What A "Fairer" Tax Code Might Look Like

A reelected Bush may rework the existing system -- or try for a consumption tax

President George W. Bush has the tax code back in his sights -- but this time he's not just talking about tax cuts. In his Sept. 2 speech to the Republican National Convention and on the stump since, he has called for making the tax system "fairer, simpler, and more pro-growth" than the current "complicated mess." Few Americans would argue with that goal, but the President is playing it safe: He's postponing the details until next year, when he would name a bipartisan commission to design a plan. Despite that fogginess, Bush's three previous tax cuts and other ideas he has floated offer some hints as to where Bush-style reform might go. Here's a look ahead:

Why did Bush bring this up?

No politician ever lost votes by attacking the Internal Revenue Code. As Ronald Reagan showed in 1984, calls for fairer, simpler taxes are popular -- and sometimes lead to major changes, such as the landmark Tax Reform Act of 1986.

But Bush has more than campaign rhetoric on his mind. He and his advisers believe that reducing taxes on savings and investment income helps spur economic growth.

In his first term he reduced the effective tax rate on capital income by nearly one-fourth by slashing rates on dividends and capital gains and by expanding business tax breaks for purchasing capital equipment.

Now some of his advisers see tax reform as the next step toward driving taxes on investment even lower. "A zero tax on capital is the right way to go," says R. Glenn Hubbard, former top economic adviser to Bush and godfather to his first-term cut in taxes on dividends.

So will this simply lead to another round of tax-cutting and rising deficits, without revenue increases elsewhere to make up the shortfall?

Not likely. Bush has vowed to halve the deficit by the end of his second term. With even Republicans beginning to feel queasy about the soaring deficit, he'd have a hard time walking away from that pledge. The Administration might claim that tax cuts will juice up growth enough to pay for themselves. But the record doesn't offer much support.

More likely, Bush aides say, any tax overhaul would be designed to be revenue-neutral. But to get there, Bush would have to close loopholes to pay for any rate cuts or fresh exemptions. "One piece of this has to be raising someone's taxes," says Congressional Budget Office director Douglas Holtz-Eakin. "And that's politically difficult."

Until now, neither the current Congress nor the Administration has shown any inclination to make such hard choices.

If they could muster the political will, such an approach could actually help the White House meet some expensive goals -- like corralling the runaway alternative minimum tax. That levy forces individuals to figure their taxes twice, then pay the higher tab. Intended to snag the very rich, the AMT is now hitting middle-class families because it isn't indexed for inflation: The number of AMT taxpayers is projected to soar, from 3 million in 2004 to 23.5 million in 2008. Repairing the AMT will cost upwards of $600 billion. That tab might be easier to bear as part of a sweeping tax overhaul.

So what would tax reform look like?

It depends how ambitious Bush is. He could settle for closing some loopholes to buy down rates further without changing the underlying structure of the income tax. Or he could push harder for savings exemptions and take the code toward a system based on taxing consumption.

The first approach would echo Reagan's 1986 triumph, dumping scores of special-interest tax breaks and using the money to sharply reduce rates. But Bush has been moving in the opposite direction. In his campaign, he is promising new tax breaks to encourage spending on everything from health care to fuel-efficient cars -- just the kind of stuff that reform is supposed to clean out. So Bush is likely to favor a version of the income tax that lightens the burden on savings and taxes consumption instead.

How would a shift toward taxing consumption differ from what we have now?

The existing code is a complicated hybrid. We call it an income tax, but it doesn't actually tax all income: The value of fringe benefits, such as health insurance and parking, goes untaxed. And the treatment of investment income verges on haphazard. About half of all capital income goes to tax-exempt accounts such as 401(k)s or pension funds. And companies often shelter their earnings from corporate taxes.

On the other hand, many companies do pay tax on their profits, then investors pay tax again on dividends or capital gains. So returns on investment may be taxed twice, once, or not at all.

A consumption tax, by contrast, is simply a levy on spending. In other words, you would take all the money you earn, subtract what you save, and pay tax on the rest.

How would Washington collect such a tax?

It could add a sales tax to the final price of goods and services we buy at the retail level, just as most states do today. Or it could have businesses pay the tax at each stage of production and pass the cost on to consumers in the form of higher prices. This is the value-added tax, or VAT, that most European countries use. Finally, the feds could collect the money through a system of tax withholding and annual returns, much as they do today. That version is called a "consumed income tax."

How would a consumed income tax work?

Think of an unlimited individual retirement account. You would simply list your income -- including, possibly, all your fringe benefits and other goodies that are currently excluded -- then subtract everything you save and invest and calculate tax on what is left. Investment earnings would be taxed once they are cashed in and you have used them to buy something.

Isn't that like the retirement savings accounts Bush has already proposed?

Bush has proposed two new savings vehicles: retirement savings accounts (RSAS) and lifetime savings accounts (LSAS). Together they would let a couple sock $20,000 a year into savings and never pay tax on the earnings -- eliminating all taxes on capital for 95% of individual taxpayers, according to William G. Gale of the Urban-Brookings Tax Policy Center.

Are those a step to a consumed income tax?

Not at all. RSAs, LSAs, and cuts in capital gains and dividend taxes are not tax reform. They are merely cuts in taxes on investment. Under a true consumption levy, allowing investment income to go tax-free would have to be coupled with ending the tax deduction for interest paid by corporations and by homeowners on their mortgages -- a huge and far less popular change.

Why would interest deductions need to go?

Because if you can deduct interest on a loan, invest the money, and earn tax-free profits, you essentially get a government subsidy for investing. That would open up a new world of tax shelters and destroy the benefits of reform. Worse, it would create a system where only wages are taxed. That would be unfair to working people. And a wage tax could never produce enough revenue to fund the $2.4 trillion the government spends each year.

If Bush pushes for bigger savings exemptions, he might try to pay for them by eliminating the interest deductions currently available to corporations. But don't look for him or any other politician to propose eliminating the deduction on home mortgage interest any time soon. It remains politically untouchable.

What do the Democrats have to say about all this?

Not surprisingly, they're skeptical. Presidential nominee John Kerry argues that Bush's real agenda is to exempt all capital income from tax. When Bush said at an August campaign stop that a national sales tax was an "interesting idea," Kerry pounced. He will also argue that Bush, whose tax cuts have made the code far more complicated, can hardly claim to favor simplification.

The sales tax debate is being tested in the South Carolina Senate race, where Republican Jim DeMint backs a 23% national sales tax. His Democratic opponent, Inez Tenenbaum, is blasting him for favoring price increases on everything from prescription drugs to baby formula.

Don't many experts argue that a consumption tax is the way to go?

Only if done right. That would require eliminating interest deductions and other tax breaks -- a tall order for politicians. But if Washington did adopt a well-designed consumption tax, would be simpler than the current code, it would eliminate the double taxation of capital income, and sharply reduce the use of shelters. And most economists believe it would boost growth at least by a few tenths of a percent each year. Economist Alan J. Auerbach of the University of California at Berkeley figures it would push up gross domestic product by 9% over several decades. But a consumption tax's biggest virtue, say supporters, is that it is fair. "You work and save. I work and don't. Why should you pay more tax than me over your lifetime?" asks Urban Institute senior fellow C. Eugene Steuerle, who helped draft the 1986 tax reform.

But doesn't it let the wealthy off the hook?

Even its biggest supporters concede that a consumption tax can be regressive. Because rich people spend a much smaller chunk of their income than do poor people, the wealthy would end up paying a far lower share of their resources in taxes.

Consumption taxes can have progressive rates that mimic today's system. But even that breaks down for the very rich, who would never spend enough to pay much tax. A tough estate tax might smooth things out. So could combining a VAT with an income tax that might kick in for taxpayers earning, say, $100,000 or more -- an idea proposed by Yale law professor Michael J. Graetz, a top Treasury Dept. aide in the Administration of former President George H.W. Bush. But for now that's an idea far beyond anything the Administration is considering.

How likely is Bush to achieve tax reform?

Depends on his priorities. If reelected, Bush will confront tax reform, overhauling Social Security, making his tax cuts permanent, and fixing the mangled Medicare bill that was passed in 2003. He won't be able to do it all. But don't be surprised if shuffling the tax deck isn't part of a second-term agenda.

By Howard Gleckman and Mike McNamee in Washington

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