WASHINGTON (Reuters) - Want to talk about tax reform? President Obama does. He’s slated 2011 for a year-long conversation about the increasingly complex income tax code, aimed at eliminating some of that complexity (read: deductions) and lowering the income tax rates.
But that conversation may go on longer than he would like. “It’s mainly going to be a lot of talk for the next two years,” said Bob McIntyre of the Tax Policy Center, voicing the most commonly held view of political analysts. It would be politically impossible for President Obama to get enough votes to pass tax reform before 2013, goes that conventional wisdom. (The alternative, that pressure to cut deficits will push Congress into a pre-2013 tax reform bill that raises revenue, is a minority view.)
But we can talk, right? Calendar-wise, we’re overdue for a code clean up; they’ve typically arrived every 10 or 15 years but there hasn’t been big tax reform legislation since 1986, when Ronald Reagan oversaw a two-year conversation that was followed by the big deal, in the second year of his second term.
So study, and listen. When you hear all that chatter about tax reform, here’s what the talk is really about.
Cynics say the real issue driving tax reform is the federal debt. Elected Washington needs to figure out how to pull in more revenues without making it look like that’s what they are doing. But that is only one of the major themes that will have to be addressed; here are others.
* How progressive should it be? The income tax system has been aimed at taxing people proportionate to their income, so high earners have higher tax rates than low earners. "Historically, the income tax system has become more progressive over time, particularly at the bottom, because there are more refundable credits," says Eric Toder of the Tax Policy Center. But in the wake of the George W. Bush tax cuts, income taxes have made up less of the tax burden carried by most individuals and families while payroll taxes, which are highly regressive, make up more. And 61 percent of Americans think the wealthiest should pay more income taxes, according to a new survey. (here) Many of the juciest tax breaks, such as the mortgage interest deduction and the writeoff for state and local property taxes, favor high-income taxpayers.
* Should it be revenue neutral? President Reagan’s tax reform was revenue neutral, and the argument at that time was that it was the only way it would pass. But this time around, the opposite dynamic could occur. “The future growing deficit is the biggest problem we have,” says Toder, who suggests it would be an opportunity wasted if policymakers were to go through something “as politically painful as tax reform” without getting some revenues at the same time.
* Will it be fair? And enforceable? There’s nothing worse than feeling like a chump on April 15 - like you’ve paid more than your fair share and your neighbor didn’t, and he’s laughing at you. That feeling is partly responsible for an enormous wave of noncompliance. The IRS has estimated that some $345 billion is lost annually because individuals and companies don’t pay all of the taxes they should. President Obama’s economic recovery advisory board, led by Paul Volcker, made compliance a major theme of its study on tax reform, suggesting that collections would rise if the tax code were easier to understand and harder to evade.
* How simple can it get? Theoretically, the U.S. could scrap its entire tax code with a no-deductions, no-exemptions, no-credits flat tax with a single rate. A three-line form, and you’re done. But that old saw about there being a simple (but wrong) answer for everything seems to apply. Too simple and you leave behind all progressivity, all efforts to encourage behaviors like charitable giving, going to school, saving for retirement and more. The Volcker group recommended that policymakers simplify the code by combining and consolidating related provisions. For example, the myriad retirement savings incentives could be streamlined, as could all of the education credits and deductions.
Given how much talk we’re likely to have on tax reform, it’s worth noting that there already is a fair amount of agreement from the middle of the political pack on what a new tax code would look like. Several key bipartisan plans have surfaced in recent months that all have the same basic approach: Deductions would be cut or eliminated and tax rates would decline. The big discussions to come will focus on the fine print: Where to draw those brackets, which deductions should get nipped, and so on.
Other more drastic proposals, such as switching to a flat tax or scrapping the income tax altogether for a sales tax, have their proponents, but are unlikely to win over the hearts and minds of enough lawmakers to become law in the next few years.
Here’s a look at the key core proposals that have already surfaced:
*The Bowles/Simpson Deficit Commission Plan. In its final report in December, President Obama’s deficit commission, steered by Erskine Bowles and former-Senator Alan Simpson, proposed streamlining the number of tax brackets, reducing rates, eliminating itemized deductions, and replacing some of them (such as the mortgage interest deduction) with less expensive (and more narrowly focused on the less well-heeled) tax credits. It also suggested taxing dividends and capital gains at ordinary income tax levels, but allowing an exclusion of some gains and dividends. Perhaps more interesting than its reform proposal was the commission’s threatened “failsafe” mechanism: If Washington doesn’t pass tax reform legislation by 2013, automatic across-the-board cuts in deductions, credits and exemptions should be put in place so that the tax code yields an extra $80-billion in revenues by 2015.
*The Domenici/Rivlin Plan. An independent Bipartisan Policy Center Debt Reduction Task Force, headed by former Senate Budget Committee Chairman Pete Domenici, a Republican, and former White House budget director Alice Rivlin, a Democrat, came in with their own deficit reduction/tax reform plan in November 2010. They proposed stripping the individual income tax system to two rates: 15 percent on the first $50,000 of taxable income ($100,000 for couples), and 27 percent on everything else. This plan replaces mortgage interest and charitable deductions with limited credits and also would treat capital gains and dividends as ordinary income, though long-term gains would be indexed for inflation, and the first $1,000 would be exempted. Oh, and they would subject all Social Security benefits to income taxes, albeit with a limited credit for 7.5 percent of benefits.
*The Wyden-Gregg plan. Republican Judd Gregg isn’t even in the Senate anymore; he retired at the end of the last session. But the plan he introduced with Democratic Senator Ron Wyden in March 2010 was probably the opening gun in the current tax reform season. They would have reduced individual tax brackets to three at 15, 25 and 25 percent, and drastically cut the number of credits, exemptions and deductions. Their plan would have almost tripled the standard deduction on the theory that cutting tax rates and raising the standard deduction would make tax deductions less valuable for many people. They would exclude 35 percent of long term gains and dividends from taxes, but subject the rest to ordinary income rates.
See? There’s a pattern around which the middle has already coalesced. Fewer brackets, lower rates, some increase in capital gains and dividend taxes, consolidation of key incentives and a weakening or elimination of many tax deductions. Of course, defining all of those qualifiers: “key” and “some” and “fewer” and “lower” and “many?” That’s at least two years worth of conversational fodder.
Writing by Linda Stern; Editing by Andy Hay