Posted on 11/24/2004 11:59:36 AM PST by Remember_Salamis
The Perils of Tax Reform Frankly, tiny and timid is better than big and bold
RAMESH PONNURU
When President Bush said that he would appoint a commission to report on tax reform in the spring, conservative hopes for a fundamental overhaul rose. Could this finally be the moment for a flat tax or a national sales tax? The answer appears to be no. Early reports suggest that the commission will look at substantial tax-policy changes, but will not scrap the code and start over.
Conservatives should be relieved, not upset. Anyone who has filed a tax return knows that there are good reasons for reform. But there are also abundant reasons for caution. Conservative enthusiasts for reform have underestimated the political risks involved. The Bush administration has acted wisely in the three tax-reform decisions it has so far made: rejecting a comprehensive, big-bang tax reform; disavowing the idea of abolishing tax preferences for homeownership and charitable giving; and placing tax reform behind Social Security on the legislative calendar. It may find itself having to lower tax-reform expectations still further in coming months.
The perils of tax reform may be judged from what happened the last two times it was on the agenda in Washington: in 1986, and then again in 1995-96. In the former year, Congress took massive strides toward simplifying the tax code. Many tax deductions were eliminated. The broadened tax base made it possible to bring down tax rates. It was a great bipartisan victory. It was also a major setback for conservatives.
Congress adopted the liberal definition of tax reform, and broadened the tax base to include things it should not have included. The treatment of saving and investment was the chief problem. Taxing income when it is made, and then also taxing the returns on any of that income, creates a bias against saving. IRAs, by shielding some of that investment income from taxation, reduce that bias. Liberal tax reformers, however, regarded IRAs as tax breaks. The 1986 reform accordingly scaled them back. It raised capital-gains taxes, too, on the related theory that low taxes on capital gains are also a nefarious tax break. And it raised taxes on business investment. For most of the subsequent two decades, conservatives have been trying to undo the policy damage wrought by those changes. By retarding the growth of the investor class, the 1986 tax reform delayed conservatism's political ascent.
When Republicans took control of Congress in 1995, they were eager to reform the tax code again, but this time on conservative terms. Many conservatives — notably Dick Armey, Steve Forbes, and Jack Kemp — supported a flat tax. The flat tax would end the bias against saving by not taxing the returns on it. In effect, it would be a tax on consumption. People in almost all income classes would be taxed at the same rate (17 percent in most plans). There would be no deductions: not for mortgage interest, not for charitable giving, not for anything. The goal was to keep the tax code, as much as possible, from influencing people's economic decisions.
A minority of conservatives, including Bill Archer, then the chairman of the House committee on taxes, wanted even more: an end to the hated IRS. Their preferred solution was a 23 percent national retail-sales tax. Like the flat tax, the sales tax would have applied a single tax rate to all taxpayers and would have ended the bias against saving. The crucial difference was administrative: A sales tax would relieve most people of the need to have any contact with the tax collector.
The guiding assumption among conservatives seemed to be that once their economists had agreed on an ideal tax plan, it would be Congress's job to pass it. But Congress did not seem eager to play this role. Nobody ever came up with a practical strategy for getting comprehensive tax reform enacted in either its flat-tax or sales-tax variety. Newt Gingrich appointed a tax-reform commission that produced an excellent analysis of the benefits that would flow from adoption of a flat tax. Nothing came of it. Congress never even voted on a flat-tax bill.
FIVE EASY PIECES Years of getting nowhere taught conservatives the virtues of incrementalism. After George W. Bush took office, Grover Norquist, head of the tax-cutting group Americans for Tax Reform, argued that conservatives should drop the idea of legislating a flat tax all at once. Instead, he advocated five discrete steps toward the flat-tax goal: abolishing the estate tax, the capital-gains tax, and the Alternative Minimum Tax; enacting universal IRAs to shelter most saving from double taxation; and allowing businesses to deduct the full cost of their investments as soon as they make them. Supply-siders, adapting a phrase of Ernest Christian, a Republican tax lawyer in Washington, quickly dubbed the strategy "five easy pieces."
Norquist's approach is still basically correct. Conservatives have more power in Washington than they did in 1995 — but they still don't have nearly enough to enact comprehensive tax reform, and trying would endanger what power they do have.
Consider the practical problems that would attend the creation of a national sales tax. Its proponents do not want the federal government to levy a sales tax in addition to an income tax. Many of them say that they would abolish the income tax and repeal the Sixteenth Amendment so that it would stay abolished. Good luck with that.
The sales taxers also lowball the tax rate they would have to impose. They say that 23 percent would be sufficient to fund the federal government. But this number is misleading. They would put a $30 tax on a $100 purchase. They say that is a "23 percent" tax because 30 is 23 percent of 130. Normally, we would say that was a 30 percent sales tax. Since a retail-sales tax that high would cause a lot of people to buy wholesale or resort to other forms of tax avoidance and evasion, the rate might have to go even higher. Or the government might have to convert the tax into a Value Added Tax levied at each stage of production.
According to its supporters, the sales tax would shackle the federal Leviathan. Every time you bought a pack of gum, you would supposedly remember how much you hate out-of-control federal spending. I very much doubt it would work this way. Most of us have a better sense of how much we paid in income or property taxes last year than of how much we paid in sales taxes. My guess is that a sales tax would prove easier to raise than an income tax. A VAT, which would be largely hidden from the people who ultimately pay it, would be even easier to raise — a veritable money machine for governments, as European nations have demonstrated.
A national sales tax is unthinkable. A flat tax is merely impossible. To replace our progressive tax rates with a single rate, Congress would face three unpalatable options. It would have to raise taxes on low-income taxpayers. It would have to accept a massive increase in the deficit. Or it would have to assume that the flat tax will have so extraordinarily positive an effect on the economy that the average tax rate can drop without increasing the deficit. Any of these options would be a very hard sell for a majority of congressmen.
Almost every interest group in Washington would mobilize to defeat a tax reform that abolished tax deductions. On conservatives' side would be just a few think tanks. There are good reasons to think that the mortgage-interest deduction does not actually benefit homeowners. Try to convince most homeowners of that after the homebuilders are done with their ad campaign.
SPENDING POLITICAL CAPITAL WISELY The case for moving cautiously does not rest solely on the difficulty of enacting fundamental tax reform. It is also worth considering that other uses of political capital have a higher ratio of reward to risk. The votes may already be there for repealing the estate tax, or greatly expanding tax-sheltered savings accounts. Adding private accounts to Social Security would be an uphill climb, but would also move millions of voters into the free-market camp. By increasing the number of investors, increasing the extent of their involvement in capital markets, and making the Republican party appealing to them, these policies would make it easier to enact other conservative reforms in the future. Abolishing deductions, on the other hand, would consume enormous amounts of political capital without bringing us any closer to future policy victories. In this respect, it would resemble the 1986 tax reform.
Bush has dodged a bullet by rejecting fundamental tax reform. Still, he wants — as one of his aides says — to propose something "big and bold." Looking at the policies under contemplation, however, I cannot help but think that tiny and timid might serve the president better.
The administration wants to get rid of, or at least reduce, the Alternative Minimum Tax. This tax was introduced to make sure that everyone paid taxes, no matter how many tax loopholes they had found. If the regular tax code generates too low a tax liability for someone, he has to pay the AMT instead. Though originally intended to snare rich people, the AMT catches more and more middle-class families in its net each year. (One reason it does is that it is not indexed for inflation.) The AMT does not allow most of the deductions and exemptions that the regular tax code does, and is consequently very punishing to savers and large families.
But the AMT also raises a lot of money for the federal government. In a few years, it is projected to collect more money than the regular income tax. So the officials who are thinking about getting rid of it are looking to replace the lost revenue by abolishing two of the largest tax breaks too — and that's where the trouble comes in.
One of those breaks is the tax-free status of employer-provided health care. That status has done a lot to create America's health-care troubles. It encourages workers to seek health coverage rather than higher wages. It inflates health-care costs, since people aren't paying for them directly. And it means that Americans' health coverage is tied more closely to their jobs than is, well, healthy. But people are not going to understand any of this if the administration proposes a more rational tax treatment of health care; they will think that Bush is trying to make it harder for people to get health care. The unions will fight ferociously to maintain a tax subsidy for the benefits they have negotiated. Bush has already started to limit some of the negative effects of this tax break by creating Health Savings Accounts, which extend another tax break to individuals who pay out-of-pocket for health expenses. That policy levels the playing field between individual payment of health costs and employer-provided insurance. It may not be as efficient an arrangement as a tax policy that did not favor health spending at all. It may, however, be the best that we can practically do.
The other big tax benefit on the chopping block is the deduction for state and local taxes. As with the health tax break, it probably should never have been created. Why should people in low-tax states effectively subsidize people in high-tax ones? Why should the federal government make it easier for states to maintain high tax rates? If this deduction were abolished, state politics would probably shift rightward as states' voters paid more of the price for electing tax-and-spenders. But getting rid of the deduction will obviously be very unpopular in high-tax states. When the tax reformers of 1986 briefly discussed it, they were quickly shouted down. The one thing reformers have going for them this time is that the AMT tends to hit the same states the hardest, making a trade possible. If it isn't, Bush may have to settle for taking many people off the AMT rolls.
Bush and Congress could do a lot of good on taxes without running these risks. Expanding tax-sheltered savings accounts would be very popular with investors. The mortgage-interest deduction could be converted to a tax credit, which would reduce its value only for the most affluent taxpayers. Tax credits for poor people could be consolidated and perhaps expanded, simplifying the tax code and making it less hostile to families. Getting rid of the estate tax would boost capital formation and shred as much as 10 percent of the tax code. The result would be something like the 1986 reform, except with more favorable treatment for saving and a higher top tax rate.
Bush is right to put tax reform of any kind behind Social Security reform on his to-do list. A free-market reform of Social Security would be a kind of tax reform: It could be seen as a payroll tax cut for workers made conditional on their investing the proceeds. The cost of delaying Social Security reform would be high, as would the rewards of starting private accounts now. (The longer workers get to compound their interest, the better.) The political opportunities Social Security presents are, as mentioned before, also greater than those that tax reform does. Conservatives may be inclined to be "big and bold" on tax reform, but they should above all else be smart and sober about it.
Here's my prediction for tax reform in the 109th Congress:
AMT repealed State/Local deductions repealed
The AMT abomination needs to be repealed. Period. Over time, it will be a tax hike on more and more of the uppper middle class. We must prevent future tax hikes before cutting them now I guess.
Ending the State and Local deductions, as Ramesh pointed out, WILL cause a rightward shift in State and Local politics. To use a baseball metaphor, by dominating the farm leages today we will dominate the major leages tomorrow. We already see this happening through a strong crop of Republican governors emerging (Owens, Jeb Bush, Pawlenty, Sanford, Pataki, Romney, etc.). If Democrats can't get their foot in the door to politics, they'll never be able to move up the chain.
The article, like the tax code, is too damn long.
(1) No withholding. Everyone must write a check for the full amount to the IRS.
(2) Tax day to be changed from April 15 to the first Monday in November.
I'll be happy to let nature take its course from there.
A deep and good analysis by Ramesh.
(2) Tax day to be changed from April 15 to the first Monday in November.
I'll be happy to let nature take its course from there.
Ditto that. Joe and Jane Sixpack will sh!t-a- brick when they write the check. Probably have spent it all and then have to get a second mortgage to pay the bill (tax).
A Taxreform bump for you all.
If you would like to be added to this ping list let me know.
John Linder in the House & Saxby Chambliss Senate, offer a comprehensive bill to kill all income and payroll taxes outright, and provide a IRS free replacement in the form of a retail sales tax:
H.R.25, S.1493
A bill to promote freedom, fairness, and economic opportunity by repealing the income tax and other taxes, abolishing the Internal Revenue Service, and enacting a national retail sales tax to be administered primarily by the States.Refer for additional information: http://www.fairtax.org, http://www.salestax.org & http://www.geocities.com/cmcofer/ftax.html
obviously, Ramesh and like-minded Congresscritters don't
do their own taxes and haven't been audited.
It's one step forward and three steps back every time
Congress and the presidency change hands.By the time my kids
are going to pick up their tax forms they'll need a wheelbarrow,a lawyer, an accountant, and a grief counselor.
Ecellent suggestions right in line with my way of thinking.
Item 1 would cause government to shut down.
When and Where?!?!?! Remember, I lack tact and I work for cheap.
Sounds good to me.
Fairtax NOW!!
Of note is that the flat income tax retains payroll taxes of 15.3%. The flat income tax also continues to hide taxes and tax costs in prices - perpetuating the perception that the gov't is not taking as much of your money.
The flat income tax would still retain a hidden tax in prices of at least what we have now - 22%....
I respectfully, disagree. The stars may never again align themselves to allow us the opportunity of getting rid of this communist inspired mess called the progressive income tax. I say strike while the iron is HOT! NRST NOW!!!
Your 2nd suggestion is a great 1st step. Might help to reach a NRST. I think we need a "phase in"... preplanned. 9% flat tax and and 5% NRST to start (or whatever is required to assure adequate revenue) with the flat tax reducing each year and the NRST increasing until we are at 100% NRST.
"Whatever is needed to assure adequate revenue". Spoken like a true socialist. Is there any thought given to the idea that maybe, just maybe, we don't need as much government as we have? Set the rate that the public wants and adjust the government accordingly. How about anarchy and no taxes? We are entering a period of time when income will be discouraged even more than it is now. The government needs to make an adjustment to take more of your dollars. That is the only reason they would even consider changing the form of taxation. The goose that laid the golden egg is looking rather scruffy.
Ramesh is right. Remember what happened to my namesake with the poll tax.
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