Let's talk taxes. The U.S. tax code has become so byzantine that the cost of compliance for individuals and corporations in the U.S. comes to $75 billion a year--a figure that includes what Americans shell out to accountants and lawyers, the hours taxpayers spend dealing with tax affairs, and the budget of the Internal Revenue Service, according to Joel B. Slemrod, an economist at the University of Michigan.
Keep this huge cost in mind as the Democrats and Republicans fall over each other in the weeks ahead to offer tax goodies. Here's a partial list to date: a cut in the capital-gains tax rate, a child tax credit, expanded individual retirement accounts, homeowners' deductions on losses from house sales, and deductions for college. In short, tax-code social engineering is alive and well in Washington, and every change adds to the cost of compliance.
What a waste. U.S. policymakers should be moving in the opposite direction--toward radical simplification. They should be lowering rates by broadening the tax base through limits on exemptions and deductions. A simplified tax accomplishes two goals. First, it makes political choices transparent. Simplicity removes the social engineering by conservatives or liberals enacted through the tax code. Public spending is made clearly visible on the government's ledger. Second, it reduces Uncle Sam's interference in the affairs of citizens and businesses, permitting markets to work more efficiently.
What exactly would radical simplification entail? There are a number of options. There's the flat tax, favored by Representative Richard K. Armey (R-Tex.), which builds on a plan developed by Hoover Institution economists Robert E. Hall and Alvin Rabushka. This extremely radical scheme would levy a straight 17% on wages and pensions, with only personal and dependent exemptions. Business couldn't deduct interest or dividend payments, but for individuals, investment income would be exempt. This would end the bias against personal savings currently built into the tax code. In the somewhat related "X-tax" plan of David F. Bradford, an economist at Princeton University, investment income is also exempt from personal tax, but he introduces more progressivity by having rates on labor compensation rise from 15% to 25% to 35%.
We favor a less radical "modified" flat-tax proposal that would be more politically palatable. It would flatten the rate structure into two or three rates and would preserve a few of the most popular deductions, such as home-mortgage interest and charitable contributions. In the early 1980s, Senator Bill Bradley (D-N.J.) and Representative Richard A. Gephardt (D-Mo.) offered a plan with three brackets: 14%, 26%, and 30%. This proposal was designed to keep tax reform from falling too heavily on the poor. Gephardt is now drafting his own flat tax of 10% to 12% for most Americans, with a higher rate for the wealthy. The U.S. was happily headed in this direction with the Reagan tax reform of 1986.
Tax simplification is as appealing now as it was then. It would cut down on tax avoidance and eliminate the need for so many tax lawyers and accountants. It would let individuals and businesses make save-or-spend decisions free from government. And boy, would it save money: A simplified code could cut collection costs from $75 billion a year to $25 billion. That's a saving of $250 billion over five years. Pssst--Congress: Want a real tax cut? Clean up the tax code.