President George W. Bush’s Tax Advisory Commission, due to issue a preliminary report November 1, was reported Wednesday to be considering capping the home mortgage interest deduction at $300,000 principal amount, capping corporate tax deductions for employee healthcare premiums at $11,000 and eliminating the Alternative Minimum Tax. These proposals and the furore they aroused bring into sharp focus the question of how the over-complex and economically destructive U.S. tax code might be reformed.
There are two approaches to “reforming” the U.S. tax system. One is to figure out what an ideal tax system would look like, propose something like it, and emerge bloody but triumphant from Congress with something fairly close to what you started with. This approach has only been tried once in U.S. history, with President Ronald Reagan’s tax reform of 1986, lowering the top rate of U.S. Federal income tax to 28 percent, which had been given huge and unexpected impetus by a Democrat proposal by Senator Bill Bradley (D.-NJ) and Congressman Richard Gephardt (D.-MO) in the previous year. The enormous victory for good government which the 1986 reform represented was thrown away in the following years through the loophole-infested, rate raising tax “reforms” of President George H.W. Bush in 1990 and President Bill Clinton in 1993. No similar approach has ever been seriously tried since, and it’s not going to be tried now – George W. Bush, whatever his virtues, is far from being a Reagan.
The other approach to tax reform is to concentrate on the politically possible, and rule out changes that might be difficult to pass through Congress, or might alienate a segment of the electorate that you wish to keep sweet. All tax bills before and after 1986 have followed this second approach, and there is every reason to believe it will be the one adopted now. Even the first Reagan tax cut of 1981, which moved the U.S. tax system a long way in the direction of what George H.W. Bush had called “voodoo economics,” was an example of this. While the 1981 Act included substantial cuts in the top marginal rate of income tax, it also included so many special interest giveaways, such as an economically meaningless tax free bank deposit scheme and distorting freebies for corporate fixed asset investment, that much of it had to be reversed in the following year to stop the deficit spiraling off to infinity.
The unavailability of root and branch tax reform is a pity. The ‘flat tax” first proposed by Steve Forbes in the Presidential campaign of 1996 and since passed into law in a number of economically restructuring countries, notably Estonia and Russia, could raise as much revenue as the present system at a very much lower marginal tax rate. The Estonian economy has achieved remarkable growth after instigating a flat tax, and the Russian economy has achieved both economic growth and levels of tax compliance only previously seen under the most draconian of regimes imposed by the likes of Ivan the Terrible and Stalin. For Southern European countries where taxpaying is regarded as optional, or for Third World countries where information and enforcement systems are poor, there’s no question that a flat tax is the answer; it both increases revenue and generates additional economic growth through removing the system’s inefficiencies. Had Italian Prime Minister Silvio Berlusconi been the man he claimed to be, he would have introduced a flat tax already.
Even in the relatively tax-compliant, information-rich United States, if the Reagan Presidency had coincided with the Newt Gingrich Congress, some kind of flat tax plan would probably already be in effect – it is indeed only a perfected version of Reagan’s 1986 reform. In the real world of today, since it would put every tax adviser in the country out of business, as well as abolishing cherished tax shelters for housing, charities and state income taxes, a flat tax is firmly in the realm of the “politically impossible.” Neither in the White House nor in Congress is there any chance of traction for a plan that would offend so many lobbyists.
Viewed in this light, the objectives of tax “reform” become clear. It must be a major change, so that it will raise substantial revenues — necessary to stop the budget deficit running away after the follies of No Child Left Behind, the Medicare prescription drug entitlement, the Global War on Terror, and this year’s pork-sodden Transportation Equity Act. It must provide some major benefit to taxpayers that will distract them from the quiet elimination of most of Bush’s 2001 and 2003 tax cuts. It must leave enough complexity and wrinkles in the system that it remains worthwhile for special interests and lobbyists to keep sending those campaign contributions.
Oh, and if it causes the U.S. economy to implode, its economic effect must be sufficiently debatable as to preserve deniability, and prevent its instigators’ fingerprints from being found on the murder weapon.
Viewed in this light, the reduction of the ceiling on mortgage interest tax relief from $1 million to $300,000 is a non-starter. Had this been done in 2001, when Fed Chairman Alan Greenspan decided to reduce short term interest rates to levels far below the rate of inflation, it would have been a useful reform, diverting money from unproductive housing into potentially productive bond and share investment, and preventing the 2002-05 housing bubble.
Had it been done early in 2003, and combined with the elimination at the corporate level of double tax on dividends, rather than the half-baked reform by which the personal tax on dividends was reduced to 15 percent, it would have been even more beneficial. Such a combination would have corrected a major distortion in the U.S. tax system, and increased the real value of U.S. equities by a factor of 100/65, or 54 percent. At that point, at an index level for the Standard and Poors 500 Index of 800 the stock market would have been close to appropriately valued and U.S. economic growth could have resumed on a sound basis without the asset-price-deflationary collapse that is still ahead of us.
However, since June 2004 Greenspan has been increasing short term interest rates, albeit at a very gradual pace. Indeed, Friday’s report of a U.S. Consumer Price Index 4.7 percent above the previous year demonstrated that both short term interest rates (Federal Funds target rate of 3.75 percent) and long term interest rates (4.49 percent yield at Friday’s close on the 10 year Treasury bond) are still negative in real terms, and so rates will have to move substantially higher before inflation can be brought under control — to reduce inflation, you need interest rates that are actively deflationary, not merely neutral. Thus the housing market — at least that on both coasts — is due for a price collapse.
Reducing the mortgage tax relief exemption would only worsen that drop, particularly as the coastal markets are those in which $300,000 doesn’t buy you all that much house (thus the caterwauling from the media commentariat, who mostly live in overpriced, heavily mortgaged apartments in Manhattan, Washington or Los Angeles.)
Worse still, from the political point of view, reducing the exemption would divert the shrieks of anguish from those affected by slumping house prices away from Alan Greenspan, by then safely in retirement and towards the Bush administration and Congress. There’s no question that a reduction in the mortgage interest tax exemption limit is economically a highly beneficial change, but it will have to wait several years until the housing market has bottomed out and the shrieks of McMansion-induced pain have subsided.
The Tax Advisory Commission’s second proposal, to cap the deduction for corporate provided health insurance, doesn’t suffer from this problem. Indeed, to the extent that it causes cost cutting in the health industry, and additional pressure to reduce the depredations of medical trial lawyers, it will tend to reduce the share of the U.S. economy that is sucked into the vortex of health care costs, reduce the subsidy for corporate provision of health insurance, and thus be generally economically beneficial. It will doubtless reduce stock prices in the hospital sector but hey – Senate Majority Leader Bill Frist (R.-TN) has now sold his Hospital Corporation of America inheritance and so will be more or less unaffected!
Removing the Alternative Minimum Tax altogether would be very expensive, and indeed undesirable. The tax’s original objective, to prevent certain very wealthy taxpayers from escaping the income tax net altogether, is to all but the most committed inegalitarian more desirable now than it was when the tax was introduced in 1969, as inequality has sharply increased since that date and ethical standards (and tax compliance) have generally declined. The tax’s real problem is that in the envy-driven Clinton tax increase of 1993, the AMT tax rate was set at 28 percent, too close to the regular income tax rate, so that even moderate tax deductions drove high-income taxpayers into the AMT net. As the AMT exemption of $40,000 declined in real terms, this problem became more acute, forcing an increasing fraction of the U.S. population to calculate and file their taxes twice, while providing a substantial “stealth” increase in tax revenues to the IRS.
Reducing the AMT rate to 20 percent and allowing the exemption, increased in 2001, to “sunset” back to $40,000 would allow lawmakers to trumpet a substantial apparent reduction in taxes, while keeping the original purpose of the AMT. It would be expensive in the “out” years beyond 2011, but the huge AMT revenues projected for those years were never realistic in any case.
The Commission also apparently believes that the tax exemption for charitable donations should be extended to those taxpayers who do not itemize deductions. Apart from being fiscally unattractive, this is highly undesirable, indeed a move in the wrong direction. Charitable status has been claimed by a myriad of organizations, many of which are devoted to thoroughly unpleasant (generally far left) political lobbying or incur expenses far in excess of any charitable benefits to third parties. Further, the charitable exemption encourages all kinds of “donations in kind” scams in which near-worthless items are given to charity and a large write-off claimed. Much better instead to limit the charitable donation exemption to donations in cash only, thus closing an especially egregious loophole and generating substantial additional revenue. If a charity wishes to go into the used car business, it can do so but must provide a receipt to the donor only for the cash value actually received for the donated car. There are many other such loopholes to close in this area, which has for decades used spurious claims of its social benefit to justify outrageous levels of tax fraud.
Finally, the anomaly of the estate tax, currently scheduled to disappear in July 2010 and reappear at a 55 percent rate in 2011, needs to be cleared up. Rather than being abolished altogether, the estate tax should be reduced to a moderate level around 20 percent, with a high exemption of $5 million. This will probably produce more revenue than currently; it will certainly put a large and economically damaging tax avoidance industry out of business.
These changes, taken together, will probably produce a little additional revenue but nowhere near enough to close the budget gap, particularly if as one can expect a recession looms in the near future. To close the gap, open increases in taxes will be necessary, perhaps by means of a value added tax, a huge and silent revenue generator in all European countries. A gasoline tax, perhaps similar to the one outlined here a couple of weeks ago that increases as the gasoline price declines, would be a less economically damaging alternative to a VAT, but is probably “politically impossible.”
Real tax increases, particularly a VAT will be hugely unpopular. Tough! Congress and the Bush administration should have thought of that before they wasted so much money.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.