Tax Update Blog: Permalink

« Previous · Tax Update Blog Home · Next »

TAX REFORM? WHAT DOES HE MEAN BY THAT?

November 04, 2004

   Because we have done the hard work, we
   are entering a season of hope. We'll 
   continue our economic progress. We'll 
   reform our outdated tax code. We'll 
   strengthen the Social Security for the
   next generation. We'll make public 
   schools all they can be. And we will 
   uphold our deepest values of family 
   and faith.

                    From President Bush's victory speech.

It looks like "tax reform" is high on the President's second-term to-do list. Tax reform can mean many things. Some people think it means a national sales tax, or perhaps "flat tax" that excludes investment income. Others envision a cleanup of the existing system; these folks look to the Tax Reform Act of 1986, achieved the last time a Republican President had a second term.

The President advocated tax reform in his campaign without specifying what he meant. He promises to appoint a "blue ribbon commission" to recommend reforms, and he has called a national sales tax "an interesting idea that we ought to explore."

SALES TAX?

While not impossible, replacing the income tax with a national retail sales tax seems unlikely. It became an issue in a few elections. In South Carolina, opposition to a national sales tax allowed a Democrat to draw close in what had been expected to be an easy U.S. Senate campaign for Jim DeMint, and it may have had a role in the defeat of beer scion Pete Coors in his race for an open Senate seat from Colorado. Democrats think they can win by opposing a national sales tax, so it seems unlikely that the administration will spend its political capital trying to get the 60 votes needed to get a sales tax though the Senate.

PAST AS PROLOGUE?

The President's first term may tell us what his second term tax policies will look like. The first term has seen

- A lowering of rates.
- Increased expensing of business assets, in lieu of depreciation.
- Elimination of the estate tax, if only temporarily.
- Reduction in taxes on dividends and capital gains.
- Health Savings Accounts - a kind of super-IRA with a medical expense kicker.

AMT: FLAT TAX OF THE FUTURE?

The first term also saw a creeping expansion of the reach of the Alternative Minimum Tax (AMT), which applies a lower rate to a broader base of taxable income.

The Administration also floated proposals for "Lifetime Savings Accounts" and "Retirement Savings Accounts." These accounts would replace much of the baffling array of IRAs and retirement savings plans now in place. Generous contribution limits and withdrawal rules would enable most taxpayers to transfer all of their savings to these tax-sheltered vehicles.

Each of these items nudge the tax law in the direction of the "Hall-Rabushka" flat tax. If the Alternative Minimum Tax is simply adopted as a replacement to the regular income tax, and the LSA and RSA systems are adopted, the tax code looks very different:

- Single taxpayers with income below $40,250 and joint filers with income up to $58,000 are exempt from tax, sheltered by the AMT exemption. This alone could provide powerful political momentum for such a plan.
- Most interest, dividend, and capital gain income is tax-free, sheltered in LSAs or RSAs.
- If the Section 179 maximum of $100,000 is continued, most small businesses will be able to fully deduct their capital expenditures.

The result is not a "pure" flat tax; in a "real" flat tax, all capital expenditures are fully deductible, all interest, dividend and capital gain income is tax-free, and no deduction is allowed for interest expense. Yet, while perhaps not satisfying to flat-tax theorists, a system based on the current AMT, combined with the LSA and RSA provisions, begins to look a lot like the flat tax. By eliminating complexity and providing a generous exemption, it even could be a huge improvement over today's system.

Such an incremental approach seems likely; after all, it would continue the approach that won re-election. A pure sales tax or flat tax would probably founder in the face of united opposition from those who benefit from many aspects of the existing tax code. Incremental changes could move the tax law much of the way towards a consumption tax without threatening popular tax breaks, like as the home-mortgage interest deduction and the charitable deduction.

There are political and practical obstacles to tax simplification, but it is needed. Even those of us who make a living off of tax complexity find ourselves facing an embarrassment of riches.

UPDATES:

PRESIDENT TALKS SECOND-TERM TAX POLICY

SMART KIDS PONDER PRESIDENT'S TAX WORDS

      Bookmark: del.icio.us • Digg • reddit