Inching Toward Tax Reform

President Bush wants big tax changes--but in small increments

In 1986, Ronald Reagan scored a coup by persuading Congress to adopt the most wide-ranging reform of the U.S. tax code in 30 years. Ever since, conservatives have pined for Tax Reform II. Now, George W. Bush may be about to grant their wish. But while the President is an avid student of all things Reaganesque, he may adopt a fundamentally different strategy for the tricky business of muscling tax reforms through Congress. Instead of pushing for change in one bold flourish, Bush may opt for an incremental approach.

In his January State of the Union address, the President is expected to kick off his campaign against the tax code, blasting its complexity and unfairness. Yet he's likely to avoid offering a specific reform blueprint. Current White House thinking, sources tell BusinessWeek, is to cut reform proposals into five digestible chunks. Some could be passed as soon as next year.

None of these tax proposals would be dramatic on its own. They will probably be proposed under the rubric of tax cuts geared toward giving the economy a lift. But cutting taxes isn't the Administration's only goal. Taken together, the proposals also add up to a broad if "stealthy" reform package aimed at easing the current revenue code's bias toward taxing savings and investment rather than consumption. "You'll never be able to do Big Bang tax reform," says Ernest S. Christian, a corporate lobbyist and veteran of Washington's tax wars. "But you can do it in five easy pieces."

Although aides say Bush has not yet settled on details, his advisers are examining several distinct elements that could be rolled out next year: reducing taxes on corporate dividends, slashing individual tax rates, increasing first-year write-offs for business investment, restructuring taxation of foreign income of U.S. companies, and expanding tax-free savings accounts such as individual retirement accounts.

Bush has always been attracted to sweeping reform goals, and these changes could provide a much-needed jolt to his domestic agenda as he heads into the second half of his term. Depending on economic conditions early next year, they may be marketed as tax simplification, or billed as an integral part of Bush's "growth and jobs" agenda--ideas meant to give dormant capital investment a kick. And White House pols are thrilled. They know there's nothing like juicy cuts and talk of simplifying tax laws to fire up the GOP base and, perhaps, pull in swing voters.

While the White House will argue that its mini-reforms will produce an economic boom, evidence is thin. Alan Auerbach, a tax economist at the University of California at Berkeley, figures that a major restructuring, such as a flat tax, would boost national output by less than 10% over 15 to 20 years. The more modest changes Bush is considering would have a much smaller impact. "Something is better than nothing," says Auerbach. "But it's hard to imagine the effects would be very large."

Still, moving in stages has big advantages. It gives the White House flexibility about the cost and structure of each piece of the plan, allowing it to scale back proposals if the budget deficit continues to worsen. That's a major concern of Treasury Secretary Paul H. O'Neill. It allows Bush to gather coalitions for the popular ideas while allowing more time to build support for others. Most important, the bite-size strategy may finally mean a truce among conservatives who have argued for years whether to adopt a flat income tax or a national sales tax. "This is a political struggle, not a contest to see who can come up with the most economically optimal system," says Stephen Moore, president of the Club for Growth, a group that funds supply-side candidates. "The focus now is on something you can get the votes for."

Some longtime reformers are skeptical about the cuts' bringing real reform. Urban Institute senior fellow Rudolph G. Penner, who worked on tax restructuring in the '90s, doubts that the incremental strategy will eliminate tax loopholes, a key to any serious reform. "It's almost impossible to get to a pure tax step-by-small-step," he says.

One reason: Slashing rates much below the levels approved in the 2001 tax cut will be tough. Early on, Bush will try to accelerate and make permanent those '01 rate cuts. But with deficits expected to continue in the $200 billion range, additional rate reductions would have to be offset by killing popular tax breaks, such as the mortgage-interest deduction and ending the tax-exemption for employer-paid health insurance. That's unlikely: Taking on such sacred cows would be political suicide.

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.

By Howard Gleckman in Washington

    Before it's here, it's on the Bloomberg Terminal.