The biggest challenge George W. Bush faces in coming months is keeping control of the domestic agenda while most of his attention remains fixed on the war against terrorism. He would help himself in this regard by pressing a big issue that will occupy Capitol Hill and the pundit class while the war proceeds. Tax reform could be that issue.
Bush and his advisers are well aware of the many problems with the code. Tax rates are too high, saving is taxed excessively relative to consumption, some forms of income are taxed two or three times while others are not taxed at all, and in general the tax system is just too complex and in desperate need of radical simplification.
It is much easier to deal with these problems by just cutting taxes appropriately. However, the recession's heavy toll on future budget surpluses makes significant tax cuts politically impossible for now. This makes tax reform the only viable option.
Despite the greater difficulty, tax reform can be done. Ronald Reagan showed how. In his 1984 State of the Union Address, he called upon the Treasury Department to study the tax system and propose improvements. Treasury ultimately prepared a three-volume study, which was widely praised by tax professionals. Reagan later distilled the Treasury report and sent a tax reform proposal to Congress, which incorporated most of its provisions in the Tax Reform Act of 1986.
The essence of the legislation was to broaden the tax base by restricting tax deductions, exemptions, exclusions and credits, and using the revenue to lower tax rates. The top income tax rate fell from 50 percent to just 28 percent, and the corporate rate was reduced from 46 percent to 34 percent. Higher revenue from the broader base offset the revenue lost from lower rates, so that the package was revenue-neutral.
In the years since, tax rates have been sharply increased and many new special provisions added to the Tax Code. Hence, there is now an opportunity simply to replay the Reagan strategy. There are any number of potential benefits from tax reform for Bush, both substantive and political. Following are a few.
-- Retirement. It now appears that Social Security reform is off the table for the time being. The idea of cutting payroll taxes in order to give people private accounts that would supplement Social Security benefits seems too controversial to many Republicans in Congress. But the need to give people a better retirement income than Social Security can provide has not gone away.
One way around the private account impasse would be to greatly expand Individual Retirement Accounts, Keogh Accounts, 401(k) plans and other forms of tax-deferred retirement saving. By allowing people to put away more money free of tax, this will reduce the double taxation of saving, move the tax system more toward a consumption base and give people an alternative to Social Security in retirement. If millions more Americans had several hundred thousand dollars in their IRAs or 401(k)s at age 65, they would be far less apprehensive about private accounts for Social Security.
-- Tax Shelters. There is a growing problem with corporate tax shelters that inevitably is going to require a legislative fix. Clever tax lawyers armed with IRS and court rulings have created a huge industry devoted to business transactions with no purpose other than tax avoidance. Indeed, it appears that some of Enron's problems resulted from such activities. It is not known how much corporate tax revenues are reduced by tax shelters, but estimates run into the tens of billions of dollars per year.
Thus, Bush has a readymade source of revenue to pay for tax rate reductions and savings incentives. He can raise revenues from corporations and use the money to cut taxes for individuals. That is basically what Ronald Reagan did in 1986. Over five years, he raised taxes on corporations by $120 billion and cut taxes for individuals by a like amount.
-- Simplification. Simplification of the Tax Code is a win-win situation for everyone. The IRS's Taxpayer Advocate, Congress' Joint Committee on Taxation, the American Institute of Certified Public Accountants and many others have laid out detailed lists of tax provisions creating massive complexity. And many of these problems can be fixed at relatively little cost in terms of foregone revenue. Just allowing more taxpayers to do their own taxes again, instead of paying an accountant, would constitute a de facto tax cut for many.
George W. Bush should follow Ronald Reagan's lead and initiate another Treasury study of the tax system. And he should plan on sending a detailed tax reform proposal to Congress early next year. If Democrats block action, they are implicitly defending the status quo, which is untenable. That will give Bush the best issue he could hope for in 2004.