July 2001
Is the US Tax Bill Real Tax Reform?
by Stephen Slivinski & Patrick Basham
When US President Bush presented his tax bill to Congress, he couched its appearance both in ideological terms—"It's the people's money" and, therefore, doesn't belong to the government—and on economic grounds—its passage will help to stave off a recession.
Although clearly ideologically correct, Bush's economic argument for lower taxes is contestable. But notably absent from Bush's marketing approach was the idea that there is something fundamentally wrong with the US tax system, regardless of the levels at which specific rates are set.
It wasn't too long ago that "fundamental tax reform" was a frequently-used phrase. Both US policymakers and taxpayers knew there was something terribly wrong with the tax system and weren't shy about articulating innovative ways of scrapping the current tax code and, in effect, starting over.
The reason fundamental tax reform was so compelling is that it solved problems far beyond high tax rates. It addressed the problems of complexity, fairness, and a refined definition of taxation. Why the American political class ceased talking openly about tax reform remains a puzzle since it had such appeal. Instead, policymakers embarked upon crusades to "target" tax breaks to certain groups and individuals, which, in practice, make the tax code even more complicated. And, ironically, policymakers do this in the name of "reform."
Real tax reform, however, doesn't remedy problems as they arise or only as they are discovered. Rather, it involves a fundamental reconsideration of overall tax policy. Fortunately, there are principles of tax reform that virtually all Americans (and, if given the opportunity, Canadians) can agree upon. These basic principles should apply to any attempt to reform the tax system. They are (in no particular order and not limited to):
- tax consumption, not savings or investment;
- keep the tax simple;
- keep the tax visible;
- tax a broad, easily-definable base with a low rate;
- lower the existing overall tax burden
There are two types of tax structures that satisfy all of these conditions: a single-rate national sales tax, or a flat income tax structure that doesn't penalize savings and investment. By definition, both structures accomplish the same goals, just in different forms.
We can, therefore, measure all tax cut and reform efforts in terms of how close they come to achieving the above stated goals.
The Bush tax cut
So, how does the Bush tax proposal stack up? There are actually two answers to that question, because there are two versions of the Bush Plan: the one proposed to Congress and the one passed by Congress.
First, consider the highlights of the Bush proposal in its original form.
Tax Rates: It lowered all marginal tax rates across the board, with a top rate that didn't exceed 33 percent. Granted, it didn't reverse the Clinton tax hikes of 1993, but it came close.
Rate Structure: The progressive rate structure was simplified. The five-tier structure was consolidated into a four-rate system of 10, 15, 25, and 33 percent. This meant that the trip between tax brackets would be less painful for taxpayers since the rates became flatter. And it encouraged wealth creation since the brackets became wider, allowing taxpayers to become richer than before without hitting a higher marginal tax rate wall.
Estate Tax: Canadians, fortunately, do not suffer the indignity of a US-style estate tax commonly referred to as the "death" or "grave robber" tax. Economist Stephen Moore observes correctly that, "It's unjust given that this tax is imposed on dollars already taxed when income was earned during the deceased's lifetime!" The Bush Plan proposed a repeal of the estate tax. Although it took the plan 7 years to accomplish it, this would obviously abolish one of many punitive taxes on savings in the current tax code.
The plan also increased the per-child tax credit. While well-intentioned, tax credits typically complicate the tax code further and favour some families at the expense of others. If the Bush administration wanted to help all parents, the standard deduction for children should have been increased.
The downside? The Bush Plan lacked provisions to make the code friendlier toward savings and investment. Increases in the contribution limits for pre-tax IRA and 401K1 plans would have helped, as would have a decrease in the capital gains tax rate. The main reason the Bush proposal did not include these capital-friendly provisions was political: the White House painted itself into a corner with its insistence on sticking to a target of a $1.6 trillion, ten-year tax package (out of a $5.5 trillion ten-year surplus). According to opponents of tax cutting, these other provisions would have made the plan too "expensive."
What was the end result? Overall, the Bush proposal was a positive step in the direction of making tax rates lower, flatter, and fairer. But there was still plenty of room for improvement.
Congress's compromise plan
The plan that eventually passed Congress weakened many of the more positive aspects of the Bush Plan. Overall, the compromise plan is smaller—a total of $1.3 trillionin cuts over 11 years— than the admittedly modest Bush tax cut.
Tax Rates: The rates don't drop as far as under Bush's original plan. The top rate only drops to 35 percent from 39.6 percent. Much of the tax bill's effect won't be felt for another two to six years. Here's the real stunner of the revised proposal: all of the tax cut provisions disappear in 2011, thereby dragging the US tax code back to square one.
Rate Structure: Under the bill passed, the tax structure actually increases from five to six tiers: 10, 15, 25, 28, 33, and 35 percent. This brings the American system further away from a flat-rate system, although the tax bill still qualifies as a tax cut for many taxpayers.
Alternative Minimum Tax (AMT): The compromise bill does not solve the problems inherent in the AMT. The AMT is an alternative tax regime that exists side-by-side with the current tax code. It was designed to make sure that those taxpayers who have too many deductions or exemptions (i.e., in most cases, the "rich") paid their "fair share." This politically-motivated tax regime, however, has lately begun hitting the middle class astoundingly hard as economic growth has moved many people up the income ladder.
Credits: The tax structure is further complicated by additional targeted tax credits. The Bush proposal should be given kudos for being relatively tax-credit-free, but the Congressional compromise lumps together a bunch of credits, particularly for parents with children, including a credit to couples who adopt, a credit for dependent care givers, and a credit for employer-provided child care facilities. Additionally, the per-child tax credit was made "refundable" i.e. people who pay no taxes receive a direct payment from the government. This constitutes nothing less than a new government handout, but in this bill it's called a "tax cut."
Estate Tax: The tax bill does eliminate the estate tax, but it does so over the course of 9 years. Once again, there's the catch: the death tax rises from the grave in 2011.
To its credit, the Congressional compromise does include increases in contribution limits to 401(K) and IRA plans which is actually an improvement over the Bush proposal. The downside is that it came at the expense of faster and larger rate cuts.
Conclusion
Taken as a whole, the Congressional compromise doesn't take us too far from the status quo, and thus doesn't get the nation much closer to the goal of real tax reform. The original Bush plan was a step forward; at most, the Congressional compromise constitutes only a half step in the right direction. At that speed, there are still many more steps to go. But as long as principles of sound taxation are followed, at least American taxpayers can be assured that the steps taken aren't down the wrong road.
Note
1 Somewhat similar to Canada's RRSPs and RPPs.
Reference
Stephen Moore, “Repeal the Grave Robber Tax,” Cato Commentary, Feb 22, 2001.
Stephen Slivinski is a Fiscal Policy Analyst and Patrick Basham is a Senior Fellow at the Cato Institute in Washington, D.C.
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