This is tax reform?

Posted: Oct 27, 2005 12:05 AM

President Bush recently spoke to the Economics Club of Washington, D.C., repeating his plea to make the 2001-2003 tax laws permanent. Yet he created The President's Advisory Panel on Federal Tax Reform, headed by former Sens. Connie Mack and John Breaux, which implies something about the tax laws needs to be changed. We can't ask for permanence and big changes at the same time.
I am writing shortly before the full commission report is released, so I can offer only a preliminary assessment based on Tax Notes and The Wall Street Journal. The final report may discuss five proposals, but apparently focuses on just two.

 The commission must have taken the president's appeal to leave things alone too literally, since it has taken special care to avoid lowering tax rates. Both plans would eliminate the 10 percent bracket, putting the lowest rate back up to 15 percent. That's an efficient idea, since creating that lowest rate had very little bang for the buck.

 Yet the very large amounts of extra revenue from raising the lowest tax rates are not to be devoted to reducing higher tax rates. Plan A trims the top individual tax and the corporate tax trivially, from 35 percent to 32 percent. Plan B doesn't even do that much, leaving the individual rate unchanged.

 Today's simple flat tax of 15 percent on dividends and long-term capital gains would be replaced by excluding 75 percent of capital gains for stocks but not other investments. There is no coherent rationale for applying progressive tax rates to capital gains, so this looks like a complicated distortion. Few reforms would do more to simplify tax reporting for investors than applying one flat tax rate to all capital gains, short-term or long.

 In reality, Plan A is mainly about capping or eliminating individual tax deductions and eliminating the lowest tax rate, while leaving other tax rates more or less unchanged. In exchange for little or no reduction in tax rates, taxpayers would give up all tax deductions for state and local taxes, which amounts to imposing a tax on a tax. Taxpayers in states like California and New York are unlikely to welcome such expensive "simplicity."

 Deductions for casualty losses would be scrapped, which is a tough idea to sell after this year's hurricanes. More defensibly, in my view, deductions for mortgage interest would be limited in size and deductions for charitable contributions would be allowed only for amounts in excess of 1 percent of gross income.

 Could taxpayers be persuaded to give up all these deductions in exchange for virtually zero reduction in tax rates? Not likely. Some will say the saving grace is that the plan gets rid of the Alternative Minimum Tax (AMT). But the AMT affects relatively few taxpayers with relatively high incomes, and these are the same people who would suffer most from the loss of tax and mortgage deductions. The AMT is hated because it does exactly what this "reform" would do -- namely, limit deductions. But unlike Plan A, the AMT at least offers a relatively low 26 percent to 28 percent tax rate.

 Plan B is far bolder, but this is not a virtue. It began as a strange sort of flat tax -- one that is not remotely flat. There would be four individual tax rates from 15 percent to 35 percent and a corporate rate of 32 percent. Plan B postures as a "consumption tax," simply because business investments could be immediately expensed, rather than depreciated over years. In one key respect, however, income from personal investments would be double-taxed to an even greater degree than under current law.

 In Plan B, as in the Hall-Rabushka flat tax, companies could no longer deduct any interest expense involved in investing in machinery, buildings and inventories. Since interest would no longer be deductible at the corporate level, it should not be taxable at the individual level. The tax on interest has already been collected at the source -- a business or bank.

 Under Plan B, by contrast, interest income would be subject to a 15 percent tax individual income tax, as would dividends and capital gains. For the first time ever, interest would be subjected to a double tax.

 I plan to discuss the economics of this scheme later, after I see more details. Politically speaking, we can surely expect leveraged firms to protest loudly against any loss of interest deductibility, despite the benefits of expensing investment.

 I am hopeful there will be some good ideas buried in the final report, and I expect to look long and hard for them. Unless the early reports were wildly inaccurate, however, the overall picture does not look very promising, to put it as kindly as possible.