Simple, Fair, and Pro-Growth: Proposals to Fix America's Tax System.

• Author: Zelenak, Lawrence
• Position: Book review

SIMPLE, FAIR, AND PRO-GROWTH: PROPOSALS TO FIX AMERICA'S TAX SYSTEM. By The President's Advisory Panel on Federal Tax Reform. 2005. Pp. xv, 272. Available at http://www.taxreformpanel.gov/final-report/.

INTRODUCTION

On January 7, 2005, President Bush--flush with recent electoral victory--issued an Executive Order creating the President's Advisory Panel on Federal Tax Reform. (1) The Order instructed the bipartisan Panel to recommend one or more plans for major reform of the federal income tax. (2) The president did not, however, permit the Panel to begin its work on a blank slate. Instead, the Order required (among other things) that the Panel's proposals be revenue-neutral, simpler than current law, "appropriately progressive," and supportive of homeownership and charity. (3) Although the Order contemplated that the Panel might offer more than one tax reform plan, it required that at least one option "use the Federal income tax as the base for its recommended reforms." (4)

The Panel (5) went to work promptly, held several hearings around the country, and produced a Report (not quite on schedule (6)) in November 2005. With Congress having difficulty enacting any legislation and with its limited legislative capacity focused on issues more pressing than revenue-neutral tax reform, the Report was widely viewed as dead on arrival. (7) The Report is, however, a substantial and thoughtful piece of work, and when Congress is finally able to turn its attention to tax reform sometime in the next few years, it can and should look to the Report for ideas--especially since the Report's recommendations were largely driven by the Panel's determination to repeal the alternative minimum tax (AMT), and repeal (or at least major reform) of the AMT is almost certain to be an issue of great legislative interest in the not-too-distant future. (8)

Part I of this Review outlines the basics of the two proposals that the Panel presents in the Report. Part II evaluates some of the proposals' details. Finally, Part III concludes with two comments on the place of the Panel's Report within the long-standing tax reform debate.

1. THE PANEL'S REPORT

   Following the Executive Order's suggestion that the Panel might offer more than one reform plan, the Panel's Report endorses both a "Simplified Income Tax Plan" (SITP) and a "Growth and Investment Tax Plan" (GITP). Although the two plans have slightly different rate structures--brackets of 15%, 25%, 30%, and 33% under the SITE and brackets of 15%, 25%, and 30% under the GITP--and differ significantly in their treatment of business and investment income, they have many features in common (p. 61 tbl.5.1). Each would repeal the alternative minimum tax (pp. 85-87); replace the standard deduction and personal exemptions with a "family credit," thereby eliminating the distinction between "above-the-line" deductions available to all taxpayers and itemized deductions available only to taxpayers not claiming the standard deduction (pp. 63-68); greatly reduce marriage penalties by giving married taxpayers a tax rate schedule with brackets twice as wide as those applicable to single taxpayers and by giving married taxpayers a "family credit" twice as large as a single person's credit (p. 89); eliminate the deduction for state and local taxes (pp. 83-84); replace the home mortgage interest deduction with a 15% credit, while capping the loan principal amount generating credit-eligible interest at the average cost of housing within the taxpayer's area (resulting in limits ranging from about $227,000 to $412,000) (pp. 70-75); make the charitable contribution deduction available to all taxpayers, but only to the extent contributions exceed 1% of income (pp. 75-76); cap the exclusion for employer-provided health insurance at the average cost of health insurance, while allowing a similarly capped deduction for the purchase of health insurance outside the employment context (pp. 78-82); and greatly expand opportunities for tax-favored savings outside the employment context by allowing every taxpayer to contribute up to $10,000 per year to a "Save for Retirement" (SFR) account and another $10,000 per year to a "Save for Family" (SFF) account, both based on the "tax pre-paid" Roth IRA model. (9) Both proposals retain tax-favored treatment for employer-sponsored retirement savings, but the tax favoritism in the SITP takes the familiar form of cash flow treatment (under which no tax is imposed at the time contributions are made, but tax is imposed when the taxpayer receives account distributions), while the GITP applies the "tax pre-paid" Roth IRA model to employer-sponsored plans (pp. 115-19, 159-60).

   The biggest differences between the two plans are in their treatment of business and investment income. Although the SITP has very significant consumption tax features, including the tax-favored savings vehicles described above, it retains the norm of depreciation, rather than immediate expensing, for most long-lived business assets. (10) The GITP, in sharp contrast, adopts the consumption tax approach of immediate expensing for all business assets (pp. 163-64). Although the Panel's Report does not claim the GITP is an income tax, it is also not a pure consumption tax because it retains a modest amount of taxation of investment income--a 15% rate applicable to dividends, capital gains, and interest (pp. 152, 159).

2. LOOKING AT SOME DETAILS

   1. Tax Favored Savings, Wage Taxes, Cash Flow Taxes and the Budget Window

      Despite its retention of the "income tax" label, the SITP would constitute a significant move in the consumption tax direction--primarily as a result of the introduction of SFR and SFF accounts. Under a consumption tax, income saved in one year is not taxed until it is spent on consumption in some later year. The current "income" tax follows this consumption tax--or "cash flow"--model with respect to employer-sponsored retirement savings and traditional individual retirement accounts (IRAs). (11) If a taxpayer faces the same tax rate in both the year in which income is saved and the subsequent year in which the income (augmented by the investment return on the savings) is consumed, the results to the taxpayer will be the same under either a cash flow model (with tax imposed only in the year of consumption) or a wage tax model (with tax imposed only in the year of saving). (12) Unlike employer-sponsored retirement plans and traditional IRAs, Roth IRAs are taxed under the wage tax model (13)--but Roth IRAs constitute only a small portion of tax-favored retirement savings. (14)

      The proposed SFR and SFF accounts both follow the wage tax model rather than the dominant cash flow model. Although they depart from the usual technique for introducing non-income tax features into the "income tax," the accounts would constitute a major increase in the hybridization of the so-called income tax. (15) If a married couple were to save the maximum amount of $40,000 per year in the two new accounts ($10,000 for each spouse in each type of account), and the invested funds grew at the rate of 5% per annum, at the end of thirty years they would have over $2.6 million in their accounts, which they could consume free of tax. The SITP would retain the current ceiling on annual contributions to employer-sponsored retirement plans (which would continue to be taxed under the cash flow model) (p. 117). If each spouse saved the annual maximum of $44,000 at work (16) each year for thirty years, and the rate of return on the investment was again 5%, at the end of thirty years they would have over $5.7 million in their employer-sponsored plans (which would, however, be taxed upon distribution). When wealth of this magnitude is afforded wage tax or cash flow treatment, the continued application of the "income tax" label is dubious.

      As interesting as the Panel's decision to make the SITP less of an income tax is its decision to use wage tax treatment rather than cash flow treatment to accomplish that goal. The Panel's other proposal, the GITP, exhibits even greater enthusiasm for wage tax treatment; it would replace cash flow taxation of employer-sponsored savings with wage taxation (pp. 159-60). At first glance, this preference for wage taxes over cash flow taxes is difficult to understand. After all, cash flow taxation has been the norm for tax-favored savings under the federal income tax for many decades, with apparently satisfactory results. Given the fact that the two approaches generally produce similar or identical results in the end, what could explain the Panel's preference? One reason might be cosmetics. For a taxpayer in the 33% bracket (the top bracket under the SITP), $10,000 in a wage tax account is as good as $14,925 in a cash flow account. (17) If the Panel feared that cash flow account contribution ceilings of almost $15,000 would appear too generous, it might have opted for wage tax treatment to reduce the nominal contribution ceilings to $10,000 without any change in actual generosity.

      One would hope, however, that the Panel had a better reason than that for its rejection of the long-standing preference for cash flow taxation. There is a substantive difference between wage taxes and cash flow taxes whenever a taxpayer is not subject to the same tax rate in the year income is earned and saved, and the later year in which the savings are consumed. Under a wage tax, the tax liability is a function of the tax rate in the earlier year, while under a cash flow tax it is a function of the tax rate in the later year. The Panel might have believed, for some reason, that the tax rate in the earlier year is the more appropriate rate to apply when the two rates differ. In fact, however, the Report expresses no such belief. (18) It provides no explanation whatsoever for the choice of wage taxation rather than cash flow taxation for the SFR and SFF accounts. (19)

      The Report is slightly more forthcoming with respect to the...