How To Evaluate Tax Reform

This is shaping up as the year of America's great tax debate. About time. The U.S. tax system is a mess, riddled with exemptions, deductions, and credits that serve little purpose beyond rewarding favored constituents. The tax system is expensive for individuals and corporations to comply with, too.

Tax reform is already an issue in the Presidential race. A GOP commission headed by former Representative Jack F. Kemp will soon issue recommendations. All the main tax-writing committees plan to hold hearings on tax reform this year. To evaluate all the competing proposals for overhauling the byzantine tax code, ranging from a single income-tax rate to a national sales tax, we suggest a guide that's over 200 years old: The Wealth of Nations. Adam Smith laid out four maxims with regard to taxes in general: certainty, convenience of payment, economy in collection--and equality.

The flat tax is in the forefront of tax reform, and three of Smith's maxims--certainty, convenience of payment, and economy in collection--would be well served by a one-rate structure. The leading proponents of a flat tax are Hoover Institution economists Robert Hall and Alvin Rabushka, and their ideas powerfully shaped the flat-rate tax legislation of House Majority Leader Richard K. Armey (R-Tex.). Hall and Rabushka would levy a single 19% flat rate on wages and salaries; Armey wants to get the rate as low as 17%. There would be no deductions, though to keep the system somewhat progressive Hall and Rabushka exempt from income taxes $16,500 for a married couple and $4,500 a child. Capital gains, interest, and dividends would be exempt from taxes. Businesses would lose many deductions, although investment spending would get an immediate 100% first-year tax write-off. Business would pay a 19% rate on total income (17% for Armey), after deducting wages, salaries, pensions, and costs of goods and materials. Bottom line: a highly simplified and more efficient system where income gets taxed only once as close as possible to its source.

Still, even with generous up-front exemptions, an all-or-nothing one-rate tax is less progressive. In the past decade, global economic forces have increased income inequality. Most Americans have only one major asset to their name: the home they bought using generous tax incentives. Losing the mortgage-interest deduction would squeeze the middle class. A flat tax raises other questions, such as ditching charitable deductions and the deductibility of state and local taxes while the federal government asks charities and local governments to assume more responsibilities. Perhaps a "modified," streamlined tax approach is called for, one based on two or three rates and allowing for a few of the most justifiable deductions, such as charitable contributions and home-mortgage interest.

The good news: The gale winds of creative tax reform are sweeping Washington. Radical simplification would go a long way toward creating a less intrusive government and a more efficient economy. But some equity must be preserved.

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