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TAX REFORM TRIAL BALLOONS

November 21, 2004

The Administration floated some tax reform trial balloons last week via the Washington Post and the Wall Street Journal. Second-term Tax Reform looks like it may be largely based on the President's first term policies and proposals, as we discussed recently. Still, the trial balloons have surprises.

The Washington Post story says

   ...the administration plans to push 
   major amendments that would shield 
   interest, dividends and capitals gains 
   from taxation, expand tax breaks for 
   business investment and take other 
   steps intended to simplify the system 
   and encourage economic growth, according
   to several people who are advising the 
   White House or are familiar with the 
   deliberations.

These sound like the first-term proposal for Lifetime Savings Accounts and Retirement Savings Accounts, which would enable most taxpayers to do all of their savings on a tax-free basis. It also sounds like the administration may move towards more generous fixed asset depreciation and expensing rules.

The Post says reform would eliminate the Alternative Minimum Tax (AMT) by adding one of its most important features to the regular tax. The AMT applies when it exceeds regular tax. State and local taxes aren't deductible for AMT. The lack of the state and local tax deduction is the most important cause of AMT for taxpayers in states with high income taxes.

Perhaps the biggest surprise in the Post article is the idea of eliminating the exclusion for employer-paid health insurance. While this is a big change, it is a logical extension of the philosphy behind Health Savings Accounts (HSAs). HSAs allow taxpayers with high-deductible health plans to make deductible contributions to the IRA-like HSAs; withdrawals used for health care costs are tax-free. The idea is to put make consumers more careful about incurring health costs because of the high deductibles. Eliminating the tax-free benefit is of a piece with this approach.

NO DEDUCTION FOR BUSINESS INTEREST?

By the time the administration is done with its individual planning, individuals might be almost entirely exempt from taxes on interest and dividends. The Wall Street Journal speculates that this might be paired with an elimination for the deduction of business interest expense:

   Mr. Bush has proposed new savings tax  
   breaks, essentially seeking accounts in
   which Americans could avoid taxes on 
   interest, dividends and capital gains. 
   By eliminating the tax  paid by 
   bondholders, CBIT would do much the same
   thing more broadly. Leveraged companies 
   would yelp, but that might just help 
   sell tax  reform.

All of these would push the tax system by degrees closer to a Hall-Rabushka flat tax, in which interest and dividends are tax-free, but not deductible to the payors. This approach appears to be what the administration has in mind, based on this passage from the Post article:

   Pamela F. Olson, a former Bush Treasury
   official in close contact with 
   administration tax planners, said the 
   president will pursue a tax system 
   where all income -- whether from wages, 
   dividends, capital gains or interest -- 
   is taxed only once. That would mean 
   eliminating taxes on dividends and 
   capital gains paid out of fully taxed 
   corporate profits. Most investment gains
   are currently taxed at 15 percent.

Will any of this pass? Some are sceptical that the administration will be able to pull off both social security reform and tax reform. We think there is a good chance of significant tax reform. When the President sets his mind to something, he keeps at it until gets his way. Just ask Saddam Hussein.

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