September 14, 2004,
Five Easy Pieces
How to incrementally reduce the tax bias against saving and investment.
In his GOP-convention acceptance speech, President Bush announced that he will "lead a bipartisan effort to reform and simplify the federal tax code." Specifically, the president will appoint a bipartisan panel of experts and economists to provide the Treasury secretary, as early as possible in 2005, with options to reform the tax code to make it simpler, fairer, and pro-growth.
That the federal tax system should be reformed is no longer a subject of debate. As the president said in his speech, the current tax code is "a complicated mess filled with special-interest loopholes, saddling our people with more than six billion hours of paperwork and headache every year." President Bush believes that America's taxpayers deserve a simpler, fairer, pro-growth tax code.
The debate is not whether to overhaul the tax code, but how.
Economists have long argued that the tax system unfairly "double taxes" savings, once when they are earned and again when they are saved. Reducing or abolishing the double tax on saving and investment would promote more saving, capital formation, wealth creation, and economic growth.
The last serious attempt at tax overhaul occurred in 1986 when President Reagan signed the Tax Reform Act. While the 1986 act streamlined the tax structure, reduced the number of tax brackets, and broadened the tax base, it did not fundamentally reform the tax code. In many respects, the 1986 act actually worsened the double taxation of saving and investment by raising the capital-gains tax, and scaling back the tax deductibility of Individual Retirement Accounts (IRAs). Over the years, the 1986 Tax Reform unraveled as Congress, on a bipartisan basis, raised marginal rates, increased the number of tax brackets, and added new tax deductions and credits to the tax code.
The president's call to fundamentally reform the tax code will renew debate over the "Big Bang" tax reforms such as the flat tax and the national retail sales-tax plans. Both of these plans would replace the current income tax with a tax system that does not double tax saving and investment. The flat tax abolishes all tax preferences and applies a single tax rate on income, while the national sales tax applies a single tax rate on the purchase of goods and services.
Proponents of the flat tax and national sales tax have argued that these radical reforms could double the economy over the next 15 years. But they ignore the fact that the transition to a completely new system will entail economic costs for many Americans. Consider the following example: In the long run, tax reform will increase capital available for home purchases, but in the short-run, ending the home-mortgage interest deduction could cause real-estate values to decline.
The national retail-sales tax poses a number of additional challenges. As economist Bruce Bartlett notes in his recent columns, the sales-tax rate required to replace all federal taxes would be prohibitively high, ranging from 28.5 percent to as high as 60.7 percent. The national sales tax would also be extremely difficult for the federal government to collect, and could turn out to be highly complex.
Tax reform need not be an all-or-nothing proposition; a handful of reforms would fix the lion's share of the current tax code's problems without ending politically popular tax deductions, such as those for charitable contributions, state and local tax payments, and mortgage-interest expenses.
Learning the hard lessons from the 1986 reform effort, veteran Washington tax lawyer Ernest Christian has proposed the "Five Easy Pieces" of tax reform, a strategy designed to incrementally reduce the tax bias against saving and investment. The five pieces are: lowering and flattening marginal rates; moving toward full expensing of business investment; reducing the double taxation of dividends and capital gains, expanding tax-free saving vehicles; and international tax reform.
The Bush administration's three tax-reduction packages which cut marginal rates, increased first-year expensing, slashed individual dividend and capital-gains taxes, and expanded contribution limits for IRAs have taken large strides toward four of the reform pieces. And the administration's proposed Lifetime Savings Accounts and Retirement Savings Accounts would significantly increase the amount of savings for retirement and other future needs. Like the Roth IRA, up to $5,000 in annual contributions to LSAs and RSAs would be non-deductible, but earnings would accumulate tax-free. Because these accounts don't tax savings twice, they would achieve one of the major goals of fundamental tax reform.
For the fifth piece of tax reform, the United States should exempt from federal taxes the income from U.S. export sales. This one move would level the playing field for American firms vis-à-vis their European competitors, which are allowed to exempt export sales from domestic taxation. Ultimately, the U.S. should follow most of our global competitors in adopting a "territorial tax" where only the income earned inside national borders is taxed.
Reforming the tax code piece-by-piece produces less simplification than either the flat tax or the national retail sales tax, to be sure. It would also retain the economic distortions caused by the myriad of special tax preferences in the current tax code. But if done correctly, incremental reform would achieve most of the goals of drastic tax reform without the economically painful transition costs and the equally painful political costs of ending popular tax deductions.
Cesar Conda, formerly assistant for domestic policy under Vice President Cheney, is a senior fellow at FreedomWorks, a new free-market policy organization formed by the merger of Empower America and Citizens for a Sound Economy.