Markets & Finance

McCain and Obama on Tax Reform


McCain's tax cuts would help those with very high incomes; Obama would offer breaks to low- and middle-income earners and increase the burden on the rich

Hardly anyone disagrees with this statement: The nation's tax system is a mess. The U.S. tax code is riddled with far too many deductions, credits, exemptions, exclusions, phase-ins, and phase-outs. Nobel laureate Milton Friedman noted half a century ago that constant changes in the tax code discourage long-term planning by households and businesses. He was right, but that hasn't stopped Democrats and Republicans from tinkering with taxes ever since the income tax was imposed in 1913.

Perhaps it's the safest forecast in politics and economics that history will repeat itself when it comes to the tax code. It's going to get even more complex next year, since both John McCain and Barack Obama are proposing major tax initiatives.

For instance, among his proposals, McCain wants to make the 2001 and 2003 tax cuts permanent (with the exception of the estate tax repeal), phase in a two-thirds increase in the dependent exemption, and offer a voluntary alternative tax with two rates and a larger standard deduction and exemption.

Essential Difference

Obama is more aggressive in the number of his proposed tax plans. They range from creating income-related subsidies for health insurance to refundable "Making Work Pay" credits and "Universal Mortgage" credits. He'll increase the maximum capital-gains tax to 25%. He will keep some of the 2001 and 2003 tax laws, such as the child-credit expansions and the 10%, 15%, 25%, and 28% income rates.

That breakdown of the two tax plans comes from the Tax Policy Center, a joint venture between the Urban Institute and the Brookings Institution. Its recent analysis captures the essential difference between the two tax approaches:

Senator McCain's tax cuts would primarily benefit those with very high incomes, almost all of whom would receive large tax cuts that would, on average, raise their aftertax incomes by more than twice the average for all households. Many fewer households at the bottom of the income distribution would get tax cuts, and those whose taxes fall would, on average, see their aftertax income rise much less.

In marked contrast, Senator Obama offers much larger tax breaks to low- and middle-income taxpayers and would increase taxes on high-income taxpayers. The largest tax cuts, as a share of income, would go to those at the bottom of the distribution, while taxpayers with the highest income would see their taxes rise.

McCain Wins on the Simplicity Front

For many voters, that's all the information they need to know about the candidates and taxes. But there are other ways to judge. For instance, by one critical measure—how they would deal with the omnivorous Alternative Minimum Tax—both plans are failures. The AMT was designed in the late 1960s to make sure that the very wealthiest Americans paid at least some tax. Yet because it was poorly constructed, some 3 million taxpayers now pay the AMT, and by 2010 that figure could swell to 30 million, according to William Gale, economist at the Brookings Institution.

Congress and the White House have punted for years on the AMT, largely because neither political party is sure how to replace the lost revenue. It's estimated that repealing the AMT would cost at least $800 billion over the next decade. Instead, Washington has preferred to rely on a series of "patches" to keep the dreaded tax from reaching deep down into the middle class. Both McCain and Obama plan on continuing that ignoble Washington tradition.

By the metric of simplicity, McCain edges out Obama. For one thing, he's proposing fewer tax initiatives. For another, he has embraced repealing various corporate loopholes, such as eliminating the preferential treatment of oil companies, in return for a lowering of the corporate tax rate from 35% to 25%. Nevertheless, neither candidate is embracing dramatic simplification by broadening the tax base and eliminating a wide range of deductions and credits. Both prefer to embrace tax subsidies targeted toward boosting valuable social goals, such as health-care reform. Problem is, that strategy carries a cost in complexity.

What Would Adam Smith Say?

Then there are value judgments. Personally, I like McCain's idea to cut the corporate income tax rate, although I would go further and abolish it altogether. But I prefer the greater progressivity of Obama's tax approach.

That said, I'd like to propose this standard for judging tax reform. It was written more than two centuries ago by political economist Adam Smith. In Book Five of The Wealth of Nations, he proposed four maxims with regard to taxes in general. They are equality, certainty, convenience, and economy.

Smith wrote: "All nations have endeavored, to the best of their judgment, to render their taxes as equal as they could contrive; as certain, as convenient to the contributor, both in the time and in the mode of payment, and, in proportion to the revenue which they brought to the prince, as little burdensome to the people." Of course, as Smith went on to say, most nations have also fallen far short of these goals.

A Flatter Tax Rate Is More Efficient

(I'd also add that Smith embraced progressivity: "It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.")

In other words, the centerpiece of tax reform should be simplification, reducing the interference of the government through the tax system in the financial affairs of households and business, and streamlining the progressive income tax system. Flattening the rate structure and broadening the tax base would go a long way toward improving economic efficiency and simplifying taxpayers' lives. The long-forgotten 2005 proposals by a blue chip panel appointed by the White House offered up a starting point.

But in this election, neither candidate is paying much attention to the Report of the President's Advisory Panel on Federal Tax Reform, let alone Book Five of The Wealth of Nations.

Join a debate about whether President Bush's tax cuts should be repealed.

Business Exchange related topics:

2008 Election

Economy and the Election

Tax Reduction

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