Challenges to Fundamental Tax Reform

ON A SUNNY OCTOBER MORNING more than two decades ago, President Ronald Reagan signed into law the Tax Reform Act of 1986. The idea was a simple one, and it gained broad bipartisan backing: In exchange for the lowest income tax rates since before the New Deal, the income tax base would be broadened. Both wasteful, giveaway loopholes and (unfortunately) some useful pro-growth tax policies were discarded. The new 28 percent top tax rate on households and 34 percent tax rate on corporations were not only lower than they were in the days of the New Deal and the Great Society; they were lower than today’s 35 percent tax rate on both.

Where do proponents of low tax rates stand today, more than 20 years later? The outlook, it must be confessed, is grim. If Congress does nothing, individual tax rates are scheduled to rise across the board, from a range of 10 percent to 35 percent today up to a range of 15 percent to 39.6 percent in January 2011. Pressures that didn’t exist back in 1986—the imminent retirement of the Baby Boomers, exploding health care costs, a new Cold War against global jihadism—conspire to push tax rates even higher.

Those of us who dream of one day seeing a 15 percent flat tax or a national consumed income/sales tax behold these developments as a nightmare. Let’s begin by examining the challenges facing fundamental tax reform, and then propose a way out of the woods.

The Challenges

The Total Tax Burden. You can’t know where you’re going unless you know where you are, so examining the total tax burden as a percentage of the economy is a good place to start. Back in 1986, total government taxes took 26.8 percent out of gross domestic product. In 2007, the latest full year for which the Office of Management and Budget has data, the figure was 29.2 percent. What explains the backsliding? The tax man grew fatter in both state capitals (where taxes rose by a percentage point during the period), and Washington, D.C. (where taxes rose by 1.4 percentage points). Put simply, government got bigger.

And it’s only going to get worse. Put in rough terms, the Congressional Budget Office projects that federal spending will double over the next half century, growing by about 20 percentage points to 40 percent of gross domestic product. The biggest culprits will be Medicare (socialized medicine for the old), Medicaid (socialized medicine for the poor), and Social Security (socialized pensions for everybody).

Recently, Rep. Paul Ryan (R-Wis.) asked the CBO how high the top marginal income tax rate would have to go to finance all this new federal spending. The answer—to 88 percent—is so frightening as to be laughable. In response, Ryan has introduced a bill, which has been fully scored by government actuaries and bean counters, to keep government spending at its current level of 20 percent of GDP and to create an alternative tax system with a 25 percent top rate.

The Elephant in the Room: Health Care Spending. The pressure for higher tax rates is fueled in large part by the anticipated spending demands of the retiring Baby Boomer generation. The federal government’s two major health spending programs—Medicare and Medicaid—are projected to rise from a manageable 4.1 percent of GDP today to 18.6 percent of GDP in 2082, according to CBO. That share of GDP is almost equal to government’s total share today. It’s easy to see that government health care programs account for a large part of the projected increase in government spending to 40 percent of GDP.

Reforming health care is the way out of this mess. Cutting Medicare and Medicaid are not politically viable strategies. Nor is raising the top marginal tax rate to 88 percent, for that matter. The smart move is reform.

Medicaid has a relatively straightforward reform mechanism, and it can be found in Congressman Ryan’s “American Roadmap” reform plan Give states a choice: either accept a block grant of Medicaid funding, which will grow no faster than inflation plus population growth; or, free your residents to accept Medicaid as an individual voucher they can roll over into the working world. Either way, Medicaid is transformed from an open-ended entitlement to something resembling the reformed welfare program.

Medicare requires a little more surgery. Younger workers currently pay a 2.9 percent Medicare payroll tax. They should be given the option to save this in a Medicare Savings Account which would be invested in a preset 50/50 stock/bond mix. Upon retirement, these workers could purchase a medical annuity to give themselves a health insurance plan for life. For current and near retirees, Medicare should be turned into a voucher for this same purpose. Under such a plan, those who are poor and/or sick would get a relatively bigger voucher, and those who are wealthy and/or healthy would get a relatively smaller one. Seniors could thus craft a Medicare plan specifically to their needs—not what the government says they need.

For the rest of us, a combination of beefed-up health savings accounts, the ability to purchase health insurance across state lines, greater use of health information technology, and health care price transparency should do the trick. Reforming the tax code so that it no longer favors employer-purchased health insurance over individual health insurance would also help.

Unless tax reformers get the health care tiger back in the cage, any hope for fundamental tax reform remains a pipe dream.

Dragon’s Teeth in the Current Tax Structure. In less than three years, the top marginal income tax rate will rise from 35 percent to 39.6 percent. The long-term capital gains tax rate will rise from 15 percent to 20 percent. The tax on qualified dividends will rise from 15 percent to 39.6 percent. The “death tax” will go from zero percent to 55 percent. The alternative minimum tax (AMT) will ensnare tens of millions of households. Put this together with some tax base broadeners that mostly affect families with children and CBO projects a 10-year tax increase of over $2 trillion. According to the Treasury Department, that’s an average tax increase of nearly $2,000 per year per family.

Make no mistake about it: Those who are opposed to fundamental reform of the entitlement programs view this impending tax increase as one of the key mechanisms for funding the doubling of federal government spending. According to CBO, federal revenues in this high-tax world would hit 20.3 percent of GDP by 2018—approaching the post-World War II high seen in 2000 and well above the modern average of 18.3 percent of GDP. We can expect these high tax rates to retard economic growth, drive down wages, and leave us all worse off.

Bad Ideas in Congress. There’s no shortage of new bad tax policy ideas to supplement these dragon’s teeth. For instance, Senator and presidential candidate Barack Obama (D-Ill.) recently proposed going beyond the scheduled capital gains tax hike and bringing the rate all the way back up to 28 percent. Rep. Charlie Rangel (D-N.Y.) has proposed a “surtax” on high- bracket taxpayers (70 percent of whom have small business income, according to the IRS) to pay for new spending. Senator and presidential candidate John McCain (R-Ariz.) and others believe that fighting global warming justifies a massive “cap and trade” regime on carbon dioxide emissions. This plan is essentially an excise tax on energy consumption and will amount to hundreds of billions of dollars in new taxes per year. By no means should tax reformers view the impending 2011 tax hike as the high water mark for confiscatory tax rates.

The Fight for Global Capital. When President Reagan signed the Tax Reform Act in 1986, he lauded the bill for creating one of the lowest corporate income tax rates in the developed world. At the time, the United States led the way in the fight for global capital. In the intervening 22 years, the rest of the world caught up. According to the Organisation for Economic Cooperation and Development, the United States now has the second-highest corporate income tax rate (35 percent) in the developed world, behind only basket-case Japan. The average corporate rate in Europe is only 25 percent.

Corporate profits are only the first layer of tax on capital. A second layer comes when corporate profits are distributed to shareholders (dividends), or reinvested into the corporation (which eventually translates into a capital gain). By raising the double-tax on dividends from 15 percent to 39.6 percent, and the double-tax on capital gains from 15 percent to 20 percent, policymakers will further drive capital offshore.

Government also takes a third bite at the apple: the death tax. If an investor purchases a stock after he pays a personal income tax rate of 39.6 percent and then sees a 35 percent bite in pre-tax corporate profits, a 20 percent bite in capital gains, and a 39.6 percent bite in dividends, he might be forgiven for thinking that the Viking raid of the IRS is over. But then he’s liable after 2011 for a 55 percent death tax on his remaining nest egg. The death tax, too, pushes capital toward developing nations—like China and India.

The heart of modern fundamental tax reform must begin here. High taxes on capital always and everywhere translate into lower wages and diminished living standards.

A Program for Tax Reform

Assuming health care spending can be gotten under control, below is a simple program for Tax Reform 2.0:

1. Cut the corporate income tax rate to 25 percent, in line with our European competitors. If defenders of static revenue scoring insist on paying for it, there’s plenty of central planning masked as tax expenditures in the corporate tax base.

2. Allow households to choose to opt into a simplified system. Rep. Ryan and others (including several of those who were presidential candidates on the Republican side) have proposed this step. Under this system, taxpayers could choose to keep their deductions and pay higher tax rates or opt into a system with lower rates and fewer deductions. The alternate system would be designed to raise the same amount of revenue with a broader base and lower tax rates.

3. Create simplified and consolidated tax-free savings accounts. There are over a dozen retirement and non-retirement savings accounts out there, from Roth IRAs to Coverdell ESAs. Putting all these together, combined with lower tax rates in a simplified alternate system, would be a big step forward. And this reform shouldn’t be politically difficult to enact, since it doesn’t even reduce government revenue.

4. Let businesses expense equipment and technology purchases the first year. Under current rules, these purchases must be slowly deducted, or “depreciated.” The first-year deduction or the several-year depreciation comes out to the same amount in the end, so there would be no reduction in government revenue. The resulting business investment, however, will spur economic growth and enhance productivity.

Mr. Ellis is Tax Policy Director at Americans for Tax Reform.