The Nuts and Bolts of Tax Reform


By Howard Gleckman When President Bush's hand-picked advisory panel rolled out its recommendations for fixing the federal tax code on Nov. 1, it kicked off what promises to be a corker of a battle over what's wrong with the income tax system and how to fix it (see BW Online, 10/25/05, "Toward a Saner Tax Code").

It will be years before the political system finishes chewing over the panel's proposals. Still, if Bush throws his weight behind reform, watch closely. After all, taxes are a little like the sneezing and watery eyes that come with the blossoms of spring in Washington: They aren't pleasant, but you grow used to them. And if pols embrace new ways to take our money, we are going to have to make some big changes in the way we earn, save, and spend.

LOWER RATES, FEWER BREAKS. The panel, chaired by former senators Connie Mack (R-Fl.) and John Breaux (D-La.) came up with two proposals. The first is a simplified version of the existing income tax. The second is a consumption-based system.

For individuals, the two plans are very similar, clearing many current deductions and credits out of the code, lowering rates, and providing generous new tax breaks for savings and investment. Both would also repeal the Alternative Minimum Tax, which threatens to hit as many as 30 million families by the end of the decade (see BW, 9/20/04, "What A 'Fairer' Tax Code Might Look Like").

For business, both plans would lower rates and dump most special-interest tax breaks. But they differ dramatically in how they would treat capital investment.

KEY ISSUES. Under the consumption tax plan, companies would be allowed to immediately write off the cost of all capital investment, but they would lose the ability to deduct interest costs on the money they borrow. Under the simplified income tax plan, they could keep their valuable interest deduction, but would have to write off the costs of plant and equipment over time, as they do today.

That's all hugely controversial stuff. But keeping it all straight isn't easy. To help, here is a look at some of the hottest buttons the tax panel has pushed.

Cost. The panel was ordered by the White House to develop a plan that was "revenue-neutral," which is Washingtonspeak for a proposal that nets neither more tax revenue nor less. Normally, the revenue a tax bill will produce is compared to that produced under current law. But the White House gave the panel very different marching orders: Any of its proposals had to assume that Bush's 2001-04 tax cuts were permanent, even though most are scheduled to phase out by 2010. Thus, over a decade, the reform plans would generate trillions of dollars less than would have been the case if Bush had not persuaded Congress to approve his temporary tax relief.

To make matters worse, some of the proposals, such as the new savings incentives, won't cost anything over the next 10 years -- which is all the panel is looking at -- but could suck $50 billion or more a year from Treasury coffers down the road. This will make Democrats and even some GOP deficit-hawks crazy.

What to tax? Under either proposal, most Americans will pay no tax on investment income because they'd be able to shelter almost all of their investments in tax-free accounts. While the very rich may have to pay 15% on some capital gains and dividends, that's a sweet deal. And it is actually pretty fair as long as investment is taxed at the business level. But there is a problem. Business is very good at avoiding tax. And if we don't tax capital, the only thing left is labor income. It isn't easy to finance a $2 trillion government just by taxing paychecks.

The AMT. The policy wonks all want to get rid of it. And they warn it will hammer 30 million of us if it is not fixed. But only about 3.5 million people are hit by the tax today -- mostly members of the upper-middle class in high-tax states. So here's the political question: Will people be willing to give up tax breaks they now enjoy, such as deductions for mortgage interest and state and local taxes, to avoid paying a tax that few even know about? It is going to be a tough sell.

The third rail. Nope, not Social Security. The real third rail of American politics is the mortgage-interest deduction. Even those who don't own a house look forward to the day they will. That's why nobody wants to mess with the deduction. The tax panel says only 10%-15% of homeowners would be hit by its proposed limits on the tax break. No matter, just wait until the real estate agents and mortgage brokers finish their ad campaigns. Besides, nearly every lawmaker, Hill staffer, and lobbyist will get personally hammered by the change.

Cherry-picking. This one is a real worry. As reform grinds its way through the political system, the juicy tax breaks suggested by the panel could be enacted, while the tax hikes, which are necessary to pay for them, fall by the wayside. What will the pols do when they discover at the last minute they need money to make the whole thing work? They'll raise rates -- exactly the last thing they should do.

What is a consumption tax anyway? Or, to put it another way, will people support a tax system that only economists seem to love? There are three ways to tax what economists call consumption -- what the rest of us call spending. It can be taxed at the cash register through a retail sales tax. That's what states do today. It can be added to the cost of goods, through a European-style value-added tax (VAT). Or it can be taxed through a 1040-type system. That's what the tax panel suggested -- sort of.

Think of it like this: There are only two things you can do with your money -- save and invest it, or spend it. Whatever you don't save/invest, you spend. And that's what gets taxed. In the perfect system, if you make $100,000 and put away $20,000, you pay tax on $80,000. The professors say that is no different from a sales tax or a VAT, which also taxes what you spend. The only difference is how it is collected.

Bush isn't likely to adopt either of these proposals exactly as they were suggested by the panel. But there is a good chance that he'll make some version of reform a centerpiece of his 2006 legislative agenda. And when he does, the odds are pretty high that he'll still have to confront the same issues his commission faced. As old tax reformers know, they are hard to avoid.

Gleckman is a senior correspondent for BusinessWeek in the Washington bureau


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