Bush Tax Reform

Insight Magazine ^ | Feb. 3, 2003 | By John Berlau

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In their responses to the State of the Union Address in late January, Democrats charged that President George W. Bush's tax plan, particularly the repeal of double taxation on corporate earnings and shareholder dividends, would benefit only giant corporations and the rich. But at least one of those big corporations has come out swinging against the tax cuts: the Big Five accounting firm of Grant Thornton LLP.

Based in Chicago, Grant Thornton claims in a press release that repealing the tax on dividends "is likely to have a negative impact." Proponents of the Bush plan say opposition from Grant Thornton is revealing. They maintain that the only "negative impact" the dividend repeal and other reforms to simplify the tax code and eliminate double taxation would have is on accounting firms such as Grant Thornton and other businesses that feed on the mind-boggling complexity of the current tax system.

"We want to make it the buggy-whip industry," says Rep. Chris Cox (R-Calif.), chairman of the House Policy Committee and the fifth-ranking Republican in Congress. The "it" to which Cox was referring as he spoke with Insight in his office in the Rayburn House Office Building is the monster accounting industry that feeds on the victims of the vast and convoluted tax code and therefore lobbies against repeal or reform that would simplify the system.

A tax-reform and tax-cut champion since he came to Congress in 1989, Cox has seen this type of lobbying before. Big life-insurance trade groups, such as the Association for Advanced Life Underwriters, lobbied hard in 2001 against the Bush administration's phaseout of the death tax on estates, which Cox and other conservatives had been pushing to eliminate since the early 1990s. The companies they represented sold life-insurance polices to help families pay the tax and pass the family business down to their children. "There are decades and decades of financial arrangements that have been made based upon the tax structure we've had in the country for so long," Cox says. "There are so many economic interests affected by the code now that thoroughgoing reform is opposed from myriad directions."

Yet Cox is optimistic that reform, over time, can be achieved. "If we are relentless in our pursuit of simplification, we inevitably will make progress," he says. Cox sees the repeal of the tax on dividends, as well as the "death tax" or estate-tax phaseout passed in 2001, as good steps toward getting rid of double taxation on income that is saved.

"Eliminating the double tax on dividends also is simplification," says Cox, the main sponsor of the repeal bill in Congress. He first introduced a bill to end the double tax on dividends in 1992, and had argued in his thesis at Harvard Business School in 1977 for its abolition. "When you eliminate a whole class of taxation, it ultimately is simplicity," he says.

So Cox and other reformers aren't in the least surprised that an accounting firm such as Grant Thornton, which profits hugely from the complexity of the tax code, would resist repeal of this tax. In a press release, the firm states that repeal will hurt the midsize companies it serves by "encouraging investors to abandon the middle market in favor of companies that pay dividends." Grant Thornton claims that, "unlike large public corporations, which attract equity investment by paying dividends, many middle-market companies are closely held businesses that finance growth by reinvesting profits in their company."

Economists with whom Insight consulted said the Grant Thornton analysis is false on its face. First, they say, many large public companies, such as Microsoft Corp., have not paid dividends because of the tax penalty to shareholders. Instead, they retain earnings and buy up smaller companies. But, if dividends weren't double-taxed, "you would have less pressure for corporate mergers and more growth of independent companies," says Stephen J. Entin, president of the Washington-based Institute for Research on the Economics of Taxation. "There will be more competition for money, and it will flow more readily to the highest returns." Sure enough, shortly after Bush's plan was announced, Microsoft announced that for the first time it would pay dividends.

Dan Mitchell, a senior economist at the conservative Heritage Foundation in Washington, says Grant Thornton's analysis "flunks Economics 101." He explains that Grant Thornton is "assuming investment is a fixed pie." But, Mitchell says, the dividend repeal would spur "more investment overall," which would help the economy and small and midsize companies.

A Grant Thornton spokeswoman tells Insight that the firm did not base its assertion on either a study or survey of its customers. She promised to have a partner call to explain the company's economic reasoning, but at press time none had done so.

Entin calls Grant Thornton's claims a "special-interest argument," and at the end of its press release the company provides a clue huge financial interest in defeating the reform and keeping taxes complex: "Many closely held companies have elected S-corporation status to avoid the double taxation of dividends." S-corporations are complex corporate structures with a limited number of shareholders that are very difficult to create. The partners need to hire big accounting firms such as Grant Thornton to make sure they don't run afoul of IRS rules in avoiding double taxation on their business earnings. But, the firm says in the release, "If dividend taxes are eliminated, Grant Thornton expects many S-corporations to revoke their elections and convert to C [ordinary] corporations."

And this assuredly would not hurt the businesses nearly as much as it might hurt Grant Thornton, Entin says with a laugh. In fact, it might very well help the accountant's business customers. "It would simplify things," Entin says. "The businesses would not have to jump through all those hoops to qualify for S-corporation status" -- hoops that inevitably result in misallocations of investor resources. The partners then could raise money from a broader class of shareholders and still not be double-taxed on their dividends. But of course Grant Thornton "probably would lose business," Entin says. The current tax code, Cox says, "makes accountants smile."

Cox has been a policy leader on many fronts, including national security. In the late 1990s he led a bipartisan congressional committee which unanimously concluded that the People's Republic of China posed a much more immediate threat to the defense of the United States than had been recognized. Since he was just appointed chairman of the House Select Committee on Homeland Security, many thought he would put tax reform on the back burner. Far from it.

In fact, Cox tells Insight that tackling the tax code, which in 2001 was a record 45,663 pages long, remains one of his top priorities. "There is no greater monstrosity in the law than the Internal Revenue Code, the regulations that accompany it and the case law that's necessary to interpret it," Cox says. "We live in a country in which more than 100 million people who want to pay their taxes are genuinely puzzled about what they owe. Imagine running a business in which people actually want to send you money, and a business in which you don't even have to manufacture anything to send to them in return -- just a piece of paper. And imagine going out of your way to make it so difficult for your customers to figure out how much they have to pay that not just most, but almost all of them, are likely to get the answer wrong. It's absurd. There is no aspect of American government more in need of reform."

But what are the prospects for reform? Some of the nation's greatest champions of tax overhaul, such as former House majority leader Dick Armey (R-Texas) and former House Ways and Means Committee chairman Bill Archer (R-Texas), have left Congress. The White House has made noises about simplifying the code, but has yet to push legislation to reform it in one fell swoop. Even so, noting the commitment of some of the newer members on Capitol Hill and the fact that the GOP now controls the House, the Senate and the White House, Armey and others see opportunities.

"There's good leadership in both the House and the Senate," Armey tells Insight in a telephone interview from his home in Lewisville, Texas. A former professor of economics who in Congress pushed the flat tax, Armey says there still are champions of that idea on the tax-writing and budget committees of both houses. "Jim Nussle [R-Iowa], the chairman of the [House] Budget Committee and a very influential member of [the] Ways and Means [Committee], is taking up the flat tax, and he's continuing to work with me on that," Armey says. "I understand that Don Nickles [R-Okla.] wants to take it up and be the champion in the Senate. But even if Don Nickles does not do so, John Sununu [R-N.H.] is very eager to move forward. Between Nickles, Sununu and Nussle, we've got very good championship of the idea in both the House and the Senate."

As for the White House, Armey adds, "I think the president is committed to tax simplification, but he has not been bold enough to say I'm for this plan or that plan."

This may be so because free-market tax reformers disagree about whether to overhaul the tax system with a flat rate on income, as Armey wants to do, or to replace the income tax with a retail-sales levy, as proposed by Rep. Billy Tauzin (R-La.). But in Insight interviews with members of the House Ways and Means Committee, the most important tax-writing committee, it is clear a consensus is emerging to accomplish one of the objectives of both tax systems by ending double taxation of income that is saved or invested.

Rep. Paul Ryan (R-Wis.), who joined the Ways and Means Committee after coming to Congress in 2001 and whom Armey holds in high regard, summed up the objective for Insight: "We should tax income once at its source and end the bias against savings and investment." Here's how that bias works:

When a citizen comes into money, he or she can spend what's left after paying the income tax to buy, say, a Rolls Royce or go on a world cruise aboard a luxury liner. There are some sales taxes on the luxury car and the cruise, but these don't come close to the tax rate on the original income. Yet if the citizen instead decides to save or invest the money, buying capital tools and creating new jobs, he or she again must pay a tax on interest, dividend or capital gain at the same high marginal tax rates (up to 39 percent or even higher if there's a state income tax) that was paid on the original income. On top of that, when the saver dies, his or her heirs have to pay up to a 55 percent estate tax on the income and returns from the initial investment that already had been taxed twice. (This will change in 2011 if future Congresses stick to the schedule of the death-tax phaseout enacted in 2001.)

"The fact that we are taxing savings twice, three times and sometimes more often than that is much more obvious to economists than it is to politicians," Cox says. "I strongly believe that savings should be the just reward for work. If we've already taxed your reward for work, we don't want to tax it again after you put it in your piggy bank. From a policy standpoint, we want money to circulate and be available for job creation, and a tax policy that's biased against that is wrongheaded." Taxing capital in a capitalist society, in which the means of production depend on savings for investment, just doesn't make sense, says Cox.

When tax cuts are sold to the public as efforts to rid the tax code of double taxation and bias against savings, the public tends to be supportive. Armey is heartened by a new Tarrance Group poll commissioned by Citizens for a Sound Economy, a Washington-based policy group that he now serves as chairman. The group found that, when the dividend tax was explained as double taxation on savings, 62 percent of Americans favored the Bush plan to get rid of it. "I was gratified to find out that this simplification and elimination of double taxation was the most popular part of his entire proposal," Armey says. "I think that's a good message to get into the White House."

Even so, some proponents of ending double taxation have claimed that the Bush plan might add complexity, because companies would have to set up excludable distribution accounts of earnings from which to distribute dividends. "Most people, if they have any income from dividends, still are going to have to have a professional figure it out," says Rep. John Linder (R-Ga.), who wants to replace the income tax with a national retail-sales tax. "My understanding is it's going to be based on the corporation's profits two years ago and things like that."

Cox counters that "whatever complexity exists about dividend taxation was there already. Whether a payment made by a corporation comes out of earnings and profits is a concept that's been built into the code for as long as we've had corporate income tax. These concepts were not introduced by the proposals to repeal the double tax on dividends. There is no question that repealing the double tax on dividends is going to simplify the code." Others who have looked at the plan say any complexity likely would occur only on the business side. Most individuals would have the taxes they owe calculated by their brokerage houses.

Tax simplification and eliminating double taxation on savings go hand in hand, say reformers Armey and Cox. This is one of the hard lessons learned from the battle for the Tax Reform Act of 1986, which lowered tax rates but increased the bias against saving. Some supply-siders such as Stephen Moore of the Club for Growth still maintain that on balance the act was good because it eliminated some foolish tax deductions and decreased rates. But Armey, for one, tells Insight he now regrets his vote and thinks the act has done more harm than good. "I always put it down as the dumbest vote I ever made in Congress," he says. "The problem with the '86 bill is it got out of Ronald Reagan's hands. It turned out there were a lot of things that were left out and done improperly."

Economist Entin, who was Reagan's deputy assistant treasury secretary for economic policy from 1981-88, blames congressional Democrats and (especially) liberal Republican Sen. Bob Packwood of Oregon, then chairman of the Senate Finance Committee, for hijacking the Reagan administration's reforms.

The Reagan administration had planned to lower rates, end many deductions and reduce double taxation on savings through the expansion of individual retirement accounts (IRAs), which the administration had made available to those in all income brackets in its 1981 tax-cut package. But without consulting the administration Packwood sharply limited IRA participation with income caps and other restrictions and put in place still other provisions that Entin says sharply increased the tax bias against investment. He used part of the money from these changes to restore business deductions the administration had eliminated, such as those for alternative energy. "Bob Packwood turned the entire bill into something that was anti-investment instead of pro-investment," Entin says. "It increased the tax bias against saving and investment, led to weaker investment later in the decade and paved the way for the subsequent recession."

Packwood, who resigned from the Senate in the mid-1990s amid a sexual-harassment scandal and now is a Washington lobbyist, replies that he limited IRAs because the Reagan administration's earlier expansion of them had not induced more savings. "We had very generously in 1981 increased eligibility for IRAs, and then we saw no increase in saving in '82, '83, '84, '85," Packwood tells Insight. "What we discovered is people were simply shifting savings from less tax-preferred savings to more tax-preferred savings, but not increasing their savings."

Entin and others cite studies that show that IRAs did cause an increase in savings. One of these studies was conducted by Dartmouth College economist Steven Venti, who also found that the 1986 restrictions caused so much confusion that IRA participation dropped sharply even among those who still were eligible to shield their savings from double taxation.

In 1993 the Clinton administration and a Democratic Congress erased much of the reform by jacking the top rates, which had been lowered in 1986 from 50 percent to 28 percent, back up to 39 percent. In the last few years, Congress has expanded IRAs, but the income limits and other rules remain complex, leaving many scratching their heads about saving for retirement. With IRAs, "Congress should stop doing the 'unlesses' and the 'ifs,'" says Ric Edelman, a best-selling author on financial planning. "They should make simple rules that are applicable across the board."

By both simplifying and expanding IRAs, say such supply-siders as Entin, Congress could achieve backdoor tax reform. They propose a "consumed income-tax" system in which individuals either would deduct the income they save or invest and be taxed upon withdrawal, similar to a traditional IRA, or not be taxed on the returns from after-tax income, similar to a Roth IRA. But there would be no income limits, contribution limits, age restrictions or additional tax penalties for withdrawal. More than retirement accounts, these would be all-purpose savings accounts that achieve the objective of both the flat- and sales-tax systems for ending double taxation.

In the meantime Cox is looking for opportunities to simplify and lower taxes by pulling out by the roots certain types of double taxation, such as the estate and dividend taxes. "Repealing entire portions of the code is the best way to simplify it," he says. "Whenever we try to ameliorate the effect of a tax to make it more fair, we end up having to have enormous amounts of complexity in order to achieve that result. We should simply take away entire categories of tax."

John Berlau is a writer for Insight magazine.