ON TUESDAY, President Reagan will launch his long-awaited effort to sell Congress and the American people on the most extensive revision of the tax system in years. He will propose reducing tax rates sharply, closing loopholes, making the tax structure fairer to the poor and, in general, simplifying the whole system.
A thorough restructuring is certainly needed. The system has become a swamp of unfairness, complexity and inefficiency. The accumulation of credits, deductions and exclusions designed to help particular groups or advance special purposes often conflict with each other and represent no consistent policy. Only a just and efficient tax system can sustain each citizen's faith that all share fairly in the costs of maintaining a free nation.
But as we listen to the president explain his plan on national television, we ought to keep several fundamentals in mind.
First, we should have some basic guidelines for telling whether the president is really serious or is just scoring rhetorical points. By saying certain things and leaving out others, the president would be telling us that he is not really committed to overhauling the system. At that point, we might as well turn off our TV sets and write our congressmen not to waste time on the exercise.
Second, we should not dismiss the plan just because it fails to solve the problem of the deficit. All of the tax simplification plans put forward so far, including ones advanced earlier by the Treasury and congressional tax reformers, are "revenue neutral" -- that is, they would not raise any more revenues than the present system. In a time of $200 billion budget deficits, that may sound as if what is being proposed is a mere diversion. But, in fact, making significant improvements in the tax system is important even if it does not cure the deficit.
On the first point -- whether the president is serious -- we should be clear on the fact that worthwhile changes in the tax code cannot be achieved without pain. The reason is simple. One of the main goals of tax revision is to lower income tax rates. But Congress can lower rates only if it increases the pool of income that is subject to tax. That is where the pain comes in, and where we should pay very close attention Tuesday night.
For example, it will not be possible to significantly broaden the pool of income subject to taxation without taking two painful steps: 1) taxing fringe benefits, such as employer-financed health and term-life insurance, and 2) ending the deduction for state and local income taxes.
Without these two steps, no reform proposal can be taken seriously. These two tax breaks for individuals together reduce federal individual income tax revenues by a whopping $50 billion. Resistance to these changes will be powerful. The unlimited exclusion of employer-financed health insurance encourages private health insurance, and many will argue that the alternative would be more federal spending for health care.
But whatever the arguments in favor of continuing the exclusion of all fringe benefits from tax, or for allowing individuals to deduct state and local taxes, the incontrovertible fact is that without the revenues from repeal of those two personal tax breaks, meaningful cuts in tax rates will be impossible.
Among the other exclusions and deductions that individuals enjoy, only eliminating the deduction for mortgage interest would raise a comparable amount of money, and no elected official in either party is willing publicly to utter any criticism of a tax provision that helps the two- thirds of all American families who own their own homes. As for the many other tax breaks that individuals enjoy, none has a major effect on revenues.
If rates cannot be reduced, tax "simplification" cannot even begin, because nothing other than lower rates can diminish the returns from playing the tax shelter game and increase the returns from productive enterprise.
Another test of the president's commitment to tax simplification will be his approach to the ticklish matter of capital gains. Any backpedaling on the Treasury's initial proposal to tax capital gains (i.e., profits from investments in real estate, stocks, bonds, valuable art works, beef cattle and llamas) at the same rate as personal income (i.e., wages, salaries, and payments for services) would indicate that the president's zeal for tax reform is slipping.
Currently, ordinary income is taxed at a maximum rate of 50 percent, compared with 20 percent for capital gains. That sounds generous, and in many cases it is. It is essential to the overall success of tax reform that all income be subject to the same tax. Only if that is done would individuals and businesses make decisions on the bases of real returns from saving, investment, work and services -- not on the basis of tax preferences or gimmicks.
There is, however, one catch that has to be ironed out before it is fair to tax capital gains and ordinary income at the same rate. The catch is inflation. If you buy stock for $1,000, hold it for several years while prices double due to inflation, then sell it for $2,000 and pay the regular income tax on the $1,000 profit, you have not realized any real gain.
But it is a cop-out to conclude from that that the only way to go is to retain the special advantage for capital gains. The way to go is to adjust the size of the gain being taxed to account for inflation. If that kind of proposal is absent from the president's plan on Tuesday night, then the president will be throwing in the sponge on this crucial improvement in the tax system.
There is no doubt that equalizing taxes on capital gains and ordinary income taxes would be a radical step. Some critics have argued that venture capital for risky investments would dry up if capital gains were taxed like other income. But the critics have not made their case. One of the main sources of funds for new companies in recent years has been tax-exempt pension funds and institutions. Clearly, those investors put their money up for reasons other than the tax benefits. Also, indexing capital gains for inflation would in many cases lower tax burdens even if real gains were fully taxed.
They key point is that meaningful tax reform is impossible as long as gaping discrepancies exist between the tax rates imposed on different kinds of investments. More than any other provision in the tax code, the privileged treatment of capital gains encourages tax avoidance and promotes complex transactions whose only purpose is to convert fully taxable ordinary income into mostly untaxed capital gains.
Today's law provides greater rewards to clever lawyers and accountants who engage in "tax planning" than to the entrepreneur who undertakes productive investments unembellished by the tax code. The cost of such perverse incentives is reduced economic growth and lower real income than we could enjoy if taxes did not distort investment.
An additional sign of the president's commitment may be read from the emphasis he gives to something called the "minimum tax." Aside from being hellishly complicated, the minimum tax is a politically slick way of dodging the hard work of reforming each provision of the tax code.
The minimum tax "catches" mainly wealthy individuals and businesses who reduced their tax obligations by means of accelerated depreciation, depletion, capital-gains exclusions and other legal devices for tax avoidance. All the minimum tax does is to recapture some of this lost revenue if the avoiders reduce their taxes too much.
The minimum tax sounds like a good idea, but it is really a confession of failure. It says, in effect, that we are unwilling to get the system right, so let's patch it up to cover the mistakes. The minimum tax defies comprehension, and imposes an unfathomable pattern of different tax rates on different investments. It is sheer misery for eveyone but well-remunerated lawyers and accountants. The greater the amount of revenue we try to raise with the minimum tax, the worse the distortions will be.
Yet the administration and members of Congress may prefer a stiffer minimum tax to real reform. It would spare members the need to affront lobbyists by voting, for example, to tighten depreciation or capital-gains rules. How much easier it would be to vote once on something as cosmetically attractive as a minimum tax than to vote repeatedly on provisions about which few constituents, other than well-endowed potential campaign contributors, have any interest or understanding.
Given all the difficulties -- and given the administration's self-imposed ground rules for not raising taxes or redistributing the income tax burden on individuals -- is tax reform worth the effort? We strongly believe that it is.
Basic tax reform along the lines suggested by Treasury and congressmen in the last few months would make the system incomparably more fair and would be well worthwhile even though it would not solve the deficit problem. Although the tax burden would not be shifted from one income group to another, all the plans would redistribute taxes within tax brackets so that everybody was paying a fair share. People who now make little use of special deductions, credits, exclusions, and allowances would pay less tax. People who now use these provisions heavily would pay more.
Fairness is a good argument for doing painful things, such as taxing company-financed fringe benefits.
The unlimited exclusion of health- insurance premiums from personal income tax has encouraged employers of millions of workers to provide insurance so generous that it has contributed to the appallingly rapid growth of health costs.
Furthermore, the fringe-benefit system works to the advantage of the better off. When a person in the top, 50-percent tax bracket receives one dollar of tax-free, company-paid fringe benefits, it saves him 50 cents in taxes. It saves a person in a 20- percent bracket only 20 cents. In addition, millions of people fall between the cracks. Their tax rates are too low for them to get much help from the exclusion of fringes; but they are not poor enough to qualify for Medicaid or old enough to get Medicare.
Company-paid life insurance, group legal insurance, and dependent care are equally regressive.
We also believe that ending the deduction for state and local taxes would be fair and consistent with our economic system.
To be sure, there are some good arguments on the other side. Public schools, though primarily state-or locally-financed, provide benefits to the nation as a whole. So there is a case to be made for some form of national cost "sharing." Right now, this is done through the deduction of state and local taxes.
But this is a very unfair and clumsy method. It means that an individual in the 50-percent tax bracket saves 50 cents of federal tax for each dollar he pays to support his local public schools, while an individuals who pays state or local taxes, but pays no federal income tax or doesn't itemize, gets no benefit from the deduction at all.
If we want national support for local schools (or other locally-and state-provided services), a much more effective approach would be direct federal grants.
There are other weaknesses in the logic behind the present deduction. Most state and local taxes pay for services such as roads, police and fire protection. As consumers, we purchase many other goods and services for which no deduction is allowed: telephone, college educations and so on. Why should services provided by state and local governments be treated differently?
Tax reform would help do away with the large differences in tax payments by people with the same real income, a situation that is currently eroding confidence in the tax system. Moreover, it would reduce tax- related distortions in how money is invested and remove a hindrance to economic growth.
The most outrageous distortions are tax shelters. But other tax provisions, introduced out of the best of motives, have equally undesirable effects. For example, every worker can deduct from taxable income up to $2,000 per year for deposits to an Individual Retirement Account. This provision was touted as a spur to saving. But it is a sham. Anyone who borrows funds and deposits them into an IRA or who shifts funds from some other account into an IRA can get the full deduction. The principle effect is to reduce taxes for those who have sufficient assets or financial acumen to set up an account with the appropriate label.
By narrowing the pool of money that is taxed, the IRA sham necessitates higher tax rates on other income.
The current tax mess resulted from the best of motives.
From its inception in 1913, the federal income tax has accumulated one special provision after another, in order to achieve a multitude of socially and economically desirable objectives. The mortgage deduction was present at the creation. But the glory days of tax incentives began with the investment tax credit introduced in 1962 and has lasted ever since. Individually defensible, these provisions collectively are a nightmare.
The tax system now subsidizes energy conservation, legal insurance, child care, historic preservation, and a host of other activities that many people may consider meritorious, but which can also be seen as wasteful and unfair. They give most encouragement to people in the highest tax brackets, who do not require tax inducements to obtain, say, adequate life insurance. Meanwhile, they do little or nothing for those with lower incomes for whom financial assistance is important.
The result of each new deduction, exclusion, and allowance is a narrower tax base that needs higher tax rates to raise a given amount of revenue. As special provisions proliferate, the case for denying just one more break grows weaker. And as rates go up, the fervor of those seeking such tax relief gets stronger.
Redoing the tax code can bring about a drastic reduction in the number of these special provisions. A piecemeal approach won't do. The payoff to broader measures is sharply lowered tax rates. Lower rates provide people and businesses with incentives to work, invest and save on the basis of what the real economic return will be -- not on the potential tax benefit.
Certain tax incentives will remain. The mortgage-interest deduction for owner-occupied housing is sure to survive. Some concession for charitable giving must remain because the range and sensitivity of activities performed by charitable organizations are too important to jeopardize.
It is hard for the general public to sustain interest in tax matters. The subject is as dry as the Gobi Desert and equally obscure. But the struggle is of critical importance. A tax system can hobble the economy -- or it can encourge economic growth. It can undermine confidence in government by spreading suspicion that at taxpaying time one must either cheat or be cheated. Or it can leave people free to pursue activities of benefit to themselves and society.