Why Tax Our Patience?

By Jyoti Thottam

When Washington talks taxes, the dickering usually focuses on whose payments should go up and whose should come down. But as April 15 approaches, many frustrated Americans, especially small-business owners, would be thrilled if someone just made the tax forms easier to file. As Congress weighs the impact of the controversial tax cuts proposed by President Bush, TIME's JYOTI THOTTAM asked a group of tax-policy experts to move beyond the current debate and imagine a simpler, more efficient federal tax system. Our Board of Economists--David Bradford of the Woodrow Wilson School at Princeton University and New York University School of Law, Philip Jefferson of Swarthmore College, Dan Mitchell of the Heritage Foundation, Trudi Renwick of the Fiscal Policy Institute and Max Sawicky of the Economic Policy Institute--produced a host of creative ideas and some surprising moments of consensus.

TIME: What are some of the fundamental tax reforms you would like to see?

DAVID BRADFORD: As a Treasury official in the Ford Administration, I became convinced that the way toward a simpler, more transparent system was to base the tax on consumption. The plan we developed would replace the income tax on individuals and corporations. Everything that came into the individual household was taxed, and everything that went out in the form of savings was excluded from tax, with no tax on companies. Since then I have concluded that an indirect approach, with a tax on companies and a graduated tax on individuals, would be easier to implement. The key difference between income tax and consumption tax has to do with the treatment of savings and investment. In a consumption tax, companies expense capital investment immediately. In an income tax, they depreciate it over time.

This approach yields enormous simplification of the rules related to capital gains, interest deductions and the treatment of complex financial transactions. It appalls me that all this brilliant talent is going into the design of ways of gaming our tax system.

TRUDI RENWICK: How would you deal with a mortgage-interest deduction?

BRADFORD: You shouldn't have an interest deduction in my ideal system. It would slowly go away as you move from one system to the other, if the politicians could stand the heat.

DAN MITCHELL: There are two big issues. No. 1, should you have what is called a consumption base? A consumption base is what you find in the flat tax. It is implicit in the national-sales-tax proposals. The second big issue is, do you then have one rate? Then it is a question of how to design it. I would want it to have a low rate, I would want government to be smaller, and I think bringing in less revenue is the only effective means of controlling the size of government.

TIME: And would your perfect tax system be progressive?

MITCHELL: Yes, everyone who supports single-rate tax reform also supports a generous family-based personal exemption, which creates effective progressivity without sacrificing the principle of treating all taxpayers equally. But there is a trade-off. The more income you exempt from taxes for lower-income and lower-middle-income people, the higher your rate has to be--or the more revenue you are going to take away from the government.

MAX SAWICKY: I would like to see less economic inequality than we have now. A bigger revenue system is a better revenue system if one is focused on inequality. I also admire David Bradford's work, and that's how I got into writing about the cash-flow version of the consumption tax, with a few bells and whistles that would make it aggressively progressive, such as defining bequests from estates as consumption. That leads me to the idea of a lifetime income tax, which simply taxes all income once when consumed and finally when it is transferred, at death or through gifts. And I agree with Dan that the tax should be territorial. What that means is, there would be a rebate of taxes on exports and full tax on imports.

RENWICK: There can be great debates on the national level as to what to do with tax reform, but often they fail to take into account the consequences for state and local tax systems. The current tax proposals in Washington are an example. The proposal to exempt dividends from taxation would have disastrous effects for New York State and turn its $9 billion deficit into a $10 billion deficit because it would make it very difficult for the state to tax dividends. We struggle at the state level trying to capture the income of corporations. I would like to see a movement toward combined reporting, in which corporations have to report on all their activities in all their affiliates, where you would be able to look at corporate income and allocate it across the 50 states. Each state would then have the right to tax it and capture the taxes on the income that is made in its borders.

PHILIP JEFFERSON: I would definitely want the consumption tax to be progressive. I would apply higher marginal tax rates so that those who have a higher level of consumption would be contributing proportionately more in taxes. The implication here is that we want to encourage savings. I would also want to provide generous exemptions for low-income individuals and households.

TIME: How do we get there?

JEFFERSON: One proposal that has been put forth by David Bradford is that there would be a transition when we would basically fill out both types of returns, and early in the transition you would pay 80% of the income tax and, say, 20% of the consumption tax, gradually increasing the amount paid under the consumption tax until it's 100%. That would lead to quite a bit of confusion because you would have a period in which households would be filling out two types of returns. That strikes me as a nightmare. I would favor some type of cross-section phasing, where you would draw random samples of the population each year and let those people make the transition in that year.

BRADFORD: Can I make a pitch for my transition scheme? I propose simply a new schedule in the income tax. Call it Schedule X. The information is really simple for the Schedule X tax base. You put in, for your business, the receipts from sales and subtract purchases from other businesses. Then you subtract your payments to workers. All that is information, basically, they have to have for their present tax returns. It just includes it in the new Schedule X. For individuals it is even easier. You enter your earnings from your employer.

TIME: You all seem to favor some version of a consumption tax.

JEFFERSON: Can I say why I think that is? There is a widespread perception that the current system has failed, and the biggest piece of evidence is the alternative minimum tax. The AMT already forces a lot of people to calculate their taxes twice and to pay the higher amount. By 2010 about 36 million people will fall under the AMT. I think as that starts to affect more people, they will become more conscious of the fact that something is wrong.

MITCHELL: When you have more and more households paying the AMT, it will make people hate the tax system, which politically will build support for tax reform. I will tell you a secret. I am always telling our ideological allies on the Hill, "Don't fix this. Let it fester."

TIME: We have a looming budget deficit and a war that will cost a lot of money. Is the timing of Bush's tax-cut proposals right?

MITCHELL: The big pieces of the Bush plan are things that are consistent with tax reform. The sooner lower tax rates take effect, the better the results for the economy.

SAWICKY: The problem is Bush's proposals are not worth doing later or now. There is a huge amount of resources that I can think of much better ways to use, not only for spending but also for other kinds of tax cuts and also to run some budget surpluses.

RENWICK: I think the national economy needs some stimulus, but the Bush tax plan is not getting much bang for the buck. It is not giving the kinds of tax cuts that would move the economy out of this recession and create some jobs.

BRADFORD: The thing that worries me is not the deficit per se. We have been doing badly in my mind for 25 years in transferring money to the elderly at the expense of future generations. That is my main cut on the present Administration's proposal.

JEFFERSON: I think that the President's policies are very risky to the economy. I don't see how it is really stimulating the economy. It raises questions with regard to fairness. And it raises the specter of high inflation in the future if things don't pan out exactly the way the Administration thought.

MITCHELL: The Bush Administration, I think, has a quiet tax-reform agenda. If you look at what they are doing this year, eliminating the double tax on dividends, this is an important component of tax reform. Traditionally we thought of tax reform as, Let's go from here to there, cold turkey. You can do it in incremental steps. But the Administration is doing the candy part of tax reform, not doing the vegetable part. You are getting rid of the various forms of double taxation, which everyone affected will be happy about, but you are not putting fringe benefits in the tax base, an enormous issue not only for tax-reform policy but also for health-care policy.

RENWICK: What is really driving the agenda for these tax moves is not so much simplifying the tax system as shrinking the tax revenues and shrinking government.

TIME: Do you think it is possible to have a consumption-tax system that doesn't reduce overall tax revenue?

JEFFERSON: Oh, yes. I think there should be, at least in principle, a rate structure on a consumption tax with a flat rate on businesses and increasing marginal tax rates on individuals that should yield revenue consistent with what we are collecting now.

SAWICKY: Broadly speaking, going from income to consumption base means a narrower tax base.

BRADFORD: But you are neglecting things like corporate tax sheltering going on now, at huge volumes. I think you actually probably would broaden the base. Anyway, I think it would be more progressive than the system we have now.

TIME: Under the consumption tax, would capital gains be treated as part of income?

BRADFORD: Depends on which consumption tax. Under the X tax--a consumption tax with graduated tax brackets--capital gains at the individual level just aren't there. At the individual level, you pay a tax on your wages and salary. That is it. In a full-fledged individual-level cash-flow tax, which I wrote about in a Treasury study, you pay tax on the whole proceeds. You sell the stock, pay the tax on everything.

MITCHELL: It's important to realize that the money you used to buy the stock in the first place was not taxed. Everything that goes into your savings and investment is not taxed that year.

TIME: What do you hear from small-and medium-size-business proprietors about the burdens of compliance, about distortions? Is that a constituency for reform?

SAWICKY: It raises an issue with the X tax. Presently, if you are a salaried person and you start some kind of kitchen-table business, my understanding is that you can offset business losses; you can use that to offset salary income. But if you have this absolute wall between the individual and the business broadly defined, then you can't do that anymore. Right?

BRADFORD: The boundary issues between the business and individual are tricky.

MITCHELL: The whole issue of commingling business and personal under tax reform underscores the importance of low rates. If you have a rate of 20%, your incentives to manipulate your expenses are much lower.

RENWICK: If you talk to small-business people today, I would say rising health-care cost is probably the biggest item on their agenda of what is hurting their small businesses. There is a place where the government can really play an important role in keeping those costs under control. So there are consequences of having our tax rates too low as well as having our tax rates too high, and we need to have that balance.