Tax Reform:How to Simplify the Crazy Tax Code

A growing number of economists say the U.S. needs a consumption levy that rewards thrift and enterprise and cuts down on those maddening forms

By Dan Goodgame/Washington
-- With reporting by Bernard Baumohl/ NewYork
and Elaine Shannon/Washington

(TIME, April 20, 1992) -- Americans have always hated taxes, from the Boston Tea Party to "Read my lips." But this year -- this week -- the nation's enmity carries a new emphasis. Taxpayers are angered not only by how much they pay but also by how little the other guy pays, by the sense that the system is somehow corrupt, and by the reality of just how complicated the tax codes are. A poll conducted late last month by the New York Times and cbs found that 59% of Americans considered the federal tax system to be unfair.

Their feelings are aggravated by the growing realization that despite all the talk of simplification in recent years, the laws are now more complex, not less. The last effort at tax reform, in 1986, has instead brought "more complexity, a reversal of the trend toward more progressivity . . . and a dramatic slowing in the rate of U.S. job creation," concluded a recent study by former Treasury Department tax experts Gary and Aldona Robbins.

Economists and politicians of many stripes charge that the 1986 reforms have dragged down the U.S. economy by punishing hard work, thrift and investment while encouraging Americans to borrow and spend beyond their means. Council of Economic Advisers chairman Michael Boskin argues that the 1986 law "sharply reduced incentives for investment, and we're paying a price for that in slower growth." Liberals attack the current system as both unfair and unproductive. Robert Shapiro, a domestic-policy adviser to Democratic presidential front runner Bill Clinton, charges that "our tax code has been encrusted with layer upon layer of distortions of market signals . . . It undermines the productivity of the entire economy."

No wonder Jerry Brown's proposed "flat tax" of 13% on income -- allowing deductions only for mortgage interest, rent and charitable contributions -- combined with a 13% national sales tax on goods and services has found so much resonance in the current campaign. But the Brown plan is not well thought out. It would raise taxes on the working poor, cut taxes on the wealthy and further swell the budget deficit. It is more simpleminded than simple, less a plan than a slogan.

Nevertheless, Brown may be onto something. Behind his flat tax is the basis for real American tax reform -- an idea that has been around for years but now is gaining intellectual support and public attention.

What makes sense, many economists are arguing, is to junk personal and corporate income taxes altogether for a single "direct-consumption tax" on what people spend rather than on what they earn. In some ways, a direct-consumption tax would resemble a reformulated income tax: it would be assessed by calculating an individual's total income and subtracting the amount that he or she saved and invested. All forms of income would be counted, including wages, interest, dividends, capital gains, Social Security benefits and employer-provided health insurance. The savings and investments that could be deducted might include spending on education and job training. A similar formula could be used for taxes on businesses.

Such a consumption tax would allow few deductions for individuals or companies: none, for example, for mortgage interest or business lunches. But it would end the double taxation of dividends and savings that takes place under current law, and it would enhance exports, which would be freed of U.S. taxes now incorporated into their price when sold abroad.

Ironically, Ronald Reagan's 1986 tax reform was inspired in part by a golf-course conversation with George Shultz, his Secretary of State, who praised the same 1981 consumption-tax plan, authored by Stanford economists Robert Hall and Alvin Rabushka, on which Jerry Brown claims to have (very loosely) based his current proposal. One of the most elegant consumption-tax plans was crafted even earlier, in 1977, by economist David Bradford and his Treasury tax-policy staff.

Until now, the consumption tax has never caught on politically, largely because it was considered too regressive, meaning that it was too favorable to the wealthy at the expense of other taxpayers. While that may be true for crude plans like Jerry Brown's, it is not immutable. A consumption code can be made as progressive as one wishes, by adding brackets (the 1977 Treasury plan proposed brackets of 10%, 28% and 40%) and generous exemptions (Hall-Rabushka would not tax the first $16,000 of income). A consumption tax also would tax gifts and inheritances like any other income, unlike current law, which favors the rich. And since even wealthy taxpayers spend nearly as much as they earn over the course of their lives, the consumption tax can eventually collect as much from them as would an income tax, and more efficiently. A consumption tax can -- and should, for political appeal -- be designed so that a large majority of taxpayers would pay slightly less than they do under current law, while the wealthiest would pay slightly more.

Beyond its intrinsic merits, the consumption approach would go a long way in redressing other key weaknesses in the existing tax system:

-- TIME. The IRS says it takes about 17 hours for the average family to keep records and prepare an itemized Form 1040 with a few additional schedules. But try to factor in income from a part-time business or account for taxes paid for in-home child care, and the filing time can eat up several weekends, or $1,000-plus in accountants' fees. Nearly 53 million Americans -- almost half the individuals filing income tax returns each year -- pay for help in filing.

Among them, Forbes magazine discovered, are 11 of the 12 senior members of the tax-writing committees in the House and Senate. The only member of this club who prepares his own return, Congressman Bill Archer, a Texas Republican, says he understands why so many constituents complain that "it's so expensive to get returns prepared, compared with a few years ago."

The burden on business, especially small business, is worse. Many sole proprietors find they need to buy computers or hire accountants to comply with irs record-keeping requirements for inventory. Some small businesses are required to deposit withholding taxes for their employees as often as eight times a month. One sentence in a tax instruction used by many small-business owners runs 436 words -- longer than the Gettysburg Address.

-- MONEY. The cost of all this tax paperwork is staggering. Estimates of the direct costs of tax compliance -- accountants' and lawyers' fees, time spent by individuals and businesses on record keeping and form filing -- range from $40 billion to $232 billion. The indirect costs to the economy of tax laws directing resources away from their most efficient uses are difficult to measure but are estimated to exceed the direct costs. Peter Faber, a top New York City tax lawyer who charges $400 an hour, concedes that "the whole industry of tax specialists would not exist but for the complexity of the tax code. Otherwise, we would be doing something constructive like building bridges."

-- TRUST. The complexity of the code also gives rise to public cynicism that the whole tax system is a game rigged in favor of the wealthy and powerful. Carolyn Stradley, owner of an Atlanta paving company, says, "I don't have any proof, but I'll bet I pay more taxes than Lee Iacocca," the chief executive of Chrysler. In fact, the tax reforms since 1986 -- particularly the Alternative Minimum Tax so despised in Republican circles -- have prevented most wealthy individuals from avoiding taxes altogether. But the wealthy have certainly seen their taxes diminish overall, even as taxes have risen for most Americans. Ninety percent of taxpayers pay a larger share of their income to federal taxes than they would if the tax system had not changed since 1977, while the wealthiest 10% pay much less.

Despite its advantages, a consumption-based tax system carries one crucial drawback: getting from here to there would turn the economy inside out and would require an expensive (about $25 billion, by one estimate) transition period in which to phase out such deeply rooted elements as the tax deduction for borrowing by companies and homeowners. The changeover would cause great uncertainty, which most businessmen and investors despise as much as they do high taxes. Such a sweeping revision of the tax code would be resisted most ferociously by the special interests, led by real estate and oil, who benefit from favored tax treatment under current law and who are major political contributors.

Even if adoption of a direct-consumption tax is not immediately possible, several interim reforms would relieve the current system of its worst offenses. The first would be to cut the regressive Social Security and Medicare payroll levy, which has doubled over the past decade, by at least 2 percentage points, to 13.3%. To make up for this lost revenue of about $53 billion, apply the tax to higher income brackets, or increase excise taxes on gasoline, alcohol and tobacco. Cutting the Social Security payroll tax not only would promote fairness, it would also create about a million new jobs, which is why it is supported by the conservative Heritage Foundation and the U.S. Chamber of Commerce.

In addition, the deduction for mortgage interest could immediately be capped at $20,000 a year and eliminated for second homes and vacation homes. Other tax breaks that could be phased out: the deductions for business entertainment, the exemption for inherited capital gains and the exemption of all entitlement benefits such as Social Security and Medicaid.

These reforms share a common goal of reducing the extent to which tax policy influences economic behavior. But another change would tax activities that impose costs on society: a levy on pollutants and greenhouse gases. Larry Summers, an economics professor on leave from Harvard, for example, calculates that a tax directed at halving the growth of carbon dioxide emissions would raise $16 billion a year, while increasing the price of gasoline only about 5 cents a gallon. The tax cut could raise twice as much money and still keep U.S. energy prices below those in Germany and Japan.

The revenue gained from these changes -- at least $66 billion -- could be used to further reduce tax burdens on middle-income wage earners and on the activities that the economy needs to encourage: working, saving and investing. At the end of any transition, these are goals worth the disruption.

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