Three Roads to Tax Reform

A Bush panel has homed in on ways to simplify the tax code. Here's a look at the pros and cons of each solution

By Howard Gleckman

While much of the country was fixated on President George W. Bush's Supreme Court pick, a group of Bush appointees was meeting deep in the bowels of a Washington hotel with a task nearly as challenging as reshaping the Court. Their job: finding ways to make the U.S. tax laws fairer, simpler, and more pro-growth.

The nine-member panel, which is due to make its recommendations to the Bush Administration by Sept. 30, has been hearing witnesses for months. But on July 20, it began debating the knotty questions of how to overhaul the tax code and how Uncle Sam should collect $2 trillion a year from American workers, investors, and businesses.

Although the battle is just starting, the commission's alternatives for repairing the code are already emerging. The panel is likely to send the Administration several options: retain the existing income tax while dramatically simplifying some of its most snarled provisions; replace a chunk of today's income tax with a value-added tax, a European-style system which levies a tax at each stage of production and at each point of sale; or broadly restructure the code to shift taxes away from savings and towards spending. Bush will turn the panel's ideas into a plan of his own -- the likely centerpiece of his 2006 domestic agenda.

The group also wants to fix the alternative minimum tax -- a levy that hits 3.8 million middle-class taxpayers today and could nail 50 million by 2015. That change could cost up to $600 billion over the next 10 years. And Bush has insisted that any tax rewrite raise the same amount of money as the existing revenue code. That will require the panel to consider such painful ideas as eliminating deductions for state and local taxes or eroding the tax-free status of employer-paid health care.

All that adds up to one tough task. With public debate likely to intensify as the panel zeroes in on the choices, here's a look at how they're shaping up:


Few dispute the need to come up with a less complex tax system. And one panel suggestion will retain the basic structure of the current code but clean up some of its worst provisions. "There is no such thing as a perfectly simple tax system," says Urban Institute senior fellow C. Eugene Steuerle. "But there are some areas which everyone agrees are just a mess."

Today's tax law, for example, contains at least nine separate education tax breaks. And there are a dozen more for families with kids -- each with its own definition of who qualifies as a child. These corners of the code are so complex that many families fail to use them. The panel could well suggest streamlining all these breaks.

Moreover, families don't have lobbyists to stump for simpler tax breaks -- while many industries thrive on the code's complexity. Take retirement savings, where there are more than a dozen separate incentives, including individual retirement accounts, 401(k)s, 403(b)s, and SEPs -- each with its own rules. For individuals who are looking to save, creating one simple plan makes sense.

But trimming the number of retirement savings plans can run into a buzz saw of opposition. Bush has been trying since 2003, but has faced a bitter battle from insurers, which fear such a move would cost them part of their variable annuity business. After all, why pay the fees to buy an annuity if you can get similar tax breaks by setting up your own account -- at less cost?

And many in Congress fear that a single, generous tax-advantaged savings account would kill company-based retirement plans, especially for small and midsize firms. The concern: If a business owner can put away, say, $5,000 a year tax-free for each member of his family, he may dump his company plan. If the panel suggests a single tax-favored savings vehicle, those criticisms will reemerge.

Winners: Big savers and parents baffled by today's tax system. Most businesses, since their tax breaks would be largely untouched.

Losers: Insurance companies and mutual funds selling products, such as variable annuities, that depend on special tax provisions.

Do the Euro Tax

Most U.S. trading partners have a value-added tax. Supporters say that if the U.S. adopts one, it might attract more international investment and tax multinationals in a less complicated way. Backers also believe that shifting to a VAT would be much simpler for individuals, since most would no longer have to fill out tax forms.

One version, which is being promoted by Michael J. Graetz, a Yale Law School professor and former top Treasury Dept. official, would set a VAT rate at roughly 14% of the cost of every product. That would produce enough tax revenue to fund a cut in corporate income tax rates from 35% to 20%.

Graetz would keep the personal income tax, but he would set a single rate of 25% and get rid of many current deductions. In another big change, couples would be exempt from taxes on the first $100,000 of income, a step he figures would take 150 million people off the income-tax rolls. In such a world, Graetz says, "Apr. 15 would be just another spring day."

But a VAT wouldn't be quite that simple. In Europe, companies dodge billions of euros in VAT taxes. Critics say the IRS would need thousands more agents to prevent the same problem. Consumers would have to absorb a serious -- though temporary -- case of sticker shock as the cost of everything they buy rises. State and local governments will howl that a federal VAT curbs their ability to raise sales taxes.

And because the levy is built into prices, it's invisible to consumers and easy to increase. That makes it anathema to conservatives. "The VAT is a terrible idea," says William A. Niskanen, chairman of the libertarian Cato Institute.

Winners: Individual taxpayers who spend relatively little of their income. Exporters, because most VAT systems don't tax goods headed overseas.

Losers: Retailers, who'll face irate consumers as the VAT boosts prices. Companies that produce goods abroad.

Go for Broke

The panel is also considering a third option -- a fundamental rewrite aimed at ending the code's current bias against savings. Rather than taxing dividends, capital gains, or other income that comes from savings, people would be taxed on what they spend. That, backers say, would boost investment in the U.S.

Today, while some capital income is taxed twice, similar forms of income are never taxed at all. For instance, a company that sells a bond deducts interest payments from its taxable income. The buyer pays tax on the interest -- unless the bond is owned by a pension, a nonprofit, or a foreign investor, all of which are exempt from U.S. taxes. The result: Taxes are never paid on billions in interest payments.

Consumption taxes try to fix that by ensuring that all capital income is taxed one time, but only once. Take a plan offered by former senior Bush economic adviser R. Glenn Hubbard, now dean of the Columbia Business School and a BusinessWeek columnist. Under his "comprehensive business income tax," no investor would pay tax on interest earnings. But companies would lose their ability to deduct interest payments.

Companies would take total income from sales, subtract their cost of goods, wages, and annual depreciation on their equipment, and pay tax on the difference. Under other versions, companies would write off the cost of equipment in the year they buy it, rather than depreciate it over time.

Making businesses pay tax on capital income could also reduce the wave of tax sheltering that has plagued today's system. Individuals would pay taxes primarily on wages, eliminating loopholes they've used to shelter income. And taking away business's deductions for interest expenses would sharply reduce companies' ability to dodge taxes.

But such a shift would be hugely controversial. Today, businesses pay more than $1 trillion a year in interest to finance inventory and equipment. Chief financial officers won't give up that deduction easily. "When you think of the investments that have been made on the basis of the deductibility of interest, I get very nervous about whether you could pull this off," says Joseph J. Minarik, director of research at the Committee for Economic Development, a Washington business research group.

Taxing investment income at the corporate level would also split the financial world. Brokers would love the idea, since it might encourage more individual investment. But pension managers would hate it. After all, there's little reason to lock up funds in an IRA or 401(k) if an ordinary savings account were equally tax-free.

Then there's the matter of what to do about individual taxes. In a pure consumption tax structure, families would lose their deduction for mortgage interest payments. But nobody expects that to happen, since Bush has pledged to preserve it. Yet if people kept the deduction, they could easily borrow against their house and use the proceeds to buy stock while still enjoying tax-free dividends and capital gains.

Winners: Families who save a lot. Companies that currently pay hefty taxes because they finance growth from cash flow rather than debt.

Losers: Big corporate borrowers, which would lose their interest deductions. Among individuals, big spenders would face a larger tax bite.

Certainly, winning the changes needed to build a better tax system will be tough. Democrats have little interest in helping Bush rewrite the tax code. And the business community -- a key ally on his first-term tax cuts -- will be deeply divided over reform. "I'm not optimistic that we're going to see wholesale changes," says University of Michigan tax economist Joel Slemrod. "But I welcome a debate that could make the tax system better."

Broad-based reform is never easy. Still, Bush's panel is starting a valuable and important discussion. In 1986, against all odds, Congress and President Reagan cleaned up the tax code. Now pols have the best chance in a generation to repair -- if not replace -- today's law.

Gleckman is a senior correspondent in BusinessWeek's Washington bureau