WHY TAX REFORM IS SO URGENT AND SO UNLIKELY
THE art of taxation," observed Jean Baptiste Colbert, France's controller general of finance under Louis XIV, "consists in so plucking the goose as to obtain the largest amount of feathers with the least amount of hissing." Three centuries after Colbert's cynical appraisal, the contemporary American taxpayer feels thoroughly plucked--and he is hissing louder than ever. Now the ides of April are approaching--the deadline for filing is the 15th of this month--and the resentment of taxpayers points increasingly toward a ballot-box revolt. In a spontaneous outpouring of popular indignation, citizens by the thousands have deluged Washington with complaints about rising taxes. With much justice, they insist that the whole U.S. tax structure is inequitable, capricious and economically damaging.
Clearly, the system cries out for reform. It not only distributes the load unfairly, but also has unintended economic and social side effects, ranging from the ridiculous to the calamitous. Ever since federal income tax rates soared during World War II, the opportunity to grow wealthy through hard work has been largely denied to salaried people. Instead, the road to riches twists through the thickets of tax avoidance. As a result, an inordinate number of man hours are spent in figuring out ways to outwit the collector. Because of its sheer intricacy, the tax code is one law that many Americans cannot even obey unaided. Providing such aid has created a flourishing literature of tax-tipstering and a thriving industry for lawyers and accountants, who pocket substantial fees.
In a modern industrial country, taxes--and the desire to elude them--exert an increasing control over the affairs of individuals, institutions and corporations. They influence a person in how he chooses to invest his savings (municipal bonds, cattle ranches and oil wells are among the most favorable for tax purposes). They determine many a young couple's choice of a wedding date (better at the end of one year than the beginning of the next one). They affect a family's choice of where to live and whether to rent or buy a home. Any high-salaried executive forfeits a substantial tax saving today if he does not own a house, entitling him to claim tax deductions for both mortgage interest payments and realty taxes.
For businessmen, high rates distort decisions about how to invest, how to organize a company, how to reward employees. Companies in need of capital get a richer federal tax break when they issue bonds instead of stocks; they can deduct the interest on bonds from their taxable income, but dividends on stocks must be paid out of after-tax profits. This fact has stimulated the growth of conglomerate mergers, which the Government is now vigorously attacking (see following story). It is fairly cheap and easy for one company to finance the takeover of another by issuing interest-bearing securities of dubious value--the kind of paper that Wall Streeters warily refer to as "Chinese money."
At the extreme, mindless tax policies thwart important national goals. Although the U.S. must expand its exports to end the balance of payments deficit, high corporate income taxes (the 52.8% rate is one of the stiffest among industrial countries) add to the price disadvantage that many U.S. products suffer abroad. The impact of taxes also helps to perpetuate social ills that the nation is struggling to overcome--poverty, slums and land misuse. As presently applied, property taxes promote urban decay and penalize improvements while simultaneously encouraging land speculation and the wasteful disorder known as urban sprawl. In sum, today's taxes tend to broaden the gulf between rich and poor, landlord and tenant, worker and entrepreneur.
What upsets Americans most is the feeling that they are being cheated. Their anger has only been sharpened by the prospect that Congress will extend last year's 10% income tax surcharge, as President Nixon requested last week. The vast majority of middle-class Americans have only limited ways to avoid paying federal taxes at full rates. Including the surtax, these now range from 15.4% to 77%. But thousands of extremely wealthy citizens exploit myriad loopholes in the laws and contribute little or nothing. In 1967, according to the U.S. Treasury, 21 millionaires paid no federal taxes at all; about 155 Americans with incomes above $200,000 also paid nothing. They simply took advantage of the law's countless anomalies, exceptions and special privileges. On the other hand, families below the poverty line ($3,535 a year for a family of four) pay more in federal income taxes than the Government puts into the OEO budget.
The trouble begins--but by no means ends--with federal income taxes, which account for nearly two-thirds of the nation's $247 billion tax bill. Taxpayers seem at least equally disgruntled over state and local taxes, which are rising much faster than federal levies. Last fall, voters showed their ire by turning down 55% of local bond issues, double the rate at which such borrowing has been rejected in recent years. Youngstown, Ohio, for example, was forced to close its public schools for a month because voters defeated tax increases six times.
Resistance takes many forms. Pollster Louis Harris finds an increasing unwillingness among U.S. citizens to pay higher taxes even for programs that they approve, such as greater social security coverage, the war on poverty, urban aid. Massachusetts citizens have inundated state legislators with used tea bags, symbolic of 1773's Boston Tea Party. The fad has spread from "Taxachusetts," as economy-minded citizens sneeringly call their Bay State, to Connecticut, which is considering its first personal income tax, and on to New York, which last week voted an increase from 2% to 3% in its sales tax, creating a 6% tax in New York City. In mid-March the Arkansas legislature trampled Governor Winthrop Rockefeller's $100 million package of increases meant to help schools, cities and welfare recipients. Despite such cautionary signals, the Governors of 38 states this year have asked for tax increases that add up to a record $4.9 billion.
Even though Americans surrender less of their income to the tax collector than do the citizens of many other industrial countries, their total tax burden has reached the highest point in U.S. history. Federal, state and local taxes now absorb nearly 30% of the gross national product, compared with 11% in 1929, 16% in 1935 and 25% in 1945 (despite World War II). At last count, Sweden's tax load was 41% of the G.N.P., France's 39%, Germany's 35%. British Historian C. Northcote Parkinson argues that taxes at such levels presage serious trouble. "At 35%, there is a visible decline in freedom and stability," he wrote. "At 36%, there is disaster, complete and final though not always immediate."
Shortly before leaving office, Joseph W. Barr, who was Lyndon Johnson's last Secretary of the Treasury, warned Congress: "We now face the possibility of a taxpayer revolt if we do not soon make major reforms in our income taxes. The revolt will come not from the poor but from the tens of millions of middle-class families and individuals with incomes of $7,000 to $20,000, who pay over half of our individual income taxes. Public confidence in our income tax system is threatened." Though Barr may have been exaggerating for effect, his pronouncement struck a sore public nerve. Letters condemning the tax system poured upon Congressmen. Tax reform, so long sought in vain by a small coterie of legislators, seemed at last to be an idea whose time had come. Opportunely, the Johnson Administration's Treasury Department about then bequeathed Congress a lengthy list of proposals to narrow the tax avoidance routes and make the rules fairer for everyone. The handiwork of Assistant Secretary Stanley Surrey, the package calls for the most thorough overhaul of U.S. tax laws in years. Arkansas Democrat Wilbur Mills, the cautious chairman of the tax-writing House Ways and Means Committee, has been holding hearings on these and other proposals.
Mills, who has characterized the U.S. Tax Code as a "house of horrors," was at first encouraged by firm indications that the Nixon Administration considered tax reform among its top domestic priorities. Last month, however, Nixon's Treasury aides scaled down their immediate aims to a few bits of loophole closing. Reform is important, they agreed, but a subject so complex needs much more study--perhaps until 1971.
Capital Gains and Oil Depletion
Mills knows only too well-that tax reform offends so many vested interests that usually only the U.S. President can summon enough public support to ram it through. But now Mills is not so sure that he needs President Nixon's backing. The voters' support for substantial revision, he says, is broader and stronger now than ever before in his memory. Even within the Senate, traditionally softer on tax reform than the House, the mood is changed. "They're getting reaction from home the same way we do," says Mills. This time, he may decide to act on his own to plug the loopholes, whether or not he can expect help from the White House.
His job will not be easy. Tax exemptions and exclusions have seldom been repealed. Instead, in the past 50 years, Congress has opened myriad new tax shelters to accommodate taxpayers who feel aggrieved by somebody else's privilege. An unfortunate result is mind-numbing complexity: the present Revenue Code (1,200 pages) runs longer than War and Peace. Albert Einstein called the federal income tax "the hardest thing in the world to understand." Contemplating his own return, he remarked: "This is too difficult for a mathematician, It takes a philosopher."
Ideally, Congress should scrap the entire unwieldy tax code and start over with a law almost free of exemptions and .with rates as much as one-third lower than those now in force. "Short of a whole new law, Congress might quell much of today's uproar by closing some of the more flagrant routes to tax avoidance, which deprive Treasury of $50 billion a year in potential revenue.
Long-term capital gains, which cost as much as $8.5 billion a year, constitute the biggest loophole. Profits from stocks, bonds or other investments held for more than six months are taxed at only one-half the rate on ordinary income, and no more than 27 1/2% in any case. Defenders of capital gains have a compelling argument: people must be encouraged to take risks with capital if a private economy is to thrive. On the other hand, many experts agree with Economist Joseph Pechman of the Brookings Institution, who holds that the present ceiling is too low. To discourage speculation in securities, the holding period might be extended from six months to one year. Congress also needs to redefine and limit the scope of investments eligible for capital gains. They now include not only securities and real estate, but ordinary dealing in timber and cattle breeding as well. Oil and other depletion allowances, which by Treasury estimates deprive the Government of $1.3 billion in revenue, have become the towering symbol of privilege and preference. They can spare oil companies and investors from taxes on 27 1/2% of their revenue from operating an oil well. As long as a well produces, the depletion write-off continues, even if the original cost of exploration and drilling has been recaptured 19 times over--as typically occurs. Other treasures from the earth and seas rate lesser but equally arbitrary allowances: 23% for uranium, 15% for copper, silver and gold, 10% for coal, 5% for oysters, clams and clay for flower pots. The theory is reasonable: extraction depletes natural resources. But oilmen lately have made enormous discoveries in Alaska and elsewhere; the U.S. has enough proven oil reserves to last for 20 years.
The depletion rule has survived years of violent political attack partly because oilmen are generous contributors to the campaign war chests of both parties. Yet if the depletion allowance remains untouched, the case against other unfair tax preferences all but collapses.
The allowance is clearly excessive. It should be scaled down gradually to a much lower figure, perhaps 15%, and no developer should be allowed to write off more than he actually invests.
Bonds and Charities. Tax-free state and local bonds provide the simplest method for tax avoidance. Owners do not have to report the income from such investments on their tax returns. As a result, the Treasury loses $4.6 billion a year. And four-fifths of that amount is pocketed by the wealthiest 1% of the U.S. population, which owns 80% of all tax-free securities.
Because of the exemption, hard-pressed state and local governments are able to cut the cost of financing schools, highways, water and sewage facilities. But most economists agree that tax-free bonds are an inefficient means of accomplishing that end. For every dollar that localities save, the U.S. Treasury loses two. Still, mayors and Governors are so adamantly opposed to ending the exemption that Congress is unlikely to do so. But legislative interest is rising in a Wilbur Mills idea for making state and local bonds taxable, provided that the Government returns the tax take from them directly to the states. This would close the loophole by which a few wealthy Americans escape taxes entirely. More important, it would do so without raising the net cost of state borrowing or depriving the Treasury of revenue.
Then there is the matter of charitable contributions. Worthy though they may be, they cost the Treasury at least $21 billion a year. For taxpayers who plan properly, the law can reward the giver as much as the receiver. If a donor gives a block of stock or other property that has risen in value from, say, $100,000 to $1,000,000 while he owned it, he can deduct the full $1,000,000 from his other taxable income. But he escapes tax on the entire capital gain. Thus, for an actual cost of $59,500, he gets credit for a $1,000,000 gift to charity.
Ordinary taxpayers may deduct only 30% of their income for charity, but a lucky few can enjoy prodigious tax savings ($20 million in one famous case) by earning the right to unlimited charitable deductions. For a taxpayer to qualify, his donations plus his federal taxes must equal 90% of his taxable income for eight years out of ten. Because of this provision, John D. Rockefeller III, board chairman of Manhattan's Lincoln Center for the Performing Arts, has owed no federal income tax for years. (He has voluntarily paid some anyway.) The unlimited charitable deduction affects only a handful of taxpayers and costs the Government comparatively little in lost revenue. The right to escape taxes by donating appreciated assets seems more open to question.
The deductibility of charitable contributions has led to an astounding proliferation of nonprofit foundations. The Internal Revenue Service recently counted 30,262, and new ones are springing up at the rate of 2,000 a year. Many of the smaller foundations appear to be blatant tax dodges, aimed at enriching their founders through cozy loans and property deals. One donor claimed a tax deduction for giving a foundation $65,000, although the money was immediately lent back to him. Such inside deals are immensely unpopular in Congress, which will probably move to place new controls on foundations this year. Texas Congressman Wright Patman, a tough critic of foundations, is demanding that they pay a 20% tax on their investment income.
Quite a few churches use their tax-exempt status to prosper in commercial enterprises, where they have a considerable advantage over tax-paying competitors. The Cathedral of Tomorrow, for example, a 2,200-member Protestant church in Akron, has bought a shopping center, an electronics company, a plastics and wire plant, as well as the Real Form Girdle Co. of Brooklyn. The church is paying for the companies on the installment plan out of untaxed profits over a period of 12 to 15 years. Meanwhile, the former owners continue to run the firms. Such "bootstrap sales" enable owners to get a higher price for their companies than they could obtain from a tax-paying buyer. Many churchmen condemn the practice as unjust, but both the Supreme Court and Congress have so far refused to upset it.
Many city folk have taken up farming as a neatly sheltered sideline. Farm losses can be used to offset other income, and such losses are comparatively easy to show for tax purposes because the law allows loose bookkeeping practices on the theory that farmers have more important chores. A growing herd of agricultural management companies today helps executives, sportsmen, movie stars and other well-to-do citizens round up tax savings from investments in cattle, orchards and nut groves. Full-time farmers correctly complain that the arrangement has helped to drive up the price of farm land (as have agricultural subsidies). In 1965, California farmers claimed a net loss of $6,000,000 for tax purposes, even though Agriculture Department figures showed that the state had a net farm income of $812 million. The loophole should at least be narrowed, perhaps by placing a $15,000-a-year ceiling on farm losses that can be deducted from other income.
Real estate owners enjoy a triple tax break. Like other borrowers, they can deduct the interest paid on their loans. They may also deduct all the operating costs of a building from rental income. Finally, they may opt for "double depreciation"--they can deduct for the deterioration of their property at twice the rate at which the law presumes it will really wear out. That fast write-off proviso enables landlords to pocket a tax-free flow of cash while showing a bookkeeping "loss" for tax purposes. Double depreciation usually provides such a windfall for about seven or eight years. After that, the amount that can be deducted declines to no more than what can be written off under ordinary, "straight-line" depreciation. At that point, landlords often sell their property and pocket profits, mostly at the capital-gains rate, letting a new owner begin the write-off routine all over again.
The manner in which real estate is taxed at the local level helps to despoil the urban environment. It is questionable whether much more money should be squeezed out of property, but realty taxes are misapplied and maladministered almost everywhere. The local property tax is actually a confusing combination of two taxes--one on land, the other on structures. While land is undertaxed, structures are overtaxed. Overtaxation of buildings gives slum landlords an incentive to not improve their property, because that would only bring higher assessments and taxes.
Meanwhile, the undertaxation of land helps speculators hold property out of use while they wait for a city's growth to raise its price. As buildings leapfrog around the holdouts, other taxpayers generally have to foot the bill for the costly roads, water and sewer lines that make land richly salable. In addition to encouraging the growth of "slurbs"-half-city, half-country belts with the worst features of both -- the process has driven up costs of homesites by 68% in the past eight years, forcing many families out of the market. "Today's property tax," says Robert Hutchins, president of the Center for the Study of Democratic Institutions, "promotes almost every unsound public policy imaginable."
The solution lies in raising land taxes. Southfield, Mich., has just demonstrated that the idea works. Five years ago, the city was listed as a depressed area. Then it boosted the tax on land and cut the tax on buildings by reassessing them. In the resulting building spurt, Southfield has been constructing office space faster than neighboring Detroit, a city 30 times its size. Said Assessor G. Ted Gwartney: "All we had to do was throw off the shackles."
Transforming today's tax morass into a system with less capacity for social damage will require strenuous effort.
Given the ignorance and inertia of many state and local legislative bodies, the un happy fact is that few cities are likely to copy the Southfield formula. Chances for significant tax reform in Congress look only slightly better.
Disappointingly, the Nixon Administration has so far indicated only that it will back tighter restrictions on con glomerate mergers, part-time farmers and foundations. If Congress cannot agree on a basic way to correct today's inequities, it may unfortunately choose a halfway approach suggested by Stanley Surrey. He would require all earn ers to pay at least a minimum tax at rates approximately one-half of normal, thus putting a ceiling on the benefits of tax preferences. In return, no person would have to pay more than 50% of his total income in federal income taxes. Officials of the Nixon Treasury and many reform-minded Congressmen rightly fault that idea as merely papering over today's loopholes. The plan would end none of the questionable favoritism in the present law. Moreover, it would allow the rich to pay something akin to a cheap license fee for the right to go on using loopholes.
It would be much better if Congress would clear the slate, start over again and retain only a few basic deductions, probably including: 1) personal exemp tions for individuals, boosting the amount somewhat above the outdated $600 level enacted 21 years ago; 2) charitable contributions, without the appreciated-property loophole; 3) state and local sales and income taxes but not state gasoline taxes; and 4) business expenses, but with tighter controls against abuses. The current law covers a rather liberal range of activities. Last week, for example, Topless Dancer Marlene Sherman of San Francisco proudly announced that the IRS had agreed to let her deduct the $1,300 cost of a silicone operation that swelled her bustline from 34 inches to 40.
With or without White House backing, Congress should strive to redraw the tax code into something much fairer and less complicated. But serious tax reform will have to attack special interests all at once if it is to have much chance of enactment. Piecemeal efforts invite public apathy, which makes it easier for Congress to acquiesce to the demands of loophole beneficiaries. When tax-code reform is accomplished, Congress will be free to act on some new and imaginative tax ideas, such as Nixon's plan to offer special incentives for the rebuilding of ghettos and Economist Walter Heller's program for federal-state revenue sharing on a no-strings, per capita basis.
Inaction will cause a further festering of the nation's economic and social sores. It will also have a corrosive effect on morals as well as public attitudes. Indirectly, tax inequities can only increase today's growing disrespect for institutions and laws of all kinds. Thus the tax mess undermines the nation at a time when the U.S. needs the firmest kind of foundation to cope with internal strains and external pressures.
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