Opportunity 08: Independent Ideas for America's Next President

Chapter 23: Fixing the Tax System: Support Fairer, Simpler, and More Adequate Taxation

SUMMARY A good tax system raises the revenues needed to finance government spending in a manner that is as simple, equitable, stable, and conducive to economic growth as possible. But the challenge for the next president will be to make reform work not just in the abstract, but in the real world, where special interests often rule the roost. The next president should support reforms that would tax all income once (only) at the full tax rate, simplify and streamline the tax code, and, of course, raise sufficient revenues. To achieve these goals, the package of specific reforms proposed in this paper would —tax all new corporate investment income only once; —remove all corporate subsidies in the tax code and strengthen corporate anti-sheltering provisions; —integrate payroll and income taxes for individuals; —introduce return-free filing for many taxpayers; —consolidate and streamline tax subsidies for education, retirement, and families; —eliminate or revise various tax deductions; —create a value-added tax that would, eventually, raise 5 percent of the gross domestic product (GDP) in revenues. 331 Fixing the Tax System Support Fairer, Simpler, and More Adequate Taxation WILLIAM G. GALE 23 332 WILLIAM G. GALE CONTEXT In the next few years, several factors will push tax issues to the forefront of policy discussions. First, under current law, almost all of the Bush administration’s tax cuts will expire at the end of 2010. The loss in revenues from making the tax cuts permanent would be enormous— equal to several times the resources needed to repair Social Security—and economic growth would be unlikely to come anywhere close to covering that loss. As a result, the required spending reductions would be enormous, too. For example, if certain key programs—Social Security, Medicare, Medicaid, defense, homeland security, and net interest—were off-limits, all other federal spending would have to be cut by almost half to pay for permanent tax cuts. A second factor is the rapid growth in the Alternative Minimum Tax (AMT), which will increase the inequity and complexity of the tax system . Tax filers pay the AMT when their AMT liability exceeds their regular income tax liability. Designed in the late 1960s and strengthened in 1986, the AMT operates parallel to the regular tax system and was originally intended to capture tax on excessive sheltering activity. The tax has evolved, however, so that it does not tax many shelters but does tax a variety of other things—like having children, being married, or paying state taxes—that most people do not consider shelters. Moreover, the number of taxpayers facing the AMT is slated to grow exponentially, from about 3 million today to 30 million by 2010, because the AMT is not indexed for inflation and because some temporary AMT tax cuts are about to expire. A third issue—which may not require immediate action but should nevertheless help frame the current debate—is the expected increase in government spending over the next several decades. Since 1950, tax revenues have hovered between 16 and 20 percent of GDP. Under current projections, however, government spending is projected to rise to about 27 percent of GDP by 2030. The increase will be fueled mainly by increased entitlement spending for Social Security and especially Medicare and Medicaid. Unless candidates are willing to suggest truly massive cuts in such programs, they will have to come to terms with the need for an increase in revenues to above 20 percent of GDP. Despite these pressures on the system, tax changes are not inevitable, and achieving meaningful reform—that is, with substantial design improvements—will require strong political leadership. Fixing the Tax System 333 WHY JUNKING THE INCOME TAX IS NOT THE ANSWER Discarding the nation’s existing Byzantine tax system and instituting “simple” flat-rate taxes has visceral appeal, and some candidates have endorsed reform proposals based on this approach. However, when realworld implementation issues are considered, each of these proposals has significant drawbacks. The three primary flat-rate reforms are the following: —A national retail sales tax (NRST), under which a single tax rate would apply to all sales by businesses to households. Sales between businesses and between households would be untaxed. —A value-added tax (VAT), requiring each business to pay tax on the sum of its total sales to consumers and to other businesses, less its purchases from other businesses, including investments. Thus, the increment in value of a product at...