Tax reform : Another dismal science

By DAR HADDIX, UPI Business Correspondent

WASHINGTON, March 21 (UPI) -- At the National Association of Business Economics conference in Washington, D.C. on Monday, some economists made it clear that U.S. tax policy reform isn't going to be so easy as simply implementing a value-added sales tax or a flat tax, especially in light of new concerns about long-term entitlement program costs.

Economists named simplifying the tax code and maintaining necessary federal revenues as some of the most important goals, and agreed that even if the tax reform panel President George W. Bush has charged with overhauling the U.S. tax code makes recommendations, any serious changes would be unlikely without some real leadership from Bush.


"The income tax is a mess," said Yale University law professor Michael Graetz. "People at every level encounter extraordinary complexity." Taxpayers, he said, now struggle through more than 100 pages of instructions when completing their 1040s, compared to 10 pages in 1940.


"(The tax return instructions are) about four times longer than 'War and Peace,' and considerably harder to read," Graetz said.

Simplifying the tax code would also ease the burden on the Internal Revenue Service, which is so overworked that it now audits only 3 percent of returns, as opposed to 6 percent in the 1980s, he said.

The bottom line, he said, is that he "can no longer remain optimistic about fixing the income tax. It seems to me that if tax reformers were serious about (making income tax simpler), then they must put simplification at the top of the agenda but simply has not been at the top of the agenda for either Republicans or Democrats." Both Democrats and Republicans have helped complicate the tax code by using it to try and solve any social problem affecting the nation, he said.

On Jan. 7, Bush appointed a nine-member panel directed by former U.S. Senators Connie Mack, R-Fla., and John Breaux, D-La., to examine how to reform the U.S. tax system. The panel, which must present its conclusions to the U.S. Treasury Secretary by July 31, 2005, has met three times so far.

Additionally, said Graetz, the U.S. government has estimated that fixing the problems with the alternative minimum tax (AMT), which while designed for high-income taxpayers is increasing taxes on a growing number of citizens as income levels go up, will cost about $1 trillion, which is why Congress hasn't done anything about it yet, he added.


"The (AMT) ... is a train wreck coming down the road," he said. "If nothing is done to fix it permanently tens of millions of people will have to struggle to calculate their income tax twice."

But of the alternative tax plans being bandied about right now, "It is my view that (the flat tax and national sales tax) are not realistic alternatives for reform as put forth so far," Graetz said.

The flat tax, for example, wouldn't really be flat nor be a cure-all, Graetz said, as it taxes exports and exempts imports. "While economists agree that exchange rate fluctuations will deal with this in the long term, American businesses simply will not accept a tax on that kind of basis."

As for a national sales tax, "There is no reason to believe that any government could collect a national sales tax on a level that could completely replace income tax."

Also, both taxes would shift the burden from wealthier to poorer taxpayers, he said. In the 1990s, he added, several senators proposed a tax system with a VAT on businesses and a progressive consumption tax that would boost economic growth but not shift the tax burden, but it didn't fly in Congress.


Graetz bashed another potential tax proposal known as "five easy pieces" -- a tax reform solution conceptualized by former U.S. Treasury Department officials Ernest Christian and Gary Robbins, which essentially advocates taxing income while lowering high marginal tax rates -- which includes such changes as implementing lower capital gains rates, lower rates for dividends, expensing 100 percent of business investments, more IRAs and a territorial system of taxing international income.

"They're all revenue losers," he said.

Graetz's solution to U.S. tax reform? "We can achieve low rates and a much simpler tax system by returning the current income tax to its pre-World War II status -- that is, a relatively small tax on a thin slice of Americans," which would include raising the alternative minimum tax exemption for married couples to $100,000, indexing the AMT for inflation, lowering the AMT rate 25 percent, and repealing the income tax, freeing about 150 million Americans from filing individual tax returns. A low flat rate tax would be imposed on the rest of taxpayers. It would make the U.S. similar to OECD countries regarding tax on consumption but would leave it with a much lower tax on income compared to the rest of the world, he said.


Graetz also recommended lowering corporate tax rates 25 percent and "more closely aligning book and tax accounting for corporations," he said, which would be the only way to curb corporations from exploiting loopholes to create tax shelters.

To make up for any revenue losses, he proposes a VAT of 10-14 percent rate.

"This plan is ... designed to maintain current federal revenues and ... it does not entail a substantial shift across income brackets."

Among the benefits, he said, would be that lower taxes would make the tax system more conducive to savings and economic growth; businesses would be incented to give employees health insurance and retirement savings; the marriage penalty would disappear; combining taxes would make international trade easier; and tax system transition pains would be eased. Additionally, the Earned Income Tax Credit would be awarded based on wages and wouldn't require filing a tax return. And, since all reporting of taxes would be done by retail businesses, there would be no individual returns to file.

William Gale, senior fellow at liberal think tank the Brookings Institution, while agreeing that simplification was essential to tax reform, stressed the importance of maintaining adequate federal funds to meet future spending.


The bottom line, Gale said, is that tax cuts have to be paid for, as they aren't going to generate enough growth to pay for them, so the United States has to raise taxes or cut spending. If people don't want to cut Social Security, Medicare or Medicaid, or defense or homeland security, then the rest of government will have to be cut by half to pay for the tax cuts. So, the United States need to decide whether to cut Medicaid and Medicare "by very substantial amounts," or raise taxes, Gale said.

"Those really seem to be the only two choices. My sense is we're not going to cut Medicare or Medicaid, and therefore we need to think of revenue options."

Gale disagreed with Graetz' assertion that the sales tax would be 23 percent, on grounds that the calculations were performed partly with the assumption that consumer prices would go up, and producer prices stay the same, or producer prices fall, and consumer prices stay the same. However, in this case the revenue was calculated using one assumption and the price the government would have to spend was calculated with another, he said.

"When they calculated how much revenue they would get, they calculated that (consumer) prices would go up. When calculating how much the government would have to spend to maintain the current program, they assumed producer prices would fall. That turned out to be a $500 billion-a-year mistake in terms of government revenues, and when you fix that, the rate turns out to be about 30 or 35 (percent) ... and that assumes that there's no avoidance, no evasion, and no erosion of the tax base," so health care spending and other spending that isn't taxed in any other countries would be taxed in the United States under that plan.


With such high rates, he said, a sales tax would not be enforceable, since there's no backup verification of what people should pay for taxes, unlike with the current system. For example, right now, employers send in documentation of employees' wages to the IRS, which wouldn't happen with a purely sales-tax-based tax system.

As for the flat tax, once one starts considering things like charitable contributions, health insurance deductions, and state and local taxes, the rate goes up to around 30 or 35 percent, something "unlikely to be politically palatable," he said.

Responding to the 'five easy pieces' option, which he said was likely to be considered by the tax reform panel, he said that the idea behind the plan was to go from a progressive income tax to a flat consumption tax. However, he said this wouldn't be the case, as it would encourage tax shelters.

"If you have (expensing) and no interest deductions then ... the tax rate on capital is zero; if you've got expensing and interest deductions then you've got an enormous tax shelter and a negative tax rate on capital income. So if you move to a system where we don't tax interest income but we do allow interest deductions then you've essentially moved not only to a consumption tax but to a wage tax .... on stupid people because smart people will figure out that they can borrow money and use the interest deduction to shelter their wages."


When asked if the tax reform panel would probably come up with a plan that was politically viable, Graetz said the panel needs to come up with their own plan and take some sacred cows like the VAT and flat taxes off the table. The president and Congress also need to demonstrate leadership to get the task accomplished, he said, as the Republican Congressional leadership has pursued "unrealistic" proposals, while the Democratic leadership has simply been silent.

"The president has to get on board," Gale said, and push the agenda like he has for other issues -- otherwise, it won't go anywhere, as such legislation has a better chance if it comes from the White House, not from Congress, especially with the same party dominating both the House and Senate, Gale said. "Parties don't compromise within themselves," he added.

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