remaining untaxed\ncapital gains. Under a fully operational cash flow tax\nsystem, under which assets would be defined as prepaid and\nno records of current and past corporate earnings and\nprofits would be kept, it would be impossible to distinguish\nbetween distributions that were dividends out of current\nincome and distributions that were réturn of accumulated\ncapital. The dividends would not be subject to tax under\nthe new law. Distributing past earnings would be a way of\nreturning to the individual his accumulated capital gains\ntax free. In order to eliminate the need for corporate\nrecords for income tax purposes on the final day of the\ntransition period, it would be necessary to have a single\nday of recognition for past gains.\nIt would be possible to develop a method of final\ncapital gains tax assessed on the recognition date be paid\nover a long period at a low interest rate, to avoid forced\nliquidation of small firms with few owners.\nThe advantage of the transition proposal outlined here\nare the following: 1. It would enable all of the simplifying\nfeatures of cash flow tax to be in full operation after 10\nyears, including elimination of required income tax records.\n5-54\n2. It would allow consumption out of past accumulated\nearnings to be exactly the same as it would have been under\nthe income tax during the first years after the effective\ndate. 3. It would provide for appropriate and consistent\ntaxation of income earned before the effective date. 4. By\ngradual elimination of taxes on income earned from past\naccumulated capital, this proposal would mitigate the redis-\ntribution of wealth to current asset owners that would occur\nafter immediate full adoption of a cash flow tax. The major\ndisadvantages of this transition program are that it would\nrequire a recognition date that would impose a large one-\ntime administrative cost on the system, and it would require\nsome taxpayers to fill out two sets of tax forms for a\nperiod of 10 years, a temporary departure from the long-term\ngoal of low administrative costs.\nAlternative Transition Plans\nOne alternative plan would be to adopt the new tax\nsystem immediately, designating all assets as prepaid,\nwithout a recognition date to \"flush out\" past capital\ngains. Although this plan would be the simplest one, it\nwould give too great an economic advantage to individuals\nwith unrealized capital gains and would cause too large a\ntransfer of future after-tax consumption to present asset\nowners.\n5-55\nAnother transition plan would be to adopt the cash flow\ntax immediately and designate all assets as current income.\nThis would require valuing all wealth on the effective date\nand imposition of an effective one-time wealth tax. Such an\napproach would be harsh on older persons planning to live\noff accumulated capital in the early years after the effec-\ntive date.\nA second, more complicated option would allow prepaid\ntreatment of assets but, in exchange for the elimination of\ntaxes on future capital income, would impose an initial\nwealth tax related to an individual's personal circumstances.\nFor example, the initial tax could be based on age and\nwealth, with higher rates for persons with more wealth and\nlower rates for older people. 14/ Although it might provide\na transition program that approximates distributive neutrality,\nsuch a plan would be even greater departure from the goal of\nsimplicity.\nA third option would allow three types of assets:\nprepaid, as defined above, qualified, as defined above, and\na Type 3, which would treat assets as defined under the\ncurrent system. In principle, we would like people to be\nable to consume out of Type 3 assets tax free and to invest\nin prepaid and qualified assets only out of savings from\ncurrent income. In effect, this plan would initiate cash\n5-56\nflow taxation on current earnings only and would treat pre-\neffective date earnings exactly as they are treated under\nthe current system, including the same treatment of post-\neffective date capital accumulation from pre-effective date\nwealth. This plan would be extremely difficult to administer.\nNot only would individuals have to keep books for three\ntypes of assets, but also total annual wealth changes would\nhave to be measured (valuation of unsold assets would not be\na problem because even if too high a value were imputed,\nraising both measured wealth and saving, consumption would\nremain unchanged) in order to arrive at a measure of annual\nconsumption. Treatment of corporate income under this\nsystem would also be complicated, because some investments\nin corporate stock would come from all three types of assets.\nUnder this transition alternative, Type 3 assets would\nbe subject to a transfer tax and converted to prepaid assets\nat death. Eventually, Type 3 assets would disappear from\nthe system, and the complete cash flow tax would be in\noperation. Alternatively, all Type 3 assets could be\ndesignated prepaid after a fixed number of years.\nAlthough the three asset plan has the advantage of\ntreating owners of capital exactly as they would have been\ntreated under the income tax and changing the rules only for\nnew capital, 15/ its administrative complexity is so great\nas to discourage serious consideration.\n5-57\nFootnotes\n1/\nThe exact change in the rate of tax on capital income\nearned in corporations by different individuals will\ndepend on the fraction of corporate income currently\npaid out in dividends, the current average holding\nperiod of assets before realizing capital gains, and\nthe individual's tax brackets. While the current\ncorporate income tax does not distinguish between\nowners in different tax brackets, integration, which\nattributes all corporate earnings to the individual\nowners would tax all earnings from corporate capital\nat each individual owner's marginal tax rate.\n2/\nThe taxpayer can, in fact, avoid this problem by selling\nhis shares before the effective date at the current\nlower capital gains rate and then buying them back.\nHowever, one other objective of transition rules,\ndiscussed in the next section, should be to avoid\nencouraging market transactions just prior to the\neffective date.\nFor example, workers damaged by employment reductions\nin industries with increasing imports due to trade\n5-58\nliberalization are eligible for trade adjustment\nassistance.\nNote that is is not clear just what is meant by\nan \"existing asset\" in this context; a building is\ngreatly affected by, e.g., maintenance and improvement\nexpenditures over time.\n5/\nThe appropriate rule may be to allow no depreciation at\nall.\n6/\nSection 1231 property is generally certain property\nused in the taxpayer's trade or business. If gains\nexceed losses for a taxable year, the net gains\nfrom section 1231 property are taxed at capital gains\nrates; if losses from section 1231 property exceed\ngains, the net losses are treated as ordinary losses.\n7/\nIn the case of a subchapter S corporation, the\ncharacter of net capital gains flow through to the\nshareholder. The character of tax-exempt interest\ndoes not.\n5-59\nExpenditures made pursuant to binding contracts\nentered into before the effective date should also\nbe grandfathered.\n9/\nThe income tax computation assumes a full accretion\ntax, under which all returns to capital are taxed as\naccrued at full rates. Thus, the rate of accumulation\nunder the income tax would be cut in half. Under the\npresent law, taxation of capital gains is deferred\nuntil realization and then taxed at only one-half the\nregular rate. For example, if the asset is realized at\ntime 3, after-tax income would be $325. It should be\nnoted, however, that if the asset is corporate stock,\nprofits are taxed at a rate of 48 percent every year.\nIf the corporation is not reducing its tax base sub-\nstantially through accelerated depreciation or the\ninvestment tax credit, then, combining the corporate\nand personal taxes, the capital income of the corporate\nshareholder may be taxed under current law at an even\nhigher rate than the rate on ordinary income.\n10/ For example, if the before-tax interest rate were 10\npercent, wealth would quadruple in 15 years. With the\n50 percent tax rate used in Table 1, wealth holders\n5-60\nwould be better off under the consumption tax, even if\ntheir assets were initially defined as income, if they\ndeferred consumption out of wealth for at least 15\nyears.\n11/ A wealthy person could appear to \"shelter\" his current\nlabor income by converting prepaid assets into qualified\nassets, deducting the deposits in qualified assets from\ncurrent labor income. However, this practice would not\nreduce the present value of his tax base, because he\nwould have to pay a tax on the principal and accumulated\ninterest whenever the qualified asset is liquidated for\nconsumption.\n12/ It is possible that only wealthy people should be\nrequired to fill out an income tax return. The main\nreason for retaining the income tax would be to tax\naccumulated past capital for an interim period of time,\nto mitigate the inequitable distribution effects of a\ntransiotn to prepaid treatments of assets. It is\nlikely that only people with significant amounts of\npast accumulated capital would have a higher liability\nunder the income tax. The requirement to file an\nincome tax return might be limited to taxpayers reporting\n5-61\nan adjusted gross income above a certain minimum level\n(for example, $20,000 or more) in any of several years\nbefore the effective date.\n13/ Technically speaking, individuals paying the cash flow\ntax during the interim period should not have to pay\ncapital gains tax between the first day of the interim\nperiod and the time an asset is sold. One way to avoid\nthis would be to adjust the basis upwards to conform to\ninterest that would have been earned on a typical\ninvestment after the beginning of the interim period.\nBy doing this, the present value of capital gains tax\npaid, for assets growing at that interest rate, would\nbe the same as if the gain were realized on the effective\ndate.\n14/ Because the wealth of older persons would be subject to\nthe accessions tax sooner, it would not be necessary\nfor equity to tax it on the effective date.\n15/ The three asset plan can be viewed as a sophisticated\nform of \"gradfathering.\""
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