Because it is difficult to estimate the tax consequences of the particular actions that such tax provisions are intended to reward, they act less as a spur to socially desirable behavior than one might expect while still resulting in loss of revenue.
There are many ideas for tax simplification. One that is frequently mentioned is to replace the income tax with a flat-rate or progressive consumption-based tax system. Revenue estimates have varied quite widely, but it appears that under revenue-neutral reform, switching to a flat consumption-based system might increase U.S. incomes over the long term by about 10 percent (Altig et al., 2001; Auerbach, 1996; Joint Committee on Taxation, 1997; Jorgenson and Yun, 2002; Kotlikoff, 1993). However, a consumption tax at a single flat rate would shift the tax burden among households significantly, which would create winners and losers among different groups of taxpayers.8
Whatever the level of taxes in the future, GDP and incomes would be higher if the tax system were more efficient than it currently is. An efficient tax system is one that minimizes distortions that adversely affect working, saving, investing, spending, and other important economic decisions. A pure income tax would treat different forms of income in the same way, thus broadening the tax base. This would allow lower marginal tax rates without losing revenues, so that economic decisions would be less driven by their effect on taxes owed and be more likely to raise income throughout the economy.9
Variations in the way different categories or sources of income are taxed tend to distort wage, price, and profit signals in the economy, thereby diverting resources into lower productivity uses. This is particularly so for variations in taxing different sources of income of one type, such as business profits and capital income. For example, if one industry benefits from a special tax provision, higher after-tax returns in that industry will draw resources to it from other activities that have higher economic value. Except in the case of demonstrated market failure, only equal tax treatment of different economic activities will lead to the most efficient use of scarce resources; see Box 8-1. All of the special provisions in the current income tax code—including the favorable treatment of home ownership (even for vacation properties)—create economic costs or “deadweight losses.” These are the losses in “welfare” (economic well-being) that occur when tax rules distort economic behavior: individuals and businesses act in ways that take