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Setting standards for genuine tax reform

SOME politicians are touting the wonders of the tax reform bill squeezed out of the House last month. But taxpayers may be forgiven some skepticism about the fourth ``reform'' of the tax system in five years. Some would hope for a lower tax bite; but don't count on that. The tax reform proposals are all constrained to be ``revenue neutral'' -- to yield as much revenue as the current system.

The House bill, like its two predecessors, ``Treasury I'' of November 1984 and ``White House I'' (or ``Treasury II'') of May 1985, holds out the appeal that it raises corporate taxes and cuts household taxes. But make no mistake: A dollar of taxes is still a dollar out of your pocket and into Uncle Sam's, no matter how it is collected.

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``Revenue neutral'' means no tax cut. Still, it will mean another arbitrary shuffle of tax burdens. The Senate, where the measure heads next, may be moving toward a tax code that need not be altered to appeal to its members.

Simplicity will not be achieved by a passive approach. Active, fundamental tax reform should aim at taxing either all income or all expenditure at about the same low rate of 19 to 20 percent while integrating the corporate and individual tax systems.

This approach, which contains exemptions for the poor, has been proposed by economist Robert Hall and political scientist Alvin Rabushka of Stanford University and introduced as legislation by Sen. Dennis DeConcini (D) of Arizona. Hall and Rabushka have even created a post-card-size model of the single tax form that would be used under this proposal.

Comparing the post-card system with the Byzantine tax code now in use is like putting the stark, linear Washington Monument next to Bernini's columns at the altar of St. Peter's Basilica. The appeal of complexity

But if simplicity has its appeal, so does complexity. Many people make their living off the complexity of the tax code, and many more expend considerable time and energy arranging their affairs to minimize taxes.

The current system, though, diverts capital and labor from sound economic uses to tax shelters. Such resource misallocation costs the economy somewhere between $100 billion and $200 billion annually.

The complexity of the tax code also prolongs the adjustment process whereby resources move out of older, uncompetitive industries and into newer industries. High-tech companies have supported reform that taxes more things at lower rates. Rapidly growing businesses and innovative companies concentrate on developing new ventures instead of diverting resources to exploit tax breaks.

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Congress has been its own worst enemy on tax reform. Tax breaks have kept alive uncompetitive industries that should be allowed to lapse.

This process should be ended or at least sharply curtailed, to let our intrinsically strongest industries develop as well as possible.

How should we proceed with true tax reform? In two stages:

Stage 1 involves finding a way to move steadily toward taxing more things at lower rates so that everyone keeps more of the dollars earned from extra effort, no matter how they are earned.

Stage 2 requires designing a steady but gradual and predictable transition to the new system. The Achilles' heel of reform proposals

We must start by identifying problems with the current approaches to tax reform. Successful sweeping change will require that no tax break be considered untouchable.

The Achilles' heel of current versions of tax reform is the imbalance created by exempting from consideration the major provisions affecting homeowners. That exemption produced two serious problems.

First, it meant that if rates were to be lowered in a revenue-neutral setting while leaving the largest single tax expenditure -- owner-occupied housing -- off the table, the only way to make up enough lost revenue was to rescind investment incentives and disallow deductibility of state and local taxes.

This expedient concentrated much of the burden of base-broadening on two powerful constituencies -- manufacturing industries and the high-tax states -- which could then ask with some justification, ``Why pick only on us?''

The second problem arising from special treatment of owner-occupied housing was the incentive it created to begin dismantling provisions for indexing. Treasury I indexed interest income and expense for tax purposes, in effect removing a large subsidy to borrowers and a tax to lenders that is implicit in the current system. Under the ``untouchable'' status of owner-occupied housing, mortgage interest was exempt from interest indexing; this provided a gaping loophole for highly leveraged home ownership. Incredibly, the Treasury's 1985 tax writers decided that instead of simply closing the loophole, they would drop the whole interest-indexing provision.

That's like worrying that the cows might get through a hole in the fence and deciding to knock down the fence instead of mending the hole.

Once interest indexing was lost, and with it the opportunity to lower interest and exchange rates, other important indexing provisions affecting depreciation, capital gains, and inventories were dropped at various stages in the movement from Treasury I to Treasury II to Ways and Means I.

Accelerated depreciation, investment tax credits, and special capital-gains treatments are merely ad hoc devices to attempt to correct after the fact for the capricious impact of inflation on the returns to investment. Regressive tax breaks

Beyond indexing, another serious problem for tax reform was the failure to recognize that deductions, exemptions, and exclusions -- usually called tax expenditures -- which have doubled relative to GNP since 1974, are, besides being excessive, also regressive.

A $2,000 personal exemption, highly touted as a break for those of lower and moderate incomes, is worth $1,000 to the top 50-percent bracketeer and only $300 for a worker in the 15 percent bracket. It would be far better to make a $2,000 exemption into a $300 credit for everyone.

The same point about the regressivity of tax breaks applies to owner-occupied housing as well.

In stark contrast to the favorable tax treatment afforded business and household debt is the unfavorable treatment of equity finance. Businesses cannot deduct from their taxable income dividends paid to shareholders, while shareholders are taxed on dividends. The result is double taxation of dividends and heavy reliance on debt financing, which adds to debt.

Some corporations try to avoid double taxation of dividends by retaining earnings to push up the value of their stock, which represents a claim on those earnings. But pursued too aggressively, this strategy can lead to a leveraged buyout and the issue of even more debt.

Dividends should be fully deductible from the taxable income of corporations to cut their overreliance on debt and end the bias against riskier projects that are better financed by contingent claims like equity. Treasury I called for 50 percent dividend deductibility, but subsequent tax plans have steadily eroded it virtually to zero. It has become clear that Treasury I's compromises with reality in the areas of owner-occupied housing, dividend deductibility, and indexing served as openings which the opponents of tax reform have parlayed into an erosion of reform proposals back toward current law.

To retain income-based taxes, a systematic base-broadening, rate-lowering plan must be designed that gives Congress considerable flexibility over a five-year period. My colleague Norman Ornstein and I have proposed a balanced approach to scaling back tax breaks that enables a reduction of rates down to a 15-23-30 set of brackets, with a 30-percent rate for corporations.

The basic idea of our plan is to cut in half the value of a huge collection of tax deductions, exemptions and exclusions in exchange for much lower tax rates that reduce incentives to seek tax shelters even more sharply than does the President's plan.

We accomplish an across-the-board devaluation of tax breaks by converting deductions and exemptions into tax credits evaluated at 15 cents on the dollar. The revenue gain, which is tremendous in view of the $400 billion value of tax breaks currently built into our tax code, is used to buy down tax rates. This approach gives all current recipients of tax breaks ``half a loaf,'' phasing in the rescission of breaks gradually over a five-year period. Indexing preserves the real value of tax measures expressed in terms of current dollars.

We must wean ourselves from the idea that the tax system can and should do all things for all people, or else we will be stuck with a tax structure that is neither simple nor fair nor conducive to growth.

The most consistent design for tax reform, evenhanded base-broadening to bring down the rates, is fully compatible with a basic administration theme: Fewer tax breaks mean less government intrusion into our lives.

Tax reform worth doing will yield a simpler system that taxes more things at lower rates, which is clearly fairer. There have to be fewer places to hide if the same amount of revenue is to be collected at lower rates. Enhanced simplicity and fairness mean a stronger economy that marches to the beat of economic opportunity instead of stumbling after the siren wail of ephemeral tax breaks.

John H. Makin is director of fiscal policy studies for the American Enterprise Institute for Public Policy Research.

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