Toward a Saner Tax Code


By Chris Farrell Last January, President George W. Bush named a bipartisan panel to come up with a better tax system. Final recommendations are due Nov. 1, but the President's Advisory Panel on Federal Tax Reform has already issued its preliminary recommendations.

My reaction to the committee's work: Bravo. It has come up with a sound, practical way to make the tax code simpler and fairer, with lower compliance costs for the average citizen, while also doing away with the alternative minimum tax, or AMT (see BW Online, 10/18/05, "An Either/Or Plan for Tax Reform"). (The panel actually produced two plans -- one involving income taxes, the other closer to a consumption tax. Since the real differences largely involve business taxes as opposed to individual taxes, I'm concentrating on the income tax proposal.)

That's why it's disturbing that the reaction so far among Washington cognoscenti has been a collective yawn. The White House hardly stirred. "We're going to take into account all the work they have done and the recommendations they are making," said White House spokesman Scott McClellan.

TAXING ISSUES. There is no question that the American tax code is a disgrace, riddled with exemptions, deductions, exclusions, credits, phase-ins, phase-outs, and temporary breaks (see BW Online, 5/30/05, "Tax Reform's Key? Stop Hammering Investors"). Almost every year, thanks to congressional and Administration fiddling, the tax code becomes ever more Byzantine. The total number of pages in the federal tax code is more than 60,000, up 48% in nine years, according to the Cato Institute, a Washington (D.C.)-based think tank. The percent of taxpayers who hired a professional to help calculate their taxes jumped to 62% in 2003 from 50% in 1995.

The panel's reform mantra can be summed up as simplification, fairness, and modesty. Specifically, it isn't advocating a radical tax overhaul, such as a national sales tax or flat tax. Instead, it suggests broadening the tax base by eliminating many deductions and exemptions, and replacing many of them with a handful of credits.

The number of schedules and worksheets would decline from 52 to 10. It would streamline the number of tax rates from six to four, with a top rate of 33% vs. the current 35%, and it would maintain progressivity, with the wealthy paying a higher percentage than their lower-income neighbors. Best of all, the panel's broadening of the tax base will make up for any revenue lost by the elimination of the AMT.

MORTGAGE INTEREST. The most striking recommendation is transformation of the mortgage-interest deduction into a credit. Currently, interest payments on a mortgage below $1 million are deductible. Obviously, that tax break is more valuable to high-income earners.

The panel suggests converting the deduction into a credit equal to 15% of the mortgage interest paid. The amount of a mortgage eligible for the credit would be circumscribed by the Federal Housing Administration loan limitation. That figure varies by region, but currently averages about $265,000. In other words, the credit will still encourage homeownership, especially among first-time buyers. Yet it will limit the tax break for upper-income households moving into McMansions.

Another highlight involves tax-deferred savings. For instance, the American worker is increasingly responsible for putting away money for retirement. But the government makes it tougher than necessary. Think about it: There are 401(k)s, 403(b)s, 457s, SIMPLEs (Savings Incentive Match Plans for Employees), SEP-IRAs (Simplified Employee Pension-IRAs), IRAs, nondeductible IRAs, Roth IRAs, Roth 401(k)s, sole 401(k)s, and so on. Each retirement plan has different rules and regulations, despite some movement in recent years toward making them more harmonious. There's also a variety of education savings plans.

15% BRACKET? The panel wants to replace these multiple accounts with three: Save at Work, Save for Retirement, and Save for Family.

The Save at Work account would act like a 401(k), funded with pretax dollars. The Save for Retirement account would replace various IRAs; it would largely imitate an expanded Roth, allowing individuals to set aside up to $10,000 in after-tax dollars that could be withdrawn tax-free in retirement. The Save for Family account would substitute for tax-advantaged educational and health savings plans. Taxpayers could contribute savings of up to $10,000, and withdraw up to $1,000 a year for any reason and no tax liability.

Other highlights include replacing personal and family tax breaks with a single family credit, and purging the marriage penalty. The President's tax-reform panel estimates that three-quarters of all taxpayers will be in the 15% tax bracket.

The panel's most immediate problem was to resolve the dreaded individual alternative minimum tax (see BW Online, 9/20/04, "What A "Fairer" Tax Code Might Look Like"). And it succeeded.

INFLATION'S BITE. Indeed, the panel's minimal mandate was to eliminate it. The original goal of the AMT, which became law in the 1970s, was to do away with tax loopholes that allowed the extremely wealthy to avoid taxes. But, since 2000, the AMT has evolved into a parallel tax system. Assuming the law stays in place, 3.6 million filers -- 30% with incomes below $200,000 -- could pay the AMT this year, estimates the Tax Foundation, a nonpartisan tax-research organization based in Washington, D.C.

What happened? Congress failed to index the AMT for inflation. Over time, rising real estate values, higher local tax payments, increased incomes, and the proliferation of credits for children and education pushed more middle- and upper-middle-income folk into the AMT.

The Bush Administration's tax cuts also reduced regular income tax liabilities, while the AMT remained essentially unchanged. Since taxpayers are on the hook for whichever bill is larger, the decline in income taxes forced more taxpayers out of the regular tax system and into the AMT. If the panel gets its way with tax reform, middle-class taxpayers won't have to hold their breath and calculate the AMT as the Apr. 15 deadline nears.

IN BUSH'S COURT. To be sure, I don't like everything the panel has recommended. It's a slam dunk that there will be fierce opposition. The real estate industry can't be happy. Politicians from high-tax states are outraged, because the deduction for state and local income taxes will be eliminated.

And the White House, reeling from a variety of setbacks -- including the political death of the Administration's main domestic priority, Social Security reform -- doesn't have a lot of political capital to spend these days.

The last major overhaul of the tax system occurred in 1986, but that was a very different time. Back then, President Ronald Reagan and a bipartisan group of congressional power brokers worked together to pass the Tax Reform Act of 1986. So far, George W. Bush has shown that he is no Ronald Reagan, and vitriol -- not bipartisanship -- is now the language of Washington.

NO EXCUSES. Still, President Bush may have no choice but to try and seize the mantle of tax reformer. He may also be able to force a reluctant Congress to go along. The reason is simple: the AMT.

Without reform, the AMT will hit more and more middle-class families, provoking the risk of a vicious backlash for the party in power. I say, shame on Washington if political inertia and special-interest bagmen prevent Congress and the Administration from embracing the advisory panel's blueprint for much-needed reform.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on Minnesota Public Radio's nationally syndicated finance program, Sound Money, as well as on public radio's business program Marketplace. Follow his Sound Money column, only on BusinessWeek Online.


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