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The Senate Finance Committee recently began its tax reform effort in earnest, holding a hearing called “Kick-Off for Tax Reform: Tackling the Tax Code.” It certainly needs tackling.The number of pages of federal tax rules exploded to 66,498 in 2006 from 26,300 in 1984, according to a Cato Institute study. Compliance costs with this mass of rules topped $265 billion in 2005, according to the Tax Foundation.
While the hearing went mostly unnoticed, it marks the opening of a rare opportunity to enact fundamental tax reform.The chairman of the finance committee, Senator Grassley, set the tone by signaling an openness to consider the leading reform proposals, including the flat tax, the retail sales tax, and the value-added tax. This is welcome news because it means Senator Grassley does not intend to limit himself to the narrow recommendations of the president’s tax panel.
The tax panel’s recommendations are not without some merit, but they are not ambitious enough to solve a problem of this scope. The panel’s central focus was the Alternative Minimum Tax, a parallel tax system originally intended to prevent a handful of the extremely rich from dodging taxes, but now increasingly the bane of the middle class.
The AMT must be eliminated in any tax reform plan, both for economic and political reasons. Economically, the tax creates a steep jump in effective marginal rates, discouraging work, savings, and investment. Politically, it forces Democrats to the table for fundamental tax reform, because high-tax, Democratic coastal states are most vulnerable to the tax.
Rather than including AMT repeal in a larger fundamental tax reform plan and forcing Democrats to make a difficult decision on such a plan, the panel started by assuming standalone AMT repeal, and then tried to find enough major tax hikes to offset the cost of repeal on a static basis.
The panel’s two largest tax hikes would hit New Yorkers particularly hard — elimination of the deduction for state and local income taxes and a limitation on mortgage interest deductibility.These provisions would be palatable in a big-bang tax reform plan that could be expected to boost economic growth by 10% to 12%, the impact Harvard economist Dale Jorgensen has predicted from a broad-based consumption tax. But in the naked form presented by the tax panel those recommendations hit with a thud, and slowed the push for tax reform.
At the recent hearing, Senator Baucus correctly questioned the White House’s lack of engagement on this issue. While the tax reform panel could have done more to advance broad principles of reform and help the president choose from among the leading options, it didn’t. President Bush should not let the panel’s lack of imagination limit his own. Treasury Secretary Paulson is new to the job, but no doubt is already broadly familiar with the relative merits of the leading reform plans.
There are three fundamental tax reform plans that already have congressional support among which President Bush and Secretary Paulson can choose. The one with the broadest support is the Fair Tax, H.R. 25, which would completely scrap the income tax, close the Internal Revenue Service, and replace it with a new, 23% national retail sales tax. There would be no tax on labor, savings, or investment, making this the ultimate supply-side shot in the arm of the American economy.
The second reform plan is a hybrid sales tax and business tax plan, S. 1921, which would scrap the income tax and replace it with two taxes, an 8.4% retail sales tax and an 8.4% business transfer tax. Some view this plan as more politically viable than the Fair Tax, though it has not gained much traction.
The third reform plan is the optional flat tax, H.R. 1040, which would create a flat, 19% income tax for two years before falling to 17%. Taxpayers could choose the old system or opt into the new flat tax, but once they were in they’d have to stay. Initially, this system would mean higher complexity and compliance costs, since taxpayers would calculate their taxes both ways, but the hope would be that over time the simpler, new system would predominate.
It is not too late for the president to pick up one of these tax reform plans and make it his own. By doing so he can elevate the popular tax reform issue as a platform for this fall’s elections and build momentum for legislative success.
Mr. Kerpen is a policy analyst in Washington.