Jewish World Review Nov. 22, 2004 / 9 Kislev, 5765
Tax reform limited by, uh ... tax reform
It's encouraging that President Bush has made tax reform such a second-term priority. But practical limitations, some of Bush's own doing, should temper expectations.
The current income tax is an economic burden. The transaction costs alone are staggering.
A Cato Institute study estimated that more than a million people are employed administering and complying with the income tax code. The Office of Management and Budget found that Americans spend more than 6 billion hours a year attempting to comply with it.
The current code also hinders productive economic activity, particularly capital formation. Marginal income tax rates are still too high, and dividend income is still subject to excessive double taxation.
The lodestar for tax reformers has long been lower rates on broader bases. The 1986 tax reform moved in that direction, limiting income exclusions and reducing the number of tax brackets to just two, 15 percent and 28 percent.
Since then, there have been more than 7,000 tax changes, with a proliferation of credits, deductions and additional tax brackets.
Even with the Bush tax cuts, the top marginal rate has crept back up to 35 percent.
In his after-election press conference, Bush enumerated his goals for tax reform: revenue-neutral, or raising as much money for the government, simpler and fairer.
He also seemed to indicate a desire to keep the current deductions for mortgage interest and charitable contributions.
There's not much room for reform within those constraints.
In 2002, the last tax year for which detailed information is available, aggregate adjusted gross income was just over $6 trillion. Deductions and exclusions to that totaled not quite a third of that, nearly $2 trillion. So, there's room to broaden the tax base.
But the deductions Bush seems to favor keeping - mortgage interest and charitable contributions - were about $480 billion. And if high-income earners are going to retain any ability to itemize deductions, then for equity reasons the standard deduction for non-itemizers probably has to be retained. That's another $480 billion.
So, nearly half the deductions are caught up in just those three categories.
Of the remainder, the lion's share is the deduction allowed for state and local income taxes, expanded recently to include sales taxes as an alternative. That amounts to a federal subsidy to high-tax states, and should be eliminated. But politically, it won't be easy.
Another way to broaden the tax base would be to eliminate tax credits. Credits total nearly $80 billion, about 10 percent of total tax liability.
But more than three-quarters of the money is in just two credits: the child credit, a favorite of social conservatives, the expansion of which was a central feature of the Bush tax cuts; and the Earned Income Tax Credit for low-income workers.
So, once any deductions or credits are accepted, the opportunity to broaden the base, as a practical matter, quickly narrows.
The revenue-neutral condition Bush has placed on tax reform is also highly constricting, given how progressive the federal income tax code has become.
According to the Treasury Department, the top 10 percent of income earners now pay 65 percent of all federal income taxes, although they make only 43 percent of the money. The bottom 50 percent pay just 4 percent of income taxes, although they make 14 percent of the money.
The Bush tax cuts, by giving a deeper percentage-rate reduction the lower the income, actually made the federal income tax more progressive.
As a result, if tax reform is to raise the same amount of money, a simpler, flatter tax code is likely to shift the burden to those making relatively less. Which, for many people, will fail the fairness test.
The current configuration of the income tax, aggravated by the structure of the Bush tax cuts, makes traditional reform politically difficult, particularly if constrained by revenue neutrality.
As a practical matter, fundamental tax reform probably now has to take the form of a consumption tax, or replacing the federal income tax with a national sales tax.
That's actually a better approach. A consumption tax is easier to administer and more conducive to productive economic activity. Equity issues can be handled through rebates, and there would be an increase in liberty if what you earned and how you earned it was none of the government's business.
But it's obviously a much more radical reform, one likely to occur only after a presidential candidate runs explicitly on it and wins. Which Bush, needless to say, did not do.
JWR contributor Robert Robb is a columnist for The Arizona Republic. Comment by clicking here.
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