An Either/Or Plan for Tax Reform

Lower rates and fewer deductions or a consumption tax -- that's what a Presidential panel wants. Trouble is, either move would be fiercely opposed

By Howard Gleckman

In Washington, as on Wall Street, nothing beats low expectations. And very few outfits have had less expected of them than the grandly named President's Advisory Panel on Federal Tax Reform. Created in January, 2005, to simplify and improve the federal tax code, the commission is made up of two ex-senators, a long-retired congressman, a handful of professors, and a former IRS commissioner.

Few figured this group would produce much, given Washington's deep partisan divisions, the massive challenges of fixing the mind-numbingly complex and archaic tax code, and the rapidly weakening clout of the Bush Administration.


  But, lo and behold, on Oct. 18, in the capital's most ridiculously pompous edifice -- the mausoleum-like Ronald Reagan Building -- the tax panel came up with two intriguing ways to remake the tax system. While the commission won't issue a formal report until Nov. 1, it reached a clear consensus on two alternatives.

The first would be a vastly simplified income tax, which would lower rates a bit, scrap the dreaded alternative minimum tax (AMT) that is ensnaring an increasing number of taxpayers, and dump or curb most deductions and credits.

The second would replace the existing income tax with a consumption-type levy, though one which would still be paid by filing an annual tax return. Each would provide generous new tax breaks for savings and investment.


  Before a half-awake crowd of perhaps 50 policy wonks, and with a few dozen T-shirted picketers on a nearby sidewalk calling for the abolition of the IRS, the panel members laid out ways to do what every politician claims to want: Vastly simplify the tax laws while ending many, if not all, special-interest tax breaks.

Even the panel members are quick to acknowledge that neither proposal is perfect -- and there is plenty to criticize. For instance, the plans would allow most people to effectively shelter all their investment income from tax. That sounds good. But there is a downside. If most saving is tax-free, the only thing left to tax is wages. And funding the huge U.S. government solely on wage taxes would eventually put an enormous burden on workers.

There is another, more subtle problem. The panel's income-tax plan pays for eliminating the AMT by sharply limiting tax breaks for mortgage interest, health care, and state and local taxes. Curbing those deductions makes some sense. But the only reason they are being cut so deeply is that the panel is assuming the Bush tax cuts for 2001-04 will be made permanent instead of expiring after 10 years, in most cases. But why should that be? Why not scale back some of those tax cuts in an era of high deficits?


  Still, the panel's simplified income-tax plan deserves serious and careful thought. Its second scheme, less fully-baked, is a valuable analysis of the advantages and pitfalls of replacing the existing tax code with a consumption tax -- you get taxed on whatever you buy.

The consumption tax is a long way off. But the simplified income tax may be on the horizon. Tax reform, like Social Security reform, is an idea whose time has not yet quite come. Still, don't be surprised if the panel's ideas pave the way for the next big restructuring of the income tax. It is only a matter of time.

Hard-core conservatives hate the panel's reform plan and prefer to replace the existing code with a national retail sales tax. They think that would allow them to shut down the IRS, which they are convinced is filled with jack-booted thugs. Regrettably, even Bush's Republican-dominated tax panel concluded that such a tax might have to carry a rate of 87% -- too high a price to pay, even if did mean replacing jack-boots with bunny slippers.


  The left will hate the plan because it creates new incentives for savings, eliminates the deduction for state and local taxes, and, for the first time, taxes some employer-sponsored health insurance. But limiting popular deductions is the price to pay for getting rid of the hated AMT, a step which would cost the Treasury $1.3 trillion over the next decade.

Liberals can't keep calling for an end to the AMT without being willing to find the money to pay for it. If they would rather raise tax rates, they should say so.

Businesses would hate the changes too, and that's the big reason why they are unlikely to go anywhere soon. For instance, the insurance industry detest these ideas. After all, with so many tax-free savings plans, who will need high-priced annuities?


  The housing industry also will object. So will governors, who fear the loss of state and local tax deduction and tax-exempt bonds, which would lose their special status in a world where you could put most of your money in a tax-free account.

If implemented, the changes will create huge winners and losers. These are changes the political system may not be ready to make today. But the panel has put some important ideas on the table. The next step is George Bush's. It would be a pity if all he does is let them gather dust.

Gleckman is senior correspondent in the Washington bureau of BusinessWeek

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