Baby Steps in the Tax Plan


By Christopher Farrell It's tax-filing season. W-2 forms, 1099 forms, and other annoying pieces of paper are cluttering desks all across the land. No one likes the current tax system, and in most cases it's not because citizens object to paying taxes. No, taxpayers are furious as they struggle to figure out their myriad deductions, credits, exclusions, and exemptions.

Economists despair at the waste from the billions of hours and billions of dollars spent on administrative and compliance costs. The Bush Administration estimates compliance costs associated with the federal income tax totaled $135 billion in 2001, or 10% of revenue taken in. Policymakers don't even try to defend a tax code that has ballooned from 26,300 pages in 1984 to 45,662 pages in 2001. Even tax professionals don't agree on the meaning of many rules.

WASTE OF RESOURCES. It's a shame the White House and Congress can't take a simpler tack. Just lower everyone's taxes as much as possible by eliminating most deductions, credits, and shelters. Stop favoring savings and investments, and treat investment income like all other income. Let the individuals and families decide whether their money is for short-term spending or long-term savings.

I have no idea if the economy would grow faster with these changes. I believe it would, but I don't know for sure. What is certain is that such a system would be simpler, fairer, and easy to understand.

Look at the estate tax. It's riddled with far too many loopholes. Savvy lawyers and accountants have generated a multitude of trusts designed to help their clients evade steep tax bills. It's a bad law and a waste of economic resources. Still, progressive taxation, the core idea behind taxing the heirs of plutocrats, is sound in a society that cherishes equality of opportunity and democratic merit while deploring a permanent aristocracy of wealth and power.

Some 90% of all the different acronym trusts could be eliminated and a relatively low estate tax rate be imposed in return, calculates William Gale, economist at the Brookings Institution. That's a reasonable trade-off.

WHATEVER HAPPENED TO... Yet calls for a fundamental overhaul of the labyrinthine tax system have been relatively mute since the mid-1990s. Back then, academics, economists, legislators, researchers, and others fiercely debated the merits of junking the income tax altogether. The most popular ideas were a national sales tax, a value-added tax, the USA tax, and the flat tax. In essence, all favored taxing consumption and wage income over savings and investment income.

The peak in political attention came when former Presidential candidate Steve Forbes and his flat tax made the cover of both Time and Newsweek during the 1996 campaign. However, Forbes' White House bid fizzled, and so did the momentum for tax reform.

That is, until now. Overshadowed by the prospect of military action against Iraq, the Columbia shuttle tragedy, and the startling hike in long-term federal budget deficits, the Bush Administration is taking unmistakably bold steps toward fundamentally changing the tax code.

MAJOR SHIFT. It wants to make the abolishment of the estate tax permanent. It proposes ending the double taxation of dividends. It has put forward junking IRAs, 401(k)s, 403(b)s, and the like. The White House would like to substitute three savings plans -- two for individuals and one employer-sponsored defined-contribution account -- that would shelter from taxes far greater investment sums than current law allows.

Taken altogether, the Administration is embracing a major shift in tax policy emphasis away from investment income and toward consumption. Indeed, the fifth chapter of the recently released annual Economic Report of the President from the White House Council of Economic Advisors makes a detailed case for taxing consumption over investment. The CEA cites research suggesting that the change could lead to a rise in real output of as much as 6% a year over the long haul.

That may be the result obtained in a rarified economic model. And yes, taken separately, a number of the Administration's ideas are good or at least intriguing starting points for discussion. But Bush's stealth tax reform is deeply flawed. For one thing, a piecemeal approach toward a consumption-based tax system would only increase the complexity and cost of the current code. The green-eyeshade brigade would find even more loopholes for their well-heeled clients to exploit -- for a hefty fee, of course. Government would still distort rational economic behavior through avid social engineering and favoring special interests.

TOO MUCH INEQUALITY? For all these reasons, and considering the prospective drag of a massive budget deficit, the tax system could become more inequitable and less progressive without the promised trade-off of faster economic growth. The economic gap between the rich and the poor could widen further -- not because the New Economy favors skill and education, but because of deliberate government tax policy.

In a famous phrase, the legendary University of Chicago economist Henry Simon called too much inequality "unlovely." Simon believed the "aim of policy is to assure that the economic prerequisites for sustaining the civil and civilized standards of an open liberal society exist," wrote Hyman Minsky, the late economist. That's just what a simpler, progressive income tax system would accomplish. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online


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