November 1, 2005 | WebMemo on Taxes
The President's Advisory Panel on Federal Tax Reform has issued a report calling for significant changes to the internal revenue code. More specifically, the Panel proposed two options, the Simplified Income Tax Plan (SIT) and the Growth and Investment Tax Plan (GIT). Both plans seek to simplify the tax system incrementally and reduce penalties on productive behavior. While the Panel's recommendations all point in the right direction, the Panel unfortunately backed away from more sweeping reforms. Lawmakers should use the Panel's report as a starting point on the way to a more simple and fair tax system, such as the flat tax.
The Two Plans
The SIT and GIT plans share certain features. Some of these are uninspiring-neither plan, for example, significantly lowers tax rates. However, there are many positive changes in both plans, including repeal of the alternative minimum tax (AMT) and elimination of the deduction for state and local taxes. In addition, both plans eliminate the marriage penalty, reduce the tax bias against income that is saved and invested, and reduce some of the complexity of the current tax code.
Last but not least, both plans have features that are not so important economically but of significant interest to many taxpayers-including a recommendation to transform the home mortgage interest deduction into a credit that would target benefits more toward lower-income taxpayers and a proposal to make the tax preference for charitable contributions available to all taxpayers who donate at least one percent of their income.
The SIT plan is best characterized as a reform of the current tax system. In addition to the changes already mentioned, it would reduce the double-taxation of capital gains and eliminate the double-taxation of dividends. On the business side, the treatment of business investment would be simplified, but "depreciation" would not be replaced with expensing-meaning that there still would be a tax on new investment. Companies would no longer be taxed on income earned abroad-thus moving closer to the more competitive "territorial" tax system used by almost every nation.
The GIT plan comes closer to what economists call a "consumption-base" system, largely because of changes in the treatment of business investment. Companies would be allowed to immediately deduct, or "expense," investment expenditures rather than gradually deduct, or "depreciate," those costs over many years. The GIT plans also "flips" the tax treatment of interest. Companies no longer would be able to deduct interest expenses. In effect, this means firms would pay a withholding tax on interest payments. In a pure consumption-base system, in which double-taxation is eliminated, this also would mean no tax imposed on those who receive interest payments. The GIT plan does not fully eliminate double-taxation, however, because there would be a 15 percent tax on interest, dividends, and capital gains.
Grading these proposals requires a benchmark, and the flat tax is the ideal standard by which any tax reform plan should be judged. As discussed in an October 24 WebMemo, a flat tax contains all the features of a good tax system, including a low tax rate on work and entrepreneurship and a low tax rate on saving and investment. The flat tax also gets high grades for simplicity, neutrality, and competitiveness.
Grading the Report
With the flat tax yardstick in mind, the recommendations of the President's Tax Reform Panel deserve positive-albeit not spectacular-grades.
Benchmark No. 1: A lower marginal tax rate on work and entrepreneurship
The ideal tax system has a single tax rate set at the lowest possible level. This minimizes the tax penalty on labor and increases incentives to earn more income.
The Tax Reform Panel acknowledges the
importance of low tax rates, writing in the Report that:
Federal Reserve Board Chairman Alan Greenspan explained to the Panel that the excess burden, or cost, of the tax code grows more than proportionately as tax rates increase. In fact, economic theory suggests that if you double the tax rate, you quadruple the excess burden. This means that high tax rates have disproportionately high economic costs associated with them.
The Grades: The key criterion is whether personal income tax rates are reduced-particularly the top rate because that is a key indicator of the tax code's hostility to work and entrepreneurship.
The SIT plan deserves a C+ because it has a very small reduction in tax rates. The top tax rate falls only to 33 percent from the current 35 percent level.
The GIT plan deserves a B- because it features a somewhat larger reduction in tax rates and the top rate falls to 30 percent from 35 percent.
Benchmark No. 2: A lower marginal tax rate on saving and investment
The ideal tax system eliminates all forms of double-taxation, such as the capital gains tax, the death tax, and the extra layers of taxation on dividends and savings. This minimizes the tax penalty on capital and increases incentives to earn more income.
The Tax Reform Panel explicitly comments on the importance of reducing the tax bias against saving and investment, noting that:
…some studies have suggested that a tax system that removes the penalty against savings by switching the current structure to a progressive consumption tax could potentially increase the size of the economic pie by between 3 and 7 percent.
The Grades: Assigning a grade in this category is more difficult because there are so many forms of double taxation in the current system. In part, the grade should be based on whether these forms of double-taxation-including the death tax, capital gains tax, and double-tax on dividends-are reduced or eliminated. Another key factor is whether individuals are given universal and unlimited "IRA treatment" so that they are not double-taxed on income that is saved and invested. Last but not least, the grade should be based on whether businesses can immediately deduct investment expenditures rather than being forced to "depreciate" those costs over a period of time.
The SIT plan deserves a B because it contains some significant improvements, such as expanded IRA treatment of saving and lower tax rates on dividends and capital gains.
The GIT plan deserves a B+ because it contains most of the reforms of the SIT plan and also permits expensing of business investment. The imposition of a special 15 percent tax on interest, dividends, and capital gains is an unfortunate feature that keeps the proposal from earning an even higher grade.
Benchmark No. 3: Fewer resources needed for tax compliance
The ideal tax system minimizes the complexity of the tax code and thus reduces the need for expensive lawyers, accountants, and software to fill out tax returns. Equally important, these resources now are available for productive uses.
The Tax Reform Panel recognized the value of simplicity, writing in the Executive Summary that:
The complexity of our tax code breeds a perception of unfairness and creates opportunities for manipulation of the rules to reduce tax. The profound lack of transparency means that individuals and businesses cannot easily understand their own tax obligations or be confident that others are paying their fair share. The tax system is both unstable and unpredictable. Frequent changes in the tax code, which often add to or undo previous policies, as well as the enactment of temporary provisions, result in uncertainty for businesses and families. This volatility is harmful to the economy and creates additional compliance costs.
The Grades: The key criteria here are the degree to which the number of forms required by the tax system can be reduced and the amount that the time and money taxpayers spend to comply with the tax law can be reduced. Complexity often is the result of policy choices. The death tax and the capital gains tax both impose heavy compliance costs, and those costs automatically disappear if these forms of double-taxation are abolished.
The SIT plan deserves a B- for shaving some lines off of the 1040 form and eliminating the need for certain worksheets. The AMT is repealed, the treatment of saving is simplified, and certain phase-outs are abolished.
The GIT deserves a B for also simplifying the basic tax return. It contains the same reforms as the SIT plan, but also shifts to expensing for business investment-a reform that significantly lowers compliance costs.
Benchmark No. 4: A more efficient allocation of resources
The ideal tax system eliminates all the distortions in the tax code by taxing all economic activity equally at one low rate. Resources are thus allocated on the basis of creating wealth rather than minimizing tax liability.
The Tax Reform Panel acknowledged the importance of this benchmark, noting in the Executive Summary that:
Tax provisions favoring one activity over another or providing targeted tax benefits to a limited number of taxpayers create complexity and instability, impose large compliance costs, and can lead to an inefficient use of resources. A rational system would favor a broad tax base, providing special treatment only where it can be persuasively demonstrated that the effect of a deduction, exclusion, or credit justifies higher taxes paid by all taxpayers.
The Grades: This benchmark is similar to the compliance benchmark above. One approach measures administrative burden and the other reflects economic cost.
The SIT plan deserves a B for eliminating a few deductions and taking a few steps toward a more neutral tax code. The business side of the tax code is significantly simplified, but the retention of many other preferences for households precludes a higher grade. The Panel took a small step toward a more rational health care system by capping the exclusion for employer-purchased health care expenses and seeking to create a level playing field between individual and business purchases of health care policy, but tax policy experts and health policy experts had hoped for a more aggressive reform.
The GIT plan deserves a B+ because it has the good and bad features of the SIT plan-including the modest changes to the tax treatment of health care-along with the additional feature of expensing. This merits a higher grade because expensing creates a more neutral environment for economic decision making.
Benchmark No. 5: Improved international competitiveness
The ideal tax system makes a country much more attractive to international investors. Direct and indirect investment will significantly increase, and the nation will become a magnet for skilled labor and entrepreneurs.
The Tax Reform Panel noticed the important role of international competitiveness, writing that:
A wave of tax reforms has swept across the world in the last two decades. Since the United States reformed its tax system in 1986, almost every major developed economy has engaged in fundamental tax reform. The Panel heard that a common theme of these reform efforts was an attempt to lower tax rates and broaden the tax base. Some countries have adopted flatter personal income tax systems by reducing the number of tax brackets in their systems. A number of countries in Eastern Europe - including Estonia, Georgia, Latvia, Slovakia, and Russia -- have adopted a single uniform rate for taxing personal income. Other countries, such as Finland, Norway, and Sweden have moved towards dual personal income tax systems under which wage income is taxed at progressive rates and capital income (dividends, interest, etc.) is taxed at a lower single rate. Countries have also lowered their corporate income tax rates and provided other tax relief for capital income.
The Grades: There are several components to grading competitiveness. Part of the grade reflects overall tax policy. For instance, are tax rates higher or lower? Is the double-taxation of saving and investment reduced or eliminated? But part of the answer reflects specific choices dealing with cross-border economic activity-most notably whether a tax system is "worldwide" or "territorial."
The SIT plan deserves a B- grade because it shifts to territorial taxation for "active" business income but retains worldwide taxation for all forms of individual income and "passive" business income.
The GIT plan deserves a B+ grade because it shifts to territorial taxation for "active" business income and individual labor income but retains worldwide taxation for individual capital income and "passive" business income.
Disappointing Approach to Revenue Estimating
If a change in tax policy improves economic performance, more income will be generated. And because more income for taxpayers also means more income for the government to tax, good tax policy can produce more revenue-this is sometimes referred to as a "revenue feedback." To provide policymakers with accurate information, the Panel should have tried to measure the feedback associated with both tax plans-a process know as "dynamic" revenue-estimating.
Unfortunately, the Panel relied on "static" revenue-estimating, which embodies a rather implausible assumption that the economy is not affected by taxes or changes in tax policy. This assumption contradicts the Panel's mandate, which was to propose reforms to increase economic growth. Yet if the Panel fulfilled its mandate and proposed reforms that increase growth, those recommendations would lead to a bigger tax base and some degree of revenue feedback.
The use of static revenue-estimating is particularly misguided because it presumably contributed to the Panel's decision to retain high income tax rates. If dynamic revenue-estimating had been used, by contrast, the panel may have been able to bring top tax rates down to a more reasonable level, such as 25 percent.
The Tax Reform Panel has produced a thorough report with an excellent review of the current system and a balanced analysis of tax policy options. The Panel's recommendations all point in the right direction. The only criticism is that the members of the Panel backed away from more sweeping reforms in an effort to cater to perceptions of political reality.
Instead, the Panel should have seized upon the opportunity to shift the perception of political reality. Many nations have adopted sweeping reforms such as the flat tax precisely because policymakers sought to change the terms of debate. Fortunately, the Panel's analysis points the way toward even bolder changes. Lawmakers should seize upon this Report and begin a discussion that will lead America to a more competitive system such as a simple and fair flat tax.
Daniel J. Mitchell, Ph.D., is McKenna Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.