Washington - Witnesses at the inaugural meeting of President Bush's Advisory Panel on Federal Tax Reform, held here last month, laid the groundwork for considering the roster of options facing panel members, who are saddled with the daunting task of recommending specific changes to the behemoth Internal Revenue Code.Former senator Connie Mack, chairman of the reform panel, said that the group would "take a fresh look at the existing tax code and will formulate options for making the tax system simple, fair and productive."
"The president is committed to major tax reform, to real tax reform - something more than just moving the boxes around," Treasury Secretary John Snow told the panel. The nine-member panel is charged with presenting their recommendations to Snow by July 31, 2005.
"The tax code is dreadfully murky in its complexity, but its size is clear and easy to see," Snow said. "More than a million words long, the Internal Revenue Code and regulations have more than doubled in terms of page-length over the past 20 years, and today's 'short' income tax form takes more than 11 hours to prepare - about the same as the 'long form' did a decade ago."
Former Commissioner of Internal Revenue Fred T. Goldberg Jr., a partner at the law firm of Skadden, Arps, Slate, Meagher & Flom LLP, presented a history of the income tax, concluding that the United States currently has "a grotesquely complicated system that distorts the allocation of resources and violates common-sense notions of fairness."
Louis Kaplow, professor of law and economics at Harvard Law School, analyzed the central concepts of an income tax and a consumption tax.
A consumption tax is equivalent to an income tax that exempts capital income, or return to savings, he explained. In relation to a consumption tax, an income tax is equivalent to a consumption tax that applies a higher rate to later consumption, since an income tax taxes savings on earnings that are already subject to tax.
The two tax bases - income and consumption - do not inherently have different distributional consequences, according to Kaplow. "It is generally feasible to design a consumption tax with the same distributive incidence as a given income tax," he said.
"There's no reason why a consumption tax has to be less progressive than an income tax," agreed William G. Gale, co-director of the Urban-Brookings Tax Policy Center. "But in the real world, every consumption tax ever designed has hit high-income people less than our current income tax system, so realistically the switch from an income tax to a consumption tax that's revenue-neutral would raise burdens on low- and middle-income households relative to the current system, and reduce burdens on high-income households relative to the current system."
Gale said that it is a myth that the consumption tax is more effective at taxing the underground economy than the current income tax is. He concluded that the income tax is a fair and proven mechanism for raising revenue, consistent with long-term economic growth. "While it could be improved, it should not be scrapped," he contended.
The underground economy issue is a red herring, according to Stephen J. Entin, president and executive director at the Institute for Research on the Economics of Taxation.
"In an honest store, they withhold the sales tax and send it in to the government, but in the underground shop, the drug dealer won't collect and send in any more than he would send in his income tax as a self-employed individual. The notion is that he gets taxed when he goes and spends some of his ill-gotten gain on a Mercedes. That's true, but the file clerk who buys drugs from him doesn't pay."
"Whether it's an income tax or a consumption tax, the same amount of cheating goes on, just in a different way - but that's not the merit of the consumption tax," he said. "The advantages are that you get more saving and investment under a consumption tax. Productivity increases and wages rise, but that calculus never enters into some people's analysis as to what is 'progressive.'"
"Some people value equality more than living standards, but the irony is that in attempting to get progressive, you make everyone worse off and you don't solve the equality issue either," he said.
Entin urged a fair, flat and unbiased neutral tax that would treat all savings like pensions and IRAs, end the double taxation of corporate income, and permanently eliminate the "death tax."
Getting there from here
Meanwhile, observers caution that the transition from the system that we have to a radically different system could be wrenching.
"The hard thing is getting someplace else from here," said Bernard S. Kent, Midwest Region partner-in-charge of personal financial services for Big Four firm PricewaterhouseCoopers. "If a change is made to a sales tax system and it's not handled properly, people would spend like there's no tomorrow before it's imposed, and then for six months there would be no sales. On the other side, people who have the ability to defer income would defer it until the tax no longer existed."
Kent agreed with the president's directions to the panel to maintain the home mortgage interest and charitable deductions. "There are good policy reasons to support these. There would be a significant decrease in charitable giving without the deduction. A decrease in charitable giving could result in a lower quality of life, or even social unrest unless government expenditures increased. In a completely flat or consumption-based tax, this would be lost."
Despite suggestions that the hearings are window dressing and that the final report has already been written, this is not the case, according to Entin. "They haven't had time," he said. "It's a real exercise, but they're laboring under very tight constraints."
"They probably already have in mind a strategy, and that's a good thing," said Tom Giovannetti, executive director of the Lewisville, Tex.-based Institute for Policy Innovation.
"They already have a set of assumptions. As a result of the assumptions and the mission constraints, they're probably looking for ammunition and arguments to justify the approach they already plan to take. That's fine, because there's been so much done on tax policy in the past 10 years that we're not operating in a vacuum."
The end result will not be a wholesale replacement of the current code, Giovannetti predicted. "The chances to accomplish some very specific and incremental reforms are good," he said. "They could pass three or four strategic improvements and call that significant."
"The worst thing about the tax code is that it severely punishes savings and investment," he said. "They could eliminate depreciation and go to 100 percent expensing, pass a universal savings account like a super IRA with no limits or very high limits, and eliminate the alternative minimum tax."
Although eliminating the AMT is widely thought to entail a huge revenue cost, Giovannetti doesn't agree. "It will be viewed as having a cost and needing an offset to pay for it, but static analysis doesn't take into account the increase in economic activity that will be generated. The political case for doing something about the AMT is compelling because it will start hitting so many voters very soon."
Giovannetti noted that the failure of the last major reform effort in 1986 makes some cynical about the possibility of future reform. "The reform of 1986 was a disaster," he said. "Its intention of broadening the base and lowering the rates was good, but it raised rates on new savings and investment, eliminated the Investment Tax Credit, lengthened asset lives in depreciation, and put tighter limits on contributions to retirement plans. The most infamous was a change in the passive loss rules on real estate, which hurt the entire real estate market."
"When people hear Washington talk about reform, they get nervous, because the current rules are at least predictable, and there's always the possibility of getting something worse," Giovannetti said.
