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Trashing the Tax Code:
Despite formidable obstacles, George Bush is likely to pull off an historic reform of the tax system
Barrons - Jim McTague
14 February 2005

Trashing the Tax Code: Despite formidable obstacles, George Bush is likely to pull off an historic reform of the tax system; Your tax bill may never be the same

There they go again! President George W. Bush and the Republican Party are determined to overhaul the tortuous federal tax system just in time for both the 20th anniversary of Ronald Reagan's 1986 tax act and next year's mid-term elections, which could see both parties fighting over large numbers of open seats.

Bush promised in his State of the Union address to deliver a tax code that is "pro-growth, easy to understand and fair to all." The current code is so ponderous that it is driving an alarming number of taxpayers to underreport their incomes or not report incomes at all. Experts estimate that uncollected taxes have grown to about $400 billion per year from $311 billion in 2004 and $127 billion in 1998.

As simple as Bush's promise sounds, it represents one of the more lofty goals ever set by a president for his second term. For the tax system is so complex that whenever you tug on a tiny thread, you risk unraveling the garment. Every proposed change to the current system could create a distinctive set of winners and losers -- and the potential losers often are politically connected. Another hurdle: The President wants any reform to enshrine his past tax cuts, even as Democrats argue that those cuts were irresponsible in light of the $427 billion federal budget deficit. In fact, they blame the cuts for that deficit. To top it off, Bush is waging this attack on the tax code while simultaneously overhauling Social Security.

Despite the many obstacles, Barron's predicts that Bush & Co. will succeed in modifying the tax system by the end of 2006. How far will they go? Just about everything is on the table -- from proposals to set a single income-tax rate for everyone to the abolishment of the income tax and the concurrent start of a federal consumption levy. The likely course is more moderate -- a modernization of the existing system. If Capitol Hill reformers rock the boat too much, they risk being tossed into an angry sea. But even the less radical proposals could markedly change the way most Americans pay taxes.

Bush is unlikely to let up. A more efficient tax system, after all, is central to his vision of an "Ownership Society." And he has the advantage of not only a sympathetic GOP majority in both the House and the Senate but also some vocal support from Democrats. In January, Democrat Sen. Russ Feingold of Wisconsin wrote Bush a letter urging him to live up to campaign promises to reform taxes. "The complexity of our tax code puts an enormous burden on taxpayers, and reforming our tax code to make it simpler and fairer could go a long way toward relieving that burden," Feingold wrote.

No surprise, the Democrats are prepared to go to war over the details. Sen. Byron Dorgan of North Dakota, for instance, suggests higher marginal tax rates and a heavier payroll-tax burden for tax filers with reported annual earnings of over $500,000, to pay down the deficit and fix Social Security. Former Clinton Chief of Staff John Podesta, who now runs a Washington think tank called the Center for American Progress, suggests raising taxes on people making $200,000 or more, to pay down the deficit in 10 years.

Democrats, however, came around during Bush's first term when he called for dramatic tax cuts, and they will probably come around again, if only to help rebuild their party's reputation. In a January poll by Democracy Corps, a Washington, D.C.-based nonprofit begun by political strategists James Carville, Stanley Greenberg and Bob Shrum, 55% of respondents felt that Republicans know what they stand for -- and only 27% felt the same way about Democrats. Democrats are trying to change that perception, especially in regard to big issues. Hence, Democrats are apt to be strong advocates of tax reform and offer compelling options of their own.

Bush kick-started his tax-reform agenda on Jan. 7 by appointing a nine-member, bipartisan advisory panel that will hold several hearings around the country on reform options and then present its findings to the U.S. Treasury by July. Treasury Secretary John Snow, in turn, will filter those findings and recommend a final plan to President Bush by year end. Bush will propose a bill to Congress in 2006 and, quite possibly, get it signed into law by October, the anniversary of Reagan's signing of the 1986 tax law.

The House of Representatives could beat Bush to the finish line. Georgia Republican Congressman John Linder, who champions a national sales tax, tells Barron's that the House Ways and Means Committee may schedule hearings on tax reform as early as March. Linder, who has been discussing his plan with his party's congressional leaders, expects the full House to have a menu of options to act upon by August. He thinks the House will move on tax reform before it moves on Social Security reform because tax reform could alleviate the retirement system's funding problems by raising more money. His sales tax, for example, would capture money from people who dodge the current tax system. The Senate leadership on the other hand, is holding its cards close to the vest. It may well be that the Senate prefers to let Bush take the lead in the tax tango.

The federal tax code, of course, is almost universally disliked. The law, riddled with special-interest provisions and perplexing rules, consists of several million words on about 17,000 pages. Former deputy Treasury Secretary Samuel Bodman, who just became Energy secretary, is fond of pointing out that taxpayers collectively spend six-billion hours a year to decipher the rules and fill out their returns. Considering there are about 131 million individual returns, that's 45 hours each. Bodman puts the collective cost of this time-consuming exercise at $120 billion each year. Part of the cost comes from the pockets of about 75 million individual taxpayers who throw up their hands in despair and pay tax preparers to fill out the forms.

Podesta's think tank points out that the Standard Federal Tax Reporter, a reference book for accountants and tax preparers, is over 60,000 pages long. His position: "Increasing complexity can mean a tax system that is overall less fair as well as less efficient, which ultimately takes a toll on our economy."

In taking aim at this mess, President Bush has told the special panel to seek "revenue neutral" options for reform. That means that the proposals cannot, on net, raise taxes. But according to economist Daniel Mitchell of the Heritage Foundation, the conservative think tank, Bush's instructions do not rule out lowering rates for current taxpayers by expanding the tax base to cover people who now pay no income tax at all. There are 44 million low-income Americans who file tax returns but pay no income taxes after taking credits and deductions, according to Scott Hodge, president of the Tax Foundation, a nonpartisan organization that analyses tax data and promotes simplification. Proposals like a flat tax or a national sales tax could see at least some of this group paying taxes.

Bush hasn't tipped his hand on what he may favor; instead he laid out broad guidelines for the panel. For instance, he said the options should assure progressivity -- that is, those who earn more should pay more -- and recognize the value of homeownership. He said the measures should simplify paperwork for taxpayers and promote long-run economic growth. And, he said, at least one of the recommendations must suggest ways to modernize the current system in a manner that achieves all of his broad goals.

The instructions seem more straightforward than they actually are. Panel member Bill Frenzel, a former congressman who is now a Brookings Institution scholar, believes Bush wants the group to preserve the mortgage and charitable deductions. That demand could limit the group's options. A flat income tax, for instance, could be out of the running because it would eliminate the mortgage deduction in return for a relatively low rate for everyone. But panel chairman Connie Mack, the former Republican Senator from Florida, says Bush has given the panel a free hand. He told Barron's that the President wants the panel "to be bold about our work." The White House declined Barron's request for clarification.

Harvard University economist Dale Jorgenson, a tax expert who has dreamed up his own tax-reform plan -- one that taxes wages at 10% and most consumption at 30% -- suggests that the panel's final report will resemble one prepared in November 2002 by former assistant Treasury Secretary Pamela Olson for then-Treasury Secretary Paul O'Neill, who was promoting tax reform during Bush's first term until he was sacked. Olson and her team at Treasury had a firm grasp of what is both economically desirable and politically possible. And through long experience, they had detailed knowledge of the revenue implications of each of the proposals. Frenzel seconded Jorgenson's suggestion, describing Olson as one of the premier tax experts in the country. She's now a tax lawyer at Skadden, Arps, Slate, Meagher & Flom in Washington.

Olson laid out five options, the most far-reaching of which is a 20%-to-25% flat tax on consumption, to be paid mainly at the cash register. The idea is that such a tax would capture revenues from the vast underground economy, including criminals and illegal aliens who don't report income. Joint filers would have a standard deduction of about $25,000 and $5,000 for each dependent; single filers would have a standard $12,500. There would be no other deductions, not even for mortgage interest or for charitable contributions. Sellers of new homes would have to collect the tax from buyers. But existing homes would trade hands tax-free. Capital gains, earned interest and dividends also would be tax free. So there would be a big incentive to save instead of spend.

The plan would make taxes remarkably simple to compute: Tax returns would be about the size of a post- card. Wealthy people would, in effect, be hit with a one-time tax, since money in the bank would lose some of its purchasing power because of the levy. But over the long run, a consumption tax wouldn't be as progressive as the current system because the wealthy own most of the capital assets that would become tax-free.

Politically correct or not, it's an idea that has a history of appealing to voters. When magazine publisher Steve Forbes ran for president on the issue, the idea polled better than he did. In 2004, South Carolina's Jim DeMint easily beat Inez Tenenbaum for a Senate seat. Tenenbaum had made DeMint's support for a flat sales tax the campaign's central issue; her strategy clearly backfired.

Olson's second option is a flat income tax -- all wages and other forms of employee compensation, including benefits, would be taxed at single, low rate. For individuals, there would be no taxes on capital gains or investment income of any kind, including rents and royalty income (corporations would pick up the tax on dividends). There would be no deductions or special tax breaks. Rates could be as low as 15% or as high as 30% for wealthier people if congress decides to sacrifice flatness for a measure of progressivity. In short, there's room to haggle.

A problem: There is less incentive to save. Olson points out that the approach also raises difficult issues concerning foreign investment. By disallowing interest payment deductions, returns to foreign holders of U.S. debt might decline, causing capital flight from U.S. markets and a consequent rise in interest rates.

Olson's third option is a variant of a well-known proposal by Yale Law School professor Michael Graetz -- a 15% "value added" tax for most individuals, plus a supplemental income and capital gains tax on high-income individuals. A value-added tax is a sales tax levied on materials and goods at each step in the product cycle. A refrigerator manufacturer, for instance, would pay a tax on rolled steel, copper tubing and wiring, getting a deduction later. A consumer would pay a value-added tax on the finished product, with the levy looking much like a sales tax. New home sales and new rentals would be taxed by the levy, but not existing homes.

Wealthier people also would pay either a 25% tax on wage and investment income and on capital gains in excess of a $100,000 exclusion for joint filers and a $50,000 exclusion for single filers, or on income and capital gains minus a mortgage deduction, charitable deductions and state and local taxes if all those total more than the standard deduction.

The attraction of the plan is that it encourages most people to save and invest, rather than spend, and it is simple. The downside is that there would be no reward for charitable giving because there would be no deduction for most people, and value-added taxes are notoriously difficult to compute.

Olson's fourth proposal, the inelegantly named "Income Value Added Tax and Reformed Income Tax with Social Security Revenue Replacement," would have individuals pay a flat 18% tax on wages, fringe benefits, pension distributions, unemployment compensation and investment income; businesses would pay a value-added tax. Joint filers could take an $80,000 standard deduction and single filers $40,000, and both groups could claim $10,000 more per dependent, a help for large families. All other itemized deductions, including the home mortgage deduction, would be repealed.

Among the benefits, says Olson, would be a lowering of tax distortions that favor real estate over other investments. The downside would be a tax hike for many middle-income families, partly because benefits are a big piece of their compensation.

Olson's last proposal, "reform the Current Income Tax," is probably the closest to the plan that President Bush will eventually send to the Congress. Modifying the current system can meet most of Bush's objectives, including making his tax cuts permanent, a goal he reiterated recently in his fiscal 2006 budget.

Under Olson's proposal, the alternative minimum tax, the levy paid by many wealthier people with heavy deductions, would disappear. The resulting revenue gap would be financed largely by eliminating many deductions, including those for state and local taxes. Marginal rates would remain around current levels, and most taxpayers would get big tax breaks on their savings -- an outcome clearly in line with the Ownership Society.

But the proposal is not without controversy. Democrats like New York Sen. Charles Schumer say the elimination of deductions for state and local taxes would hurt people in the high-tax states that usually vote for their party. Cutting the deductions, they charge, is a scheme by Republicans to mete out punishment.

The Olson option calls for four marginal rates: 10%, 15%, 25% and 35%. There are six marginal rates now: 10%, 15%, 25%, 28% 33% and 35%. The change effectively would cut taxable income, but that would be offset by having fewer deductions and eliminating the exclusion for employer-provided health insurance and most Social Security benefits.

New Lifetime Savings Accounts and Retirement Savings Accounts would let dividend and interest earnings accumulate tax-free and would replace the current tax-deferred retirement, education and medical savings accounts. There may be a capitals-gains tax like the current one -- 15% for most people -- or perhaps none at all. Itemized deductions for state and local taxes would be repealed, but those for home-mortgage interest and charitable giving would remain.

As the panel and Congress proceed, one veteran of tax-reform battles is urging Congress to take sweeping action. "Small reform will be niggled here and niggled there and you end up not getting much at all," says former Oregon Sen. Bob Packwood, who helped engineer the 1986 tax-reform bill. The plan also must have bipartisan appeal. Packwood, now a lobbyist in Washington, said that in 1986 Republicans were able to reduce tax rates and Democrats were able to close tax loopholes for the rich. Bush would likely have to offer a similar trade-off.

Most importantly, Bush must throw himself heart and soul into the effort and rally public support around his final proposal. He may not get everything he wants, but he'll probably get a lot of it.

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