A Few Modest Suggestions for Tax Reform

Andrew E. Busch

March 1, 2005

With tax day hurtling ever closer, it is worthwhile to shift our thoughts for a moment away from Social Security reform and toward President Bush’s other declared domestic priority of tax reform.

If this debate even gets off the ground—no sure bet if Social Security grinds up the administration’s energy—it will largely feature a debate among Republicans between advocates of a flat (or flatter) income tax and some kind of a consumption tax like a national sales tax.

Each side can make a powerful case. Supporters of a flat tax can argue that their proposal requires no additional bureaucratic machinery and will be more economically efficient than the current patchwork of exemptions, deductions, and varying tax brackets. It would also end (or reduce) the disincentive for additional work found in the current system by no longer inflicting higher rates of taxation as one’s income rises.

Supporters of a consumption tax will counter that their plan does away with the disincentive for work entirely, since Americans would not be taxed on their income at all but only on what they spend. This also means that the tax system would have a built-in incentive for savings and investment, which would be untaxed. If regressivity is a concern, it can be dealt with by exempting food and perhaps some other essentials from the consumption tax.

Yet both paths to reform have serious shortcomings. A real flat tax, with no deductions even for mortgage interest or charitable contributions, would be politically unsalable and (at least in the short term) socially and economically disruptive. Moreover, a flat or nearly flat tax, even if it were adopted, would probably not stay flat for long. When Ronald Reagan reformed taxes in 1986, producing a flatter tax rate structure and the elimination of many deductions, it was only a few years before politicians and lobbyists were unsimplifying the tax code again. The temptation for policymakers to add a tax break for their favorite (and undoubtedly worthy) causes is nearly irresistible.

A national sales tax would also be politically difficult to sell, as it would inevitably be painted as a blow against the non-rich. It is also difficult to believe that Washington would not, in the end, wind up with a consumption tax in addition to—rather than in place of—the income tax. A value-added-tax (VAT), or cumulative sales tax applied to each stage of production, could be a particularly insidious way to impose European-level taxation in Americans, since most of the VAT would be hidden from view in the form of higher prices.

Thus, those who are sympathetic to the principles of limited government have many reasons to find either the flat tax or the national sales tax preferable in theory to the current system, but many reasons to fear them in practice.

Policymakers thinking of how to change the tax system to produce results friendlier to limited government might reorient their thinking by focusing on a different set of issues. There are at least three such issues.

First, the uncertainties posed by the "temporary" nature of the Bush tax cuts are intolerable and ought to be corrected forthwith. Republicans ran on making the tax cuts permanent in 2002 and again in 2004. Locking in these tax cuts is probably more important than either new tax cuts or rejiggling the tax rules in a revenue-neutral way through tax reform.

Second, in taxation, transparency is the friend of limited government. That is to say, Americans who do not know how much they are paying, do not reflect that it is their money, and do not connect what they are paying in taxes with policy and policymakers in Washington are the natural friends—or at least enablers—of profligate government. There are two features of the current income tax code that obscure the vision of taxpayers. One is the practice of income tax withholding, in which taxpayers are preemptively deprived of a portion of their earnings before ever having it in hand. It is likely that more Americans know the amount of their after-tax paycheck than of their actual salary or wage statement. It is easy for them to develop a mindset in which the amount withheld was never really theirs.

Second, income tax day is arranged so that Americans rarely have reason to think of the connection between the taxes they are paying and policies emanating from Washington. Because of withholding, many Americans actually look forward to their "refund," which takes on the appearance of a gift of governmental beneficence. Even those who must pay do so on a date that is literally meaningless for any other purpose, and is incapable of forcing a more political consideration of the role of taxation in national life.

The pure solution is obvious: Eliminate withholding and change the date of tax day. To ease the burden, payment could be divided into two parts, one due on May 29 (the anniversary of Patrick Henry’s famous remonstrance against the Stamp Act in 1765) and one on November 1 (conveniently located next to an election near you). If the burden is still too great, taxpayers could instead be sent personalized coupon books based on their tax return, as if they were buying a car or a house, for a monthly schedule of payments.

The great difficulty in this scheme is that, if withholding stops and taxpayers begin to pay the next year after finishing their tax returns, the federal government will be without income tax revenue for a full year or more. A less radical reform could obviate this objection by continuing to require taxpayers to pay forward, but simply requiring them to do it themselves, without the benefit of automatic withholding, in the form of a monthly bill. In either case, taxpayers would become more fully acquainted with the real cost of their income tax.

Which brings up a third issue: millions of Americans owe no income tax at all, due to the 1986 tax reform and subsequent efforts (including the 2001 Bush tax cuts) to release the working poor and lower middle class from income tax altogether. Liberals have given the conservatives who pushed these policies little or no credit for them. Despite the good intentions behind them, it is not clear that they are consistent with the long-term interest of either conservatives or the nation. Because so many at the bottom have been lopped off the income tax rolls altogether, it is now much easier for liberals to stigmatize any across-the-board tax cut as unfairly favoring the rich. Those who used to pay income tax but do so no longer are now more tempted to view government largesse as a free gift. And there is the matter of justice: The Defense Department and the FBI defend the lower middle class against our nation’s enemies as vigorously as they defend anyone else, and there is no good reason the beneficiaries should be entirely exempted from contributing to the expense. There is already an Alternative Minimum Tax to prevent the "rich" from escaping without paying something; perhaps there should be a modest AMT ($50? $100?) for those at the other end of the scale. Unless the sole purpose of taxation is to redistribute income—and not even most liberals are willing to openly say that they believe it is—everyone should pay something. Unless everyone pays something at least some of the time, some will begin to lose touch with the real cost of government.

Andrew E. Busch is a Professor of Government at Claremont McKenna College and an Adjunct Fellow of the Ashbrook Center.