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The Next Great Theft? | Economic Viewpoints

Opinion pieces and speeches by EPI staff and associates.


The Next Great Theft?

By  Max B. Sawicky 

With the death of his Social Security privatization scheme, President Bush is trying to resuscitate his domestic agenda with an electric slide to tax reform.  Some things never change: Doubtless, Bush will try to continue comforting the comfortable and afflicting the afflicted by shifting the tax burden from the wealthy to everyone else.  How he will try and do it this time around remains to be seen.

The next shoe to drop will be the report of his Advisory Commission on Tax Reform. The commission is scheduled to deliver its recommendations on November 1.  We may have gotten a sneak peek in the past few days, as commission members have floated a few trial balloons.  The chief option put forward is to eliminate the Alternative Minimum Tax (AMT), which would be a tax cut for relatively wealthy, and to replace the cut revenue by reducing or eliminating deductions for health insurance, home mortgage interest and state and local income tax.

Those ideas are a far cry from the conservative dream of a flat tax or a national sales tax. Reducing the deduction for health insurance means increasing the tax burden on labor compensation.  In and of itself, it is perfectly in the conservative spirit of a move toward wage taxation only. The flat tax is itself a wage tax that would eliminate the exclusion for employer-paid health benefits (and all other fringe benefits) altogether.

But if the final report forsakes a focus on fundamental changes for the sake of mucking around with deductions and the AMT, that would be a significant ideological come-down—and a much more narrow, smaller-scale political focus.  It would be a Harriet Miers tax plan: high on faith, short on substance.

The Simple Tax-Free Life

First, the big picture—what do the conservatives really want?  In a nutshell, they want all business investment and returns to savings to be tax-free, leaving only income from labor to tax.  Unfortunately, the recent trend in real-world legislation is not to a pure wage tax, which would be bad enough, but to a bent system that subsidizes capital and advantages high-salary earners—the worst of all possible worlds in tax policy.

For the past two decades, the federal income tax has been creeping towards a tax based solely on wages.  Income from ownership of financial assets—dividends, interest and capital gains—is increasingly shielded from tax, to the disadvantage of wages and salaries.  Lightening the tax burden on capital—chiefly capital gains, dividends and interest—has been the major theme in conservative tax commentary.

In fact, there are six mechanisms wherein the wealthy would increasingly wiggle themselves free of federal taxation—besides the obvious resort of simply reducing rates for the upper income brackets. These are: discriminatory tax rates, savings preferences, depreciation rules, elimination of the Alternative Minimum Tax (AMT) and the Estate and Gift Tax, and corporate tax integration.

Discriminatory Tax Rates:   Presently, the tax rates on income vary depending on the type of income, or, in technical language, your income versus special income for special people. Rates on capital gains and dividends are lower than rates on other income, known as “ordinary income.”  In the name of growth incentives, the commission will propose to further reduce these preferential rates.

Savings Preferences: One way that the returns to ownership of financial assets—also known as income from capital—are shielded from tax is through Individual Retirement Accounts (IRAs) and 401(k)s.  Basically these allow you to deduct your deposits (purchases of financial assets) and pay tax on withdrawal (sales of assets), or, to deposit with after-tax dollars and pay no tax on returns.  In either case, the effective tax on your investment returns is eliminated. A zero tax on investment returns means that capital is free of tax, leaving only labor income as a source of tax revenue.

Insofar as IRAs are liberalized—where eligibility is broadened, contribution levels are raised, and conditions for the time and reason for withdrawal are made more flexible—the individual income tax becomes a wage tax.

Depreciation Rules:  Under a true income tax, a business firm is not allowed to deduct its capital expenses—to depreciate them—immediately.  Rather, the firm must spread these deductible costs over future tax returns.  The reason is that such expenditures are used to purchase productive assets—equipment and the like—which last for a number of years.  In effect, the assets are throwing off income over the period of their useful lives.

An income tax would tax this income.  If a business could deduct its costs immediately—also known as expensing or “free depreciation” —the effect is similar to the deductible IRA: to zero out any tax on the asset. The benefit to the firm is that a dollar paid later is less costly than one paid sooner. But it’s tantamount to a loan from the government.

Insofar as depreciation is made more generous, business taxes become limited to unusually profitable companies (because high profits generate taxes worth more than the initial deduction).  Most business income would be left untaxed.

The Alternative Minimum Tax: The AMT is a piggyback tax within the individual income tax, originally designed to cover wealthy people with an inordinate number of deductions that allow them to escape any tax.  Because it is not indexed to inflation, over time it covers increasing numbers of people who are not rich.  It will require reform, at the very least, to stay within its original purpose.

The AMT is a target for elimination.  The result of AMT repeal would be to vastly expand the value of deductions for higher-income taxpayers.  Of course, most deductions disproportionately benefit the better-off to begin with.

The Federal Estate and Gift Tax: This is a tax on the transfer of very large amounts of wealth paid by a very small number of people.  It, too, has been marked for elimination. Insofar as the income tax fails to tax capital, this tax becomes the only fallback.  Its repeal helps clear the decks for a pure wage tax regime.

Corporate Tax Integration:   Presently, some corporate profits are taxed twice—once as profits to the business, and a second  time when received as stock dividends by a taxpayer.  It is also true that some profits are not taxed at all, and other profits are taxed, but less than labor income.  “Tax integration” is the name given to reducing taxes on dividends—not necessarily in a way that levels the playing field within the corporate sector, but surely in a way that disadvantages those whose income derives from labor alone.

Corporate Welfare Triumphant

The reform commission might serve up options in each of these six areas: additional reductions in the rate for capital gains, dividends and perhaps interest; broader savings preferences, no doubt described as “more flexible IRAs”; more generous depreciation (“investment incentives”); elimination of the AMT (“tax simplification”); repeal of the Estate and Gift Tax (“the death tax”); and corporate tax cuts (“eliminating the double taxation of dividends for national competitiveness”).

A saving
grace in all this is that the right may be too nutty to agree on a plan.  As things stand, deficits are already high and many politicians show some reluctance to jam them further with major new tax cuts.  If GOP legislators aim for a plan that collects the same amount of revenue as the system does now, there will be lots of redistribution of the tax burden down the income ladder.

In that scenario, however, many extremists will find it hard to digest proposals for literal tax increases on lower-bracket taxpayers or through the creation of a national sales tax. For politicians, it’s one thing to yak about a national sales tax, and another to deal with actual, fairly simple calculations showing the tens of millions of voters who would incur a tax increase as a result.  Furthermore, the Bush commission is stacked with wonky types who will look down their nose at the sales tax, which is actually impossible to even implement.  The flat tax—a pure wage tax that eliminates all currently itemizable deductions—is also unrealistic.

In the end, the Bush commission may have absorbed these stark political realities and resorted to the relatively mundane proposals floated this week in an effort to find an exit strategy for the entire enterprise.  Insofar as the recommendations are incremental and technical, or dwell on deductions and the AMT, they will fail to satisfy conservative activists seeking a clear victory for capital over labor. And there will no red meat for the income tax-aphobic masses.

My slightly optimistic prediction is that this tax reform cycle ends with one light rinse but no soap, which will be for the best.  The less the current crew in Congress manages to pass, the easier it will be to clean up the monumental mess they have already made.

Max B. Sawicky is an economist at the  Economic Policy Institute in Washington, D.C.