National Tax Reform Panel Listens to Options, Obstacles

By David Hansen, CCH Washington Staff Writer

President George W. Bush's Advisory Panel on Federal Tax Reform has begun holding hearings to get the perspectives of economic experts on tax reform. After the meetings, Chairman and former Sen. Connie Mack (R-Fla.) said the panel would be setting up subcommittees to review specific proposals.

The first round of hearings, held May 11 and 12, 2005, discussed the various options for change that are available to reformers. A follow-up hearing, on May 17, highlighted the drawbacks to the choices before the panel.

Options for Reform

Value-Added Tax (VAT) -- Hoover Institution Senior Fellow Charles McClure proposed a credit method value-added tax (VAT) levied on the sale of a product, minus the tax paid by a prior seller. For example, a 10 percent VAT on $300 of wheat sold by a farmer to a miller would generate $30 in taxes. If the miller sold the wheat for $700, the tax would be $70 minus $30, he explained. McClure favored exemptions for basic purchases or purchases by nonprofit organizations. Exports would also enter international trade free of tax, he added.

Yale Law School Professor Michael Graetz suggested repealing the regular income tax instead of the alternative minimum tax (AMT) and increasing the AMT exemption to $50,000 for singles and $100,000 for couples. The AMT rate could be a flat 25 percent, he added. To replace lost tax revenue, he proposed a VAT of 10 to 14 percent, which would be exempted for businesses with gross receipts below $100,000. This amounts to almost 80 percent of small businesses, he explained.

To ensure the system wasn't too regressive, he proposed a refundable payroll tax offset to replace the earned income tax credit (EITC). Graetz also suggested a 25 percent corporate tax rate. These changes would reduce the number of tax returns from 133.5 million to 35.5 million, he stated.

Retail Sales Tax -- Americans for Fair Taxation Executive Director Thomas A. Wright asked the panel to back the Fair Tax Plan. It would tax all new goods and services at $0.23 of every $1.00 spent. This would replace federal income, estate, and payroll taxes with a progressive, national retail sales tax system administered through existing state sales tax operations. "Prebates" would be issued to every family, ensuring no taxpayer paid any federal tax up to a poverty level.

Wright said the system would tax imports and domestic goods equally at the retail level. It also would attract investment with a zero percent tax on capital. The system would also attract the repatriation of offshore profits, and encourage savings, invest and growth.

Argus Group Partner David R. Burton proposed the Broad Simplification Tax Plan (BEST). It would replace personal and business income taxes, along with estate and gift taxes, with an 8.4 percent tax on sales and business transfers. Lower income taxpayers would be insulated from the new system with a rebate paid in advance of the sales tax they paid. Another rebate would apply to all taxpayers for the sales tax paid on essential goods and services. The federal government would levy the sales tax on goods and services purchased for the first time, explained Burton, while the business transfer tax would tax gross receipts from the sale of goods and services. Businesses could deduct the cost of purchasing goods and services from other businesses; and exclude gross receipts from export sales.

The BEST tax plan would be extremely pro-growth, commented Burton. It would promote labor, savings, and investment. In addition, it would increase gross domestic product and wages by 10 to 15 percent within the first decade.

Flat Tax -- Hoover Institution Senior Fellow Robert Hall asked panelists to consider two flat tax systems. The first would set a 19 percent tax on earnings above an exemption level, such as $41,000 for a family of four. Families would not pay tax on interest, dividends or capital gains. They could deduct $7,000 per dependent as well. Businesses would pay a 19 percent tax on income. They could deduct the purchase of materials, goods and services, wages, salaries, or pensions paid, and purchases of capital equipment, land, and structures. The plan would result in a simple, one-page tax form for both individuals and companies, he stated.

In the alternative, he proposed an "X Tax" on the same principles, but with a 12 percent bracket and a 25 percent bracket for incomes starting at $60,000. The business tax rate would be the same as the highest personal tax rate. Hall would use revenues from the higher tax bracket to reduce the tax burden of middle-income families.

Free Enterprise Fund President Stephen Moore suggested a "Freedom to Choose" flat tax that allowed every worker and business the chance to opt into a 20 percent flat tax. They could not switch back once a choice was made, he stated.

FreedomWorks Co-Chairman Richard Armey, a former House Majority Leader, promoted the principle of a flat tax without proposing a specific system. A flat tax would scrap the entire IRC, and eliminate all deductions and credits. There would only be a personal exemption so families could cover their expenses before paying their taxes, he said. All income--business and personal--would be taxed once at one rate. A flat tax would be so simple that taxpayers could complete their taxes on a postcard, remarked Armey. It would treat all taxpayers fairly and would eliminate the need for special interest lobbyists by eliminating deductions. In addition, a flat tax would not discourage savings and would treat all economic activity equally. Armey did not believe charitable donations would decrease after taking away their deduction, postulating that giving is tied to income growth.

Forbes, Inc. President and CEO Steve Forbes told the panel that the current federal tax code is more than nine million words in length, while the Bible is only 773,000. It should be replaced with a flat tax of 17 percent with exemptions for a family of four on the first $46,165 of income. There would be no tax on Social Security benefits, personal savings, capital gains, and estates. Taxpayers could opt for this new tax system or choose to stay with the IRC, he suggested.

Return-Free Tax System -- Finally, three panelists discussed moving to a return-free tax system, either by withholding the exact amount of tax due or allowing a tax agency to compute tax liability.

Urban Institute Senior Fellow Eric J. Toder expressed his belief that return-free systems work only for simple returns with low compliance costs. Enacting an exact withholding system would require major tax simplification and administrative changes. Allowing tax agencies to calculate liability is more practical, but making the IRS determine what you owe would involve additional costs. A return-free system may not even be cost-effective because of so many tax preparers and software programs, and are not a substitute for tax simplification.

Stanford University Professor Joseph Bankman spoke favorably about a California no-return initiative called ReadyReturn. The state sent income data and tentative tax liability to 50,000 taxpayers in 2004. Taxpayers could challenge the data, file a traditional return, or file based on the government's information. The program was a huge success, he told the panel, with 99 percent of participating taxpayers willing to use the system again.

But Americans for Tax Reform President Grover Norquist opposed a return-free system. It would place the onus of challenging tax liability on the citizen, not the government, and would create a conflict of interest by making the same agency the tax collector and tax preparer. The hidden agenda of return-free systems is to raise more revenue and hide tax hikes, he stated.

Reform Existing Code -- Some experts advocated reforming the existing IRC instead of replacing it with a new design. Center for American Progress President and CEO John Podesta outlined a proposal that would raise an additional $500 billion during the next ten years for deficit reduction. It would reduce tax brackets to 15, 25, and 39.6 percent, and eliminate the alternative minimum tax. It also would tax dividends and interest at the same rate as income. The estate tax exemption would be set at $2.5 million, which he stated would eliminate the tax on almost all small businesses, farmers, and ranchers.

Podesta also would eliminate employee Social Security taxes and eliminate the cap on the income limit for employer payroll taxes. He would dedicate general revenues of 2.25 percent of gross domestic product to the Social Security trust fund. Podesta favors encouraging long-term saving for those earning less than $1 million by exempting 10 percent of capital gains on assets held greater than one year. The exemption would rise by ten percentage points each year. The proposal would create a tax system that is fair and simple while stimulating the economy, concluded Podesta.

Progressive Policy Institute Senior Fellow Paul Weinstein, Jr., suggested consolidating certain tax breaks into four "super incentives." He proposed replacing five education tax breaks with a $3,000 refundable tax credit for four years of college and two years of graduate school. It would go to students attending more than half-time and willing to commit to two summers of service. He also proposed making the home mortgage deduction available to non-itemizers.

Weinstein also would combine the earned income tax credit, child tax credit, and child and dependent care credit into one tax break equal to $3,500 for one child, $5,200 for two, and $7,000 for three. This would eliminate 200 pages of tax code, he stated. Finally, he would create a "universal pension" in place of six currently existing IRA-type accounts with a $3,000 contribution limit. Every taxpayer would receive a $500 stake. A refundable tax credit would go to low income workers for their contributions, and 401(k) plans would be automatically transferred when workers changed jobs. Weinstein claimed this would generate $436 billion in tax relief and combine 69 existing tax provisions into four.

Cato Institute Director of Tax Policy Chris Edwards proposed moving toward a flat, neutral consumption tax by setting individual income tax rates at 15 and 27 percent, while establishing a corporate tax rate at 15 percent. The top rate would begin at $90,000 for single filers and $180,000 for married couples.

Edwards would eliminate itemized deductions, including charitable contributions and mortgage interest. He also would set the top tax rate for dividends, interest, and capital gains at 15 percent. Corporations could deduct interest payments, health care costs, and state and local taxes, he added. Finally, Edwards would retain 401(k) plans, IRAs and health savings accounts.

Center for Strategic Tax Reform Executive Director Ernest S. Christian advocated a "Universal Savings Account" which would allow after-tax deposits to accumulate tax-free. Taxpayers could withdraw funds without penalty for any reason, he added. To help offset this, he proposed a 10 percent fee for transferring an existing account into the new universal ones. Eliminating the double tax on savings and investment is the core component of all tax reform proposals, he added. Christian also favored staying within the current tax code instead of rewriting it. "Why go searching for some new magic elixir that may have unknown results?" he asked.

Former American Business Conference President Barry K. Rogstad advocated a Simplified Unlimited Savings Allowance Tax (SUSAT). Businesses would pay an eight percent tax on the first $150,000 of a tax base and 12 percent in excess of that. The tax base would be defined as revenues from domestic operations, minus purchases of equipment and services, minus export income, minus inventory purchases. There would be no deductions for wages/salaries, dividends or interest.

Individuals would then have a 15, 25 or 30 percent tax levied on their tax base, which would be wages, plus interest, plus dividends, plus the sale of stock or other assets, minus deductions. Allowable deductions would be for 401(k) contributions, home mortgage interest, charitable contributions and expenses for secondary education.

University of Southern California Professor Edward J. McCaffery suggested placing all savings accounts on a traditional IRA model and removing all limits on contributions and withdrawals. Once that is done, he would repeal capital gains preferences, gift and estate taxes, and corporate income taxes.

Obstacles to Reform

Harvard Professor Martin Feldstein, former Chairman of the Council of Economic Advisors for President Ronald Reagan, told the panel that reducing marginal tax rates and corporate income tax distortions are the top priorities for tax reform. Current marginal rates distort individual incentives, he explained, and the current corporate rate taxes dividends twice and promotes debt financing. He suggested enacting a value added tax (VAT), flat tax, or consumed income tax. But these would be hard to implement and cause major transition problems, he cautioned.

As an alternative, Feldstein proposed two intermediate steps: taxing husbands and wives separately, and integrating corporate and personal income tax rates. Separate taxation would lower marginal rates on the spouse with a lower income, he commented. Integrating corporate and individual rates could be done by imputing to taxpayers their share of corporate earnings. If a taxpayer had a lower rate than the corporation, they would get a refund. This integration would lower the tax rate on equity investment and savings, while reducing the debt financing and anti-dividend biases of current law.

Feldstein opposed a "dual system" where an income tax coexists with a consumption tax or VAT. It complicates an already complex code, he explained. A VAT has fewer transition problems than a consumption tax, which raises questions about whether individuals should be taxed on the money they've already consumed and a deduction for what they've saved. However, it would be easy to allow taxation of income to creep back with a VAT by keeping some tax deductions.

Next, four former Assistant Treasury Secretaries for Tax Policy gave their views on the policy impact of tax reform. Ernst & Young Vice Chairman Mark A. Weinberger outlined several lessons the panel should follow. They should propose bold changes for the tax code, he said. "If no one criticizes what you do, you weren't bold enough," he explained. The panel should also rule out certain reforms when making their recommendations, to limit any debate to a narrow set of options.

The panel should also realize that a perfect tax system is unattainable, and prioritize objectives because no tax plan can accomplish everything. Setting priorities means making tough choices, he continued, and the top priority of the tax system should be to establish a simple method for raising government revenue. Finally, the panel should realize that a revenue-neutral tax reform plan will still create winners and losers.

Despite favoring a bold approach, Weinberger opposed replacing income taxes with a single consumption tax. The rate would need to be close to 30 percent and would be vulnerable to many kinds of evasion. No industrial country has enacted such a system, he added.

Partner at Capitol Tax Partners Jon Talisman named several sources of complexity in the tax code: the taxation of business income, capital gains, different tax rates, and uncertainly from the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003. Talisman also downplayed the VAT as a panacea for tax woes. For example, Great Britain's VAT is very complex and lacks transparency, he said. Talisman recommended simplifying the current tax system rather than implementing a consumption tax.

Cleary, Gottlieb, Steen & Hamilton Partner Leslie B. Samuels also recommended a piecemeal approach to tax reform. The current tax code is imperfect, but reflects the priorities expressed through the political process, he explained. A new tax system would be the result of the same process, he said. The panel should not make judgments and recommendations on theoretical tax models that will not be adopted, he added.

Samuels specifically rejected a consumption tax. No industrial country has replaced all taxes with a consumption tax, so there would be no real-world experience to follow. Taxing the financial services sector is something no one knows how to do effectively, he added. He also opposed enacting a dual system of an income tax with a VAT because it would establish two tax systems. Reforming the current tax system is the best proposal, he concluded.

Skadden, Arps Partner Pamela F. Olson cautioned against piecemeal reform of international taxation because reformers may enact a system that doesn't consider the overall effect of individual reforms. For example, a tax system that expanded business expensing but left the deduction for interest alone would reduce the business tax base. Olson also hoped the panel would recommend a broad number of reforms that included revenue-raising options. The long-term fiscal outlook of the federal government is not good, she added, and a list of different reforms could be implemented as more revenue is needed.

Olson criticized moving to a consumption tax to replace all revenue sources, partly because it would increase the tax collection burden on small businesses. She recommended using the revenue from a VAT to significantly reduce tax rates, increase exemptions, and cut the corporate tax rate.

Panelists Reflect on Testimony

After the meeting, panel Co-Chairman and former Sen. John Breaux (D-La.) found the views of the former Treasury officials particularly helpful. They seem to favor reforms within the current tax system, whether bold or not. They also support a VAT instead of a consumption tax, he added. Making a consumption tax progressive would be especially difficult, he remarked.

A return-free tax system could work for lower-income taxpayers and is worth considering, Breaux added. However, panel Chairman and former Sen. Connie Mack (R-Fla.) did not consider it a high priority among panelists and should probably be an experiment at the state level.

The panel will probably hold additional public meetings, said Mack, though none are planned at this time. The panel is breaking into subcommittees to review specific tax reform proposals. The work will continue through May and June, he added.

After the meeting, the panel invited public comment on specific tax proposals. Comments will be accepted until June 10, 2005 and should be limited to five pages. More information is available at www.taxreformpanel.gov/contact/.

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Posted May 23, 2005.