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Inching Toward Tax Reform

Ideally, the Administration would shift the tax system closer to one based largely on taxing consumption rather than income. Businesses would pay no tax on reinvested earnings, and individuals would pay no tax on income until they spend it. That would result in two broad changes: Taxes would be cut on savings and investment, and income would be taxed only once. Today, some income, such as employer-provided health-care benefits, is not taxed at all. But investment income, such as dividends, is taxed twice: First corporations are taxed, then shareholders.

Problem is, such shifts would be expensive. Eliminating the double tax on dividends, for example, would cost more than $50 billion a year. So Bush aides are exploring an alternative: Let investors avoid tax on, say, 20% of payouts next year, then gradually increase the share of tax-free dividends. Will that help much? Salomon Smith Barney chief economist Robert DiClemente figures that completely repealing the double tax on dividends would boost the stock market by doubling dividend yields from the current 1.7%. The more modest Bush plan would provide much less of a kick. "The effects are positive, but not monumental," he says.

For business, tax nirvana would mean allowing companies to deduct the full cost of plant and equipment in the year it is purchased--rather than depreciating it over time. That dream is now closer to reality. Earlier this year, Congress agreed to an extra 30% first-year write-off, but only for equipment bought before Sept. 11, 2004. The White House is considering upping that first-year bonus to, say, 50%, and extending the time during which it could be taken.

Such a plan should boost capital investment and already has strong business support. Chris Varvares, president of St. Louis consultants Macroeconomic Advisers, figures full expensing would cut the cost of capital by 8% for computers and software, say. But an incremental expansion such as Bush is considering might trim costs by only 1% or 2%. "You don't get much," he says. "But it doesn't cost much."

Bush may push a similar step-by-step plan for IRAs and 401(k)s. Today, people can put only $3,000 a year into IRAs and $11,000 in 401(k)s. In addition, there are limits on how the funds may be used and strict rules about withdrawal. While many in the Administration would like all investment income to go untaxed, that's far beyond what's politically doable today. Instead, the Bush team will try to slowly expand existing tax-free savings plans by making it easier to contribute or withdraw funds.

The key battle will be over how the changes are structured. Simply raising contribution limits might boost private savings, as reformers claim. But it would aid only high-income workers who already max out on annual payments to their retirement plans. Thus, Demo-rats want to target benefits to low- and middle-income workers. Says Brookings Institution economist Peter Orszag: "Democrats are worried about a grandmother with $75,000 in her IRA, not some guy with $4 million."

The most complex initiative the Administration may propose involves international taxes. Earlier this year, the World Trade Organization ruled that the U.S. system of tax subsidies for exports is illegal--and Bush aides saw a chance to restructure taxes on foreign income of U.S. companies. One option under consideration: allowing companies to avoid taxes until their foreign profits are returned to the U.S.

Given the difficulty of fundamental change to the tax code, stealth reform will still prove a political challenge for the White House. In 1986, Reagan achieved what many consider a miracle. Bush, whose domestic policy is more cautious than his mentor's, won't try to pull off the sort of fiscal Hail Mary play that Reagan did in 1986. But in his slower, more disciplined way, he may make substantial progress on an issue that many had given up for dead.

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