What Real Tax Reform Looks Like

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There is nothing simple about tax reform. Our current system is a smorgasbord of rate brackets and credits and deductions designed to promote growth, but also benefit special interests and preserve favored incentives. The new tax reform plan from two senators -- Democrat Ron Wyden and Republican Judd Gregg -- aims to strip the clutter. It could make filing taxes as simple as reviewing a one-pager from the IRS. It would reduce the number of tax brackets from six to three (at 15 percent, 25 percent and 35 percent); eliminate the dreaded Alternative Minimum Tax; triple the standard deduction while killing dozens of exemptions; and significantly reform corporate taxes.

But is it a good idea? I spoke with Roberton Williams, a senior fellow at the Tax Policy Center. Yesterday I published the first part of our chat, about how the dramatically simplified tax system could make filing taxes so easy it could threaten the existence of tax preparers like H&R Block. Today we continue the conversation about the nuts and bolts of a bold new vision for our tax structure:

What's the single most significant change you see in this plan?

The biggest change is on the individual side, the general simplification that makes the income tax more understandable. If you go back to 1986 the last time we did a major tax reform, we had 15 tax rates and we went down to 3. It brought the rates down a lot, and got rid of a lot of exemptions for special interests. Lower rates, fewer rates, broader base.

Over the intervening decades, Congress has added in a lot of special provisions to complicate the tax code: the child tax credit, credit for going to school, for saving for retirement. This is mostly because Congress is doing social programs through the tax program rather than through the spending side. The Tea Party would be all over you for a new spending program, but it would love you if you announce a new tax cut. So take the child tax credit. The government sends you a thousand dollars for each kid you've got. We've run it through the tax system so it looks like a tax cut instead of welfare. But it's the exact same thing. To be clear, these are good things to do sometimes! But it's made the tax system complicated and people don't understand what's going on.

We know this reform would make our taxes simpler. But how would it actually change what we pay?

One big way it could reduce your tax burden is with a large increase in the standard deduction: it will be $15,000 for individuals, whereas now it's around $5000 for singles. That does two things. It reduces taxable income, so it cuts down your tax bill. And it pushes people away from itemized deductions.

My guess is that it would cut taxes at the bottom. They would maintain all the tax credits, child, earned income tax credit, child dependent care. People at the top: their top rate stays at 35 percent rather than rising as it would under Obama's plan. But the bottom 10 percent bracket is eliminated, so they still have the bottom of their income taxed at 15 percent. It does look like people at the bottom are better off, but people in the top might be slightly worse off.

So this cuts down on itemized deductions. How does that make the system simpler?

It removes complicated deductions. For example, one really big one they have is getting rid of the deduction for state and local taxes.

How does that deduction work?

Currently, if I pay $1,000 in state taxes and I'm in the 15 percent federal tax bracket, I can deduct the $1,000 and save $150 of income tax. Effectively I pay the state $850 and the federal government kicks in $150 through my tax savings. We could have the same outcome if my state tax were only $850, I wasn't allowed to deduct that on my federal tax return, and the federal government sent the state $150. That's what they're trying to make happen.

The underlying assumption is that I'm willing to pay $850 for state services but not $1,000. Without the federal tax savings, I'd be an unhappy taxpayer. But with the deduction, the state can get more revenue--$1,000--and I'm happy paying only $850 (net of tax savings). The tax deduction is an indirect form of revenue sharing from the feds to the states. The proposal would remove the deduction from the income tax and make the revenue sharing direct.

What kind of deductions and exemptions does the plan keep?

They're keeping the mortgage interest deduction and the charitable gift deduction. This is understandable, given the complaints the administration got last year when it tried to cap charitable deductions. The two big groups that complained then were the charitable groups and the real estate industry. They said don't do this, and Congress received the idea with cacophonous boos. [Editor: Full list of deductions in the Wyden-Gregg plan here.]

Does the bill move the tax burden to the consumption side?

There is nothing that I see in the bill to do that. There might be something that I'm not seeing. It does make sense to move to a VAT. We're the only industrialized country in the world that doesn't have a VAT. You look at our fiscal situation, and there's no easy way to cut spending. So we need revenue. A VAT can be low-rate so it doesn't effect behavior much, and broad-based so it collects a lot of money. The complaint is regressivity. The poor spend every cent they've got. But you can make up for that with a tax credit at the bottom end.

Will this plan be revenue neutral? Will it raise or lose money for the government?

We haven't done a revenue estimate. The Congressional Research Service did something for them -- but it's loaded with caveats. It basically says as a package this would make money relative to current tax law. It would not make as much as the president's proposal, which raises taxes on the wealthy next year.

From the looks of things, the plan mostly cuts taxes for individuals. So where's the money coming from?

They're closing loopholes on the corporate tax side: things like not allowing firms to hold income overseas without paying taxes on it and then bring it back home, which is called repatriation. This proposes to tax that money immediately.That that would bring in more revenue. By bringing more money home you'd have more investment here and less overseas. Now it makes sense for say Exxon to invest in projects in the Middle East that have a lower rate of return than here in the US because they're deferring their tax liability. Bring those dollars home and invest in higher return enterprises at home.

Second, it taxes a lot of income not now taxed. There are two big ones here. It ends the exclusion for Social Security benefits. It would also include taxes on municipal bonds. This is a big source of wealth for rich people.

One thing the tax plan does is it cuts the value of inflation from a corporation's interest deduction. That's sound complicated! Walk me through that.

There are two ways to finance investment. You can sell stock or borrow money. To sell stock you have a return. These are non-deductible dividends. But right now firms can deduct the interest they pay on money they borrowed. It's cheaper to borrow money than to sell equity, so corporations do too much borrowing. This law is trying to balance the incentives here and attract direct investment.

(Flickr/Mat Honan)