Enron scandal exposes flaws in tax system

Posted: Feb 12, 2002 12:00 AM
Among other things, the Enron scandal points out some of the deep flaws in our tax system. The company was encouraged to become over-leveraged by a corporate income tax that rewards debt and punishes equity. At the same time, employees were pushed to overinvest in Enron stock by an individual income tax that makes saving for retirement outside a company pension plan unnecessarily costly. Both of these problems would be solved by doing what most economists now favor: abolishing the double taxation of corporate profits, and treating all saving like 401(k) and Individual Retirement Accounts -- that is, allowing a deduction for all contributions and taxing only the returns. One of the principal barriers to adoption of these sensible reforms is that outmoded ideas about taxation are deeply embedded in the policymaking process. One of these is the notion that an "ideal" tax system ought to double tax investment and saving. This misguided concept, called the Haig-Simons definition of income, is based on research done in the 1920s and 1930s. Since the 1970s, however, most economists have come to favor a consumption-based tax system precisely because it eliminates overtaxation of capital. A big stumbling block to adoption of a consumption-based system is that taxing income underlies the so-called tax expenditures budget. This compilation, published every year in the president's budget, lists all deviations from a "normal" tax system, which is based on an assumption that Haig-Simons is the only legitimate tax base. In practice, the tax expenditures list is not based on a pure application of Haig-Simons, leading to many arbitrary inclusions and exclusions. Nevertheless, all provisions of the law that reduce taxation on saving and investment are considered tax expenditures and therefore illegitimate per se. Because every item on the tax expenditures list is in effect presumed to be unjustified in principle, they are often prime targets whenever there is a need for additional government revenue. Why raise tax rates, many members of Congress often ask, when we can just restrict or eliminate tax loopholes? When this happens, they tend to consider every tax expenditure a "loophole." Consequently, revision of the tax expenditures budget is a necessary precondition for adoption of meaningful tax reform. Until that happens, every incremental improvement in the Tax Code that would move it toward a consumption base will be viewed as adding or expanding tax loopholes. Some of these measures would include allowing all investment in plant and equipment to be deducted from taxable income immediately, rather than being written off over many years, and a reduction in the capital gains tax. In its 2002 budget a year ago, the Bush administration took the first step toward changing the traditional tax expenditures analysis. It said that it considered the very concept of tax expenditures to be of "questionable analytic value" and that the presentation was being reconsidered for the future. Now, in its 2003 budget, the administration has given us an idea of what its revised tax expenditures presentation may look like. It says that it is studying three major proposals. First, items on the tax expenditures list need to be updated to conform to changing conceptions of what a normal Tax Code looks like. Toward this end, the budget has eliminated any calculation of tax expenditures for the estate and gift tax, on the grounds that Congress has voted to repeal this tax in 2010. Hence, it is no longer part of the normal tax system. Second, the administration is considering addition of "negative" tax expenditures. Presently, tax expenditures are calculated only for provisions that reduce taxes below those under a normal system. But there are also provisions that raise taxes above what would exist under it. The administration believes that these should be listed as well. Lastly, the Bush administration is looking into an alternative tax expenditures presentation based on a consumption-based tax system. This would eliminate many provisions from the tax expenditures list and add others. Being able to compare such a presentation to the traditional one would be very helpful in identifying truly illegitimate provisions of the Tax Code. All of these reforms would greatly improve the tax expenditures budget. Like so many things in Washington, it has changed little from its initial development in the 1960s. It may have served a useful purpose at the beginning, but has since become little more than an annual bureaucratic exercise that sometimes does more to confuse than clarify tax policy.