TAX REFORM: FANTASY & REALITY
HOOD, JOHN
Tax Reform: Fantasy & Reality by John Hood IF YOU BELIEVE REPUBLICAN POLITICIANS and others in the conservative movement, the issue of tax reform is a sure winner. The debate, it is said, is not...
...The flat tax, for example, would sweep away the current bias in the tax code that favors health insurance, managed care, and other third-party payers of medical bills...
...And their defenders are unlikely to listen to true reason...
...There's no way around that, at least if reformers are to stay true to their principles...
...A single marginal rate doesn't concern them nearly as much as the possibility that rich "coupon-clippers" whose income derives mainly from investments will escape tax altogether...
...Absolutely...
...Focus on savings...
...Indeed, I'm surprised by the degree to which policy wonks and politicians in safe seats have dominated the tax-reform debate and steered it toward theory and fancy...
...That is the only way to bring in enough revenue to levy a relatively low (15 to 20 percent) rate...
...The reason is simple: Both the flat tax and the national sales tax would expand the scope of federal taxation to forms of economic activity that now escape it...
...I doubt that either a flat tax or a national sales tax will pass congress...
...Now, economists who back the flat tax or national sales tax will argue that their plans do tax investors—the flat tax by taxing profits and interest payments at the business level, the sales tax at the point when the investor spends the money...
...For many, if not most, taxpayers, payroll tax for Social Security, Medicare, and unemployment insurance is greater than the federal tax liability...
...A sales tax would have no choice but to tax services, such as legal assistance, medical care, child care, and investment advice...
...Advocates of the national sales tax might view this problem as an argument against income taxation...
...Because the initial deposits in these accounts are not tax-deductible, the tax benefits are limited to tax-deferred interest or capital gains...
...But they need to start using their heads...
...Far simpler to explain—and far better as economic and social policy—would be the creation of educational savings accounts (ESAs) that would not only exempt earnings from tax but allow families to take tax deductions for deposits and pay no tax on withdrawals...
...At the same time, many of them promise generous family deductions to make the system effectively progressive while marginally flat...
...Medical savings accounts, home-ownership accounts, and unemployment savings accounts (to replace the current, deeply flawed unemployment insurance system) would naturally attract the political support of the financial institutions and mutual funds likely to manage this money, as well as the industries—such as health care and real estate—from which savers would eventually purchase services...
...service industries—including law firms and health-care providers—represent about one-fifth of private economic output, a huge and growing share of total employment, and tremendous clout in Washington and state capitals...
...One of the defects of the flat tax (and the national sales tax, if applied to all goods and services) is that it is unfair to investment in human capital...
...Is there a way for the Right to pursue a similar course without surrendering its principles...
...Throw in the financial-services industry and the realtors, and you have a recipe for political disaster...
...and they'll fight hard to keep it that way...
...National-sales-taxers promise rebates for poor taxpayers to accomplish the same objective...
...I suspect average taxpayers want to be reassured that, every year, rich investors will have to fill out a form and send it (and possibly a check) to the tax collector, just as they themselves will...
...The debate, it is said, is not about whether tax reform will cross the finish line in the next few years, but about which horse—the flat tax or the national sales tax—is the safer bet...
...Another option would be to make payroll taxes deductible on federal income-tax returns...
...Remember that the bottom 50 percent of Americans pay an average effective federal income-tax rate of about 4.5 percent...
...John Hood is president of the John Locke Foundation in Raleigh, N.C., and is the author of The Heroic Enterprise: Business and the Common Good...
...Chopping away at federal, state, and local tax rates is a useful enterprise regardless of whether the tax system itself is significantly changed...
...His experience is a lesson for conservatives on how to package even a modest tax cut to great political effect...
...The notion of diverting some payroll taxes into personal savings accounts, or trading cuts in payroll taxes for cuts in future benefits, may well generate wider enthusiasm than a flat tax or national sales tax...
...If you don't believe me, try them out on your friends...
...This is justifiable on tax-policy grounds...
...Proponents of the flat tax and national sales tax have fallen all over themselves explaining why adopting a single rate is fair...
...I'd like to see a populist assault on excise taxes, for example, as well as continued action to ratchet down tax rates on income, sales, and property and to install super-majority rules that will make future tax hikes difficult to pull off...
...Finally, focus on cutting taxes...
...The idea of making college tuition tax-deductible and giving out additional tax credits for some students and their families was a half-solution at best, but brilliant politics...
...But their own plan creates even worse problems...
...According to opinion polls, people generally agree with the idea that someone making twice as much income as they should pay twice as much tax...
...Giving at least a limited tax exemption to education spending and savings is, in fact, to enforce tax neutrality between present and future consumption...
...They will instead be hollering about the more complicated issue of how to define the tax base, regardless of the rates...
...A tax system can look good on paper and still be impossible or inadvisable to adopt in practice...
...They exist for a reason...
...This is a major reason that non-wage benefits have grown significantly as a share of total worker compensation over the past several decades...
...It attracted the support of academia, CPAs, financial advisers, and the investment industry...
...Tax reformers should instead settle on a few discrete goals and design modest proposals that have political constituencies of their own...
...In the world we actually inhabit, mortgage deductions, charitable deductions, fringe benefits, a circumscribed tax base that excludes some forms of economic activity, and tax-code complexity are givens...
...ESAs could be used to fund all educational expenses, from preschool to graduate school to even job training...
...Flat-taxers say that theirs is the only way to treat everyone equally and to reduce economic distortions caused by punitive rates...
...All flat-tax proposals would end this bias by subjecting non-wage benefits to the business tax...
...They are benefiting from a screwy tax code...
...Tax reform remains a critical issue and a viable way of galvanizing the conservative coalition...
...Not even its function as a sizable import duty would give the sales tax enough industry support to fly...
...The new governor of Virginia, Jim Gilmore, was elected with a mandate to end the state's property tax on automobiles...
...The ESA is not the only way to cut taxes by creating rather than alienating political constituencies...
...Our task is to work around them—and figure out ways to solve the most pressing problems of our biased and excessive tax system...
...For any tax reform to have political legs, it must guarantee that all Americans interact with the tax system in a roughly equivalent fashion, even if they are, for various reasons, paying different effective rates on their income...
...Here's the most important thing to remember: opponents—be they special interests or populist demagogues—will not be responding primarily to the notion of a single tax rate on income or sales...
...In effect, private education savings and spending at all levels would become tax-free...
...Provisions in last year's budget deal allow "back-ended" IRAs for higher-education savings as well as penalty-free IRA withdrawals for college tuition, medical expenses, and mortgage deposits...
...Tax reform must necessarily pick fights with powerful interests, such as doctors, lawyers, realtors, insurance agents, and bankers...
...But the answer is not to construct an intricate new system that must be passed intact...
...Both groups are missing the point...
...But expanding taxation to include managed-care contracts, employer-provided life insurance, day-care assistance, and other non-wage compensation will make lots of industries and professions hopping mad...
...A dollar of health-insurance premiums would be taxed the same way as a dollar of wages paid directly to workers...
...they know it...
...Today's tax reformers have their hearts in the right place...
...The complicated tax cuts of 1997 were modest and mostly wrongheaded, but they demonstrated the political value of designing tax cuts so that they have powerful constituencies...
...It should be obvious that tax reform that isn't also tax relief will go nowhere...
...They don't have a big personal stake in income-tax reform (or at least are unlikely to perceive such a stake...
...I think we need to find a better wager...
...While plant, equipment, or other physical capital would receive tax deduc-tions—on the appropriate grounds that to do anything less is double taxation, because earnings on the investments are also taxed—investments in human capital such as education and training, which also generate future taxable income, would continue to get taxed two or three times...
...But arguments such as "I'm paying my taxes at the business level" or "I'll pay my taxes 10 years from now when I buy a yacht" don't have much political value...
...The benefits are easier to understand, and they accrue directly to taxpayers in the form of dollars or assets...
...Here are a few ideas: Focus on payroll taxes...
...More broadly, non-wage benefits given to employees currently escape tax on both the workers and the firms...
Vol. 4 • September 1998 • No. 1
