Bloomberg Businessweek
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“There has been increasingly widespread dissatisfaction in the United States with the Federal tax system. Numerous special features of the current law, adopted over the years, have led to extreme complexity and have raised questions about the law’s basic fairness.” Sound familiar? Those are the opening sentences of a 1977 U.S. Treasury study, “Blueprints for Basic Tax Reform.” Sad to say, the income tax code’s complexity and basic unfairness have worsened since then.
The latest reminder is the dust-up over Mitt Romney’s 2010 tax return, which showed him to have an effective tax rate of 13.9 percent on his 2010 income of $21.6 million (and which was accompanied by an estimate of an effective rate of 15.4 percent on 2011 income of $20.9 million). Former Republican Presidential candidate Herman Cain got a lot of attention with his proposed 9-9-9 tax overhaul. Tax reform is a key change in the various blue chip proposals for reducing the long-term federal debt and deficit, such as the Dec. 1, 2010, plan from Erskine Bowles, the former Clinton chief of staff, and Alan Simpson, former Republican senator from Wyoming. President Obama joined the fray in his State of the Union address on Jan. 24, when he called for anyone with an annual income of more than $1 million to pay a minimum effective tax rate of 30 percent.
There’s good reason to throw a spotlight on capital gains—specifically, the lower tax rate on capital gains investments vs. ordinary income. Long-term capital gains (assets owned for at least a year) are taxed at 15 percent, compared with a top rate of 35 percent for wage earners. Romney’s multimillion-dollar income comes from investments, and therefore he pays the same effective tax rate as a wage earner pocketing $80,000 a year.
Why stop at capital gains? Since at least the 1930s, tax reformers have pushed for a much simpler system that is more equitable and efficient. Simplicity requires broadening the tax base by eliminating as many credits and deductions, phase-ins and phase-outs as possible. A simpler tax code is more equitable because those with equal incomes—no matter what the source—would pay the same tax. And since filling out the form would be so easy, it could be dubbed the Tax Lawyer and Accountant Unemployment Act. The political debate could then focus on how progressive to keep the system and how high rates should go to pay the government’s current and future liabilities.
Like it or not, some form of major tax change is coming over the next several years. The reason is well-known: The federal government’s dire long-term fiscal situation. The real question is what kind of tax overhaul. The major bipartisan deficit reduction plans rely on broadening the tax base. For example, both Bowles-Simpson and the Bipartisan Policy Center’s sweeping budget overhaul, sponsored by former Republican Senate Budget Committee Chairman Pete Domenici and former Clinton budget director Alice Rivlin, would tax capital gains at the same rate as ordinary income. They also want a bunch of well-known, economy-distorting tax expenditures to be eliminated or slashed.
One of those is the cherished mortgage interest deduction. It’s a classic case of government spending masquerading as a tax break to subsidize home ownership. (Yet Canada’s homeownership rate is comparable to the U.S. without the deductibility of mortgage interest). The exclusion for employer-provided health insurance is a tax expenditure that badly distorts the market for health insurance. Getting rid of these two tax breaks alone would shrink the size of government’s footprint on the ordinary household, says Daniel N. Shaviro, professor of taxation at New York University School of Law.
