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October 20, 2005

It looks as though the Presiden'ts tax reform panel will report two different tax-reform plans - a "simplified income tax system" and a "hybrid consumption based tax." We'll look here at "plan A," the simplified income tax.

The main features of this plan include:

- Four rates: 15%, 25%, 30% and 33%.

- No alternative minimum tax.

- Health insurance tax-free benefits cappied at $11,500 for families
and $5,000 for single filers.

- a 15% credit for home mortgage interest would replace the current deduction. The credit would be limited, with caps on the size of the loan varying among regious; the limits would range from $172,000 to $312,000.

- The state and local tax deduction would disappear.

- The exclusion for gain on home sales would be raised to $600,000, from $500,000 for couples.

- IRAs, HSAs, 401(k)s, 403(b)s, 529 college savings plans and MSAs would all be replaced by three tax-preferred plan types: "Save at Work" accounts, "Save for Retirement" accounts, and "Save for Family" accounts.

- Capital gains would be 75% excluded from income

- Dividends would not be taxed

- The top corporate rate would be reduced to 32%, from the current 35%.

- It eliminates the tax-free status of most fringe benefits (eg., child care, life insurance).

The positive aspects of the plan:

- Elimination of AMT

- It addresses the home mortgage deduction.

- It eliminates double taxation of corporate income.

- It pares back the maze of tax-favored savings vehicles.

- It addresses the rat's nest of tax-free fringes.

These positives fail to overcome the plan's shortcomings:

- The base is not broadened enough to significantly reduce rates.

- By favoring capital gains, it retains the complex distinction between ordinary income and capital gains, requiring a higher overall rate.

- The cap on home-mortgage interest is complex and confusing.

- By retaining multiple rates between corporations and individuals, it encourages taxpayers to manipulate income between themselves and controlled corporations.

- As far as I can tell, it doesn't address many of the time-wasting tax preferences and loophole closers that make computation of business income so difficult. This would include the execrable Section 199 "production deduction," depreciation issues, Section 263A, various inventory methods, the fire-into-the-crowd deferred compensation rules of Sec. 409A -- and we won't even talk about Subchapter K, the partnership tax laws.

Without a significant rate reduction to reward taxpayers for the loss of their targeted tax breaks, it's hard to see how this plan can advance. For all of their hard work, it seems like the best the commission can hope is that their ideas nudge the tax reform debate along for future Congresses.

In other commentary, Prof. Maule gives the panel an "F": "...and I wish there were an F- grade."

Other Links:

New York Times summary of proposals
Tax Update prior coverage

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