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Tax Reform Is Coming, Sure. But What Kind?


Government: TAX REFORM

TAX REFORM IS COMING, SURE. BUT WHAT KIND?

Two years ago, Richard K. Armey, a backbench Republican congressman from Texas, launched an effort to rewrite the U.S. Tax Code. He ordered his staff to run a review of every deduction and credit and even set up mini-debates with aides arguing the pros and cons of each write-off. The result of the exhaustive, yearlong review: "We came up with the current tax system," chuckles former aide Stephen Moore, now director of fiscal studies at the libertarian Cato Institute. "We justified every single deduction."

The exercise convinced a frustrated Armey that tinkering would get him nowhere. Real reform would require nothing less than replacing the entire code with a single low-rate flat tax--a proposal first floated in 1981 by Hoover Institution economists Robert E. Hall and Alvin Rabushka.

Today, Armey is Majority Leader of the House, and his flat-tax crusade rides a crest of voter fury at the current system. A growing band of Republicans--and even a few Democrats--want to destroy the tax law as we know it. "We do not have to accept as a given that the income tax will always be with us," says House Ways & Means Committee Chairman Bill Archer (R-Tex.), who has set tax reform hearings for June.

The campaign has struck such a populist chord that a massive restructuring of the tax laws seems inevitable. The issue could become the economic centerpiece of the 1996 Presidential election. And if a Republican captures the White House, federal tax laws could undergo their biggest rewrite in history. To GOP strategists, cutting the budget is just the first step toward downsizing government; overhauling the tax code is next. Even if President Clinton is reelected, the political momentum is such that the U.S. should see a major redo.

"For the past 15 years, all we've done is tinker," says Larry Langdon, tax vice-president at Hewlett-Packard Co. "We need a fresh vision and a fresh start." Agrees Senate Finance Committee Chairman Bob Packwood (R-Ore.): "The mood is there. The public is waiting for this."

While the anti-income taxers agree on the problem, they are deeply split over the solution. Each vows to raise the same amount of money as the current income tax system, but by very different routes. Some, such as Armey and Packwood, favor the flat tax. For individuals, it would tax all wages and pensions at a single flat rate but exclude investment income. Business, meanwhile, would pay tax on revenues, less the cost of labor and capital.

Under the flat tax, as well as the hybrid "USA Tax" designed by Senate Budget Committee Chairman Pete V. Domenici (R-N.M.) and Senator Sam Nunn (D-Ga.), people would file tax returns much as they do today. But the USA levy would tax individuals only on what they spend, rather than on what they earn. All investment income would be tax-deferred. Business would deduct all capital costs, but not wages and salaries.

FOURTH CAMP. Other reformers, including Presidential candidate Senator Richard Lugar (R-Ind.), back a national sales tax. Levied only on retail purchases, it would operate much like state sales taxes do. A fourth group, led by Representative Sam M. Gibbons (D-Fla.) and Senator Ernest F. Hollings (D-S.C.), favors a European-style value-added tax, which would be imposed at each stage of production, rather than just at final sale.

The front-runner for the GOP Presidential nomination, Senate Majority Leader Bob Dole of Kansas, and his chief rival, Senator Phil Gramm of Texas, both favor rewriting the tax code, but neither has endorsed a specific plan. Dole and House Speaker Newt Gingrich (R-Ga.) have dispatched Jack Kemp, a GOP tax reform stalwart, to design a plan that the Republican Party can promote in '96.

Meanwhile, some Democrats are devising their own less radical proposals to repair--rather than replace--the current income tax. Senator Bill Bradley (D-N.J.), an architect of the 1986 Tax Reform Act, would like to close loopholes and lower the top rate to below 30% from the current 39.6%. And President Clinton, worried about having to defend the current system in his reelection campaign, is searching for an alternative that aides say would boost savings while preserving progressivity.

While Clinton talks repair, Republicans vow an overhaul. To economists, all the GOP variations are essentially consumption taxes. Unlike the current code, which taxes income, these proposed levies tax you on what you buy--not what you earn. With the sales tax and the VAT, the levy is collected at the time of purchase. With the flat tax and the USA tax, you simply deduct savings and investments from your tax base, so that you're taxed only on what you spend.

While these variations are trivial to macroeconomists, who believe that any consumption tax would spur savings and investment, the differences are vast for taxpayers--and politicians. Exporters would reap a big windfall under the USA and VAT taxes, since they'd get a credit for goods shipped overseas--a benefit not provided by the flat tax.

In contrast, under Armey's flat tax, wages are deductible for business while taxable to workers. But with the Nunn-Domenici tax, companies lose deductions for labor costs, while individuals are taxed only on the wages they spend. "The most interesting dividing line is between labor-intensive and capital-intensive businesses," says Price Waterhouse Partner Peter Merrill. "Repealing the corporate income tax is not neutral across industries at all."

LOSERS. Overall, the flat tax would provide a generous tax cut for many individuals, but it would be funded with a big tax hike for nonfinancial corporations (page 86). Companies hooked on debt--real estate developers, homebuilders, and some manufacturers--would lose their most lucrative write-offs under all of the consumption-based rewrites. And no one has yet figured how to tax financial companies, such as banks and insurance companies--a possible deal-buster.

Whatever their specific tax proposal, most reformers agree on two goals: Income should be taxed only once, and the current bias in favor of debt and consumption should be ended. Why? The U.S. national savings rate is among the lowest in the industrialized world. And economists believe stronger savings will translate into increased investment, which in turn is key to future growth.

There is little doubt such economic goals are important. But public support for tax reform is being driven by something quite different--a desire for simplicity and a widespread belief that many payers are shafted by the current system. "First of all, people hate the IRS," says Gingrich flatly. Adds Grover G. Norquist, president of the antitax Americans for Tax Reform: "It's a great idea to eliminate the IRS root and branch."

A new poll for Andersen Consulting reports that 59% of the American public believes it is too difficult to fill out federal tax forms. And even major corporations find the law mystifying. "Our existing system is so overwhelmingly complex that it's draining administrative resources on the taxpayer side and on the government side," says Lisa Norton, tax counsel at Ingersoll-Rand Co.

BOON? Still, much as they hate the current code's complexities, business has learned to live with it--or even profit from it. So while reform may be an economic boon for the country as a whole, the transition could be agonizing for specific industries, such as real estate.

Is radical reform worth it? Many economists think so. Boston University economist Lawrence J. Kotlikoff figures replacing the current code with a savings-enhancing sales tax would boost the nation's stock of capital equipment by as much as 63%. That new investment would spur productivity. The payoff: Living standards would rise by up to 18%, he argues. Such predictions have been challenged by critics, and some reformers concede they can't guarantee major gains. "Will it really increase savings?" asks Domenici. "We have no way to prove that absolutely."

That's one reason the GOP plans differ so much, as each tries to strike the perfect balance between fairness and simplicity while maximizing U.S. economic growth. Just look at the Armey flat tax, tailor-made for a public that is fed up with often-incomprehensible rules and overpriced accountants. Unlike the current IRS maze, it's nothing if not simple--add up what you make, take a big standard deduction, multiply by the tax rate, pay the tax, and get on with your life. But there's a price: ditching some cherished tax breaks, including deductions for mortgage interest, state and local taxes, and charitable contributions. "I want to capture every penny of income in the tax base and subject it to taxation only one time," explains Armey. "The taxpayer would get an honest tax bill that's simple and direct."

For business, Armey's tax would be levied on cash flow. Companies would take total income, subtract capital and labor costs, and pay a tax on the difference. They could immediately write off all costs of producing goods, including capital investment and wages. But the cost of money--raised through debt or equity financing--would not be deductible. Manufacturers that buy lots of new equipment would benefit; companies that are heavily debt-financed would suffer.

Exactly what Armey's flat rate would be is hotly debated. He publicly sets it at 17% but concedes that won't raise the same revenue as current law. The Treasury Dept. figures the rate would have to be about 23% for the tax to be revenue-neutral, while flat-tax guru Hall estimates 19%.

Regardless of which number you use, corporations would take it on the chin. According to an analysis by Price Waterhouse--using 1991 return data--if the flat rate was 19%, nonfinancial corporations would pay one-third more in overall taxes than under current law, while individuals would pay about one-third less. Income from sole proprietorships, partnerships, and the like--now taxed at the individual level--would be reported on a separate business return.

The Nunn-Domenici tax scores high for being fair and encouraging savings. For business, the plan is similar to a flat tax, except that wages are nondeductible. This could hurt labor-intensive companies, but they get a big break in return: a full credit for all Social Security taxes, which now shrink the bottom line. U.S. manufacturers, especially big exporters, should like the USA Tax. They would get an immediate write-off for capital investment. And goods sold overseas would be exempt from U.S. taxes, while imports would be taxed at the border, making them more costly.

A BIG IRA. Nunn-Domenici's individual tax essentially creates one huge IRA. People would take their total income from all sources, subtract what they save and invest, and pay tax on the difference. Reinvested dividends and capital gains, money deposited in savings accounts, and investments in stocks or mutual funds would be deducted. So would some mortgage payments, charitable contributions, and limited education costs. And individuals would get a credit for payroll taxes. The levy would resemble a sales tax, but people would pay annually or quarterly, rather than every time they made a purchase. Winners and losers can be summed up simply, says Nunn: "Those who save will pay less taxes than those who spend."

But the Nunn-Domenici tax is by no means simple. And neither it nor the flat tax would shutter the despised IRS. That's why some pols would dump the income tax system entirely and replace it with a sales tax. No more forms. No more withholding. No more scrambling for 1099s. And no more IRS.

Archer, who dismisses even Armey's flat tax as too timid, vows to "tear the income tax out by its roots." He wants to repeal the 16th amendment, which established the federal income tax 82 years ago, adopt some type of national sales tax, and scrap the tax agency. He even hints that he would eventually replace the Social Security and Medicare payroll taxes with a sales levy. Archer's top objectives: "Get the IRS out of our individual lives" and exempt exports from tax.

So far, there are two sales tax versions gaining currency--a retail levy and a European-style VAT, which would be set at about 5%. It is paid at every stage of production and is usually hidden in the final price of a product. In Europe, though, VATs have become quite complex and riddled with exceptions.

The national sales tax would be imposed only on the retail purchaser. It could be collected by the states, thus eliminating nearly all of the federal tax- collection apparatus. It would also be administratively simple--unless it begins exempting food, medicine, and other essential purchases. Backers envision a levy of around 20% on all goods and services, even though such a hefty price hike could generate substantial sticker shock among consumers. Archer says the price jump would be offset by a sharp rise in take-home pay, since there would be no income tax. But to libertarians who support a sales tax, the shock effect is its great virtue. "I want people cursing the government every time they go to the 7-Eleven to buy a grape Slurpee," says Cato's Moore.

A lot of people, however, would curse the sales tax for another reason: It's inherently unfair to the poor, who consume a much larger share of their income than the rich. In fact, the various consumption tax schemes are distinguished by how they attempt to achieve fairness.

The flat tax addresses the problem with two rates: zero on roughly the first $36,000 a family of four earns, and about 20% on everything above that. Such a scheme is great for those at the top and bottom of the income ladder, but Treasury figures that families earning between $20,000 and $50,000 would actually face a big decline in aftertax income--about 4.5% under a 17% rate.

BIGGEST HURDLE. Nunn and Domenici would maintain progressivity with multiple tax rates and with their payroll tax credit. But they also pay a price: a top rate of 40%--twice that of a flat tax--and more complexity. Backers of a retail sales tax are mulling creative ways to provide everyone with about a $5,000 credit--such as sending a check to every American with a Social Security number.

Solving the fairness problem, however, pales compared to the challenge of managing an orderly transition to an entirely new tax code. "One of the biggest hurdles is how you get from here to there," says Charles W. Rau, who heads the tax department at MCI Communications Corp. One example: Many financially struggling companies, such as LTV Corp., have stayed afloat by relying on old net operating losses, which they can carry over from year to year. Those losses would disappear in a consumption tax, and troubled companies won't easily give them up.

Likewise, there's the shock to the housing industry. This year, residential housing is being subsidized to the tune of $90 billion. Eliminate the deductions for mortgage interest and state and local property taxes, and the real estate market could plunge into turmoil.

The National Association of Realtors is already gearing up to do battle. It's begun forming alliances with commercial developers, farmers, and other business groups that rely heavily on debt financing. Another possible ally: state and local governments, which would lose their tax advantage for municipal bonds in a world where all investment income is treated alike.

The prospect of fierce resistance from such powerful would-be losers convinces some veterans of past tax battles that the current income tax will never die. Bradley, for one, thinks the eventual outcome of the tax debate of the '90s will be a rerun of the '86 overhaul--"lower rates and fewer loopholes." But, in truth, it's too soon to predict a firm outcome. "Where we end up won't look anything like the original ideas," says HP's Langdon.

Certainly, the drumbeat for tax reform keeps getting louder. At the very least, the next Presidential election will set the stage for another dramatic reform of the current income tax code. And if the GOP takes the White House in 1996, the next stage in the Republican revolution may be a new federal revenue system. The result: By the turn of the century, the U.S. could well become the world's first industrialized nation that won't have an income tax to kick around anymore.

America's Dueling Tax Plans

THE CURRENT INCOME TAX A top rate of 39.6%, riddled with loopholes, favors consumption and debt over savings and equity. Taxes dividends twice. Simple for most individuals but agonizingly complex for business and anyone who invests.

VALUE-ADDED TAX An integral part of the tax systems of most industrialized countries. Levied at each stage of production and built into the cost of goods. Simple in theory but in practice filled with multiple rates and exemptions. Credited to exports but imposed on imports.

FLAT TAX In its pure form, imposes tax at a single rate for business and individuals, with no deductions or credits. Removes the tax code from investment decisions, favors neither debt nor equity, capital nor labor. A big personal exemption improves progressivity for working families, but the wealthy get the biggest benefit. Top rate about 20%.

USA TAX A hybrid that favors investment over consumption. No tax is paid on savings and investment but is levied on spending. Much like a VAT, except tax is paid annually rather than on individual purchases. Personal tax works like an IRA. Top individual rate is 40%, but workers and employers get credit against payroll taxes.By Howard Gleckman in Washington


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