The recent legislative budget crisis demonstrated again that Congress has an unfortunate appetite for an irrational tax system.
The watershed Tax Reform Act of 1986 simplified the tax system in two important ways: by eliminating certain separate categories of favored income -- e.g., a lower capital gains rate -- and by devaluing both non-taxable income and deductions through drastically lowered rates.
When the top bracket rate was 50 percent, each $100 of deductible expense saved the well-to-do taxpayer $50 in taxes. Similarly, each $100 in tax-exempt income from a state or a municipal bond, or from Social Security benefits, saved $50 in federal income taxes. Now, with the average rate for the wealthy reset at 31 percent, the tax savings to these individuals from deductions, tax shelters and tax-exempt income are substantially reduced.
Thus, while it is a politically popular notion, the simplistic proposal to "soak the rich" with higher tax rates would, if enacted, perversely raise the value of deductions and tax-exempt income. If the goal of Congress is to raise more revenue from the wealthier segments of our population, a more direct method would be to reduce deductions.
Unfortunately, the policy makers, along with those who attempt to influence policy, are fixated on rates applied to those in upper brackets of income instead of on the more crucial amount of tax collected from them. In part, this fixation reflects ideological expediency -- a rate of tax is an easy thing to both discuss and understand. The proponents of higher rates are joined by those whose self-interest is best served by maintaining or even increasing certain deductions. Among these are charities, the home building and finance industries, issuers of tax-exempt bonds and high taxing states.
If instead of raising rates, deductions (except for investment expenses) were eliminated or substantially reduced, the resultant increase in taxes collected would be very large -- large enough to permit the rates for all taxpayers, except the wealthiest, to be reduced. A Lewis Carroll would then be able to brag that the deficit is being reduced while tax rates are being cut.
Moreover, fairness would be enhanced by this approach, as a strong decrease in the amount of deductions for those with higher incomes would bring more progressivity to the system, while at the same time achieving the desirable goal of simplification.
The high level of Social Security taxes, currently levied on annual wages up to $51,300, is deemed to be unfair by many. At best, these taxes are viewed as a form of forced savings. At worst, they are seen as severely regressive. It is not widely recognized that a substantial portion of these taxes is needed to fund the individual employee's future retirement and medical expenses.
Effective in 1991, the Social Security wage base will roll forward to $53,400, while the overall rate (apportioned at 6.2 percent for retirement and 1.45 percent for medical coverage) will stay at 7.65 percent. However, a major change in Medicare payroll taxes has been introduced in the recent tax bill: the Medicare tax base will increase from $53,400 to $125,000, with no change in the rate of 1.45 percent.
A perception of fairness could be achieved and needed revenue could be raised if a one percent social benefits tax were imposed on compensation (wages, bonuses, stock options and personal service income from partnerships and Subchapter S Corporations) in excess of $125,000.
If a corporation executive, an entertainer or a partner in a law firm earned, say, $225,000, a one percent tax on the amount over $125,000 would equal $1,000. This is not an onerous sum and, if set aside for appropriate social causes such as health care, would almost surely add to the common good.
The deficit problem is still with us. It will not be resolved without increasing revenues. Relatively simple steps such as those outlined here could yield the double benefit of raising needed revenue and soothing the inflammatory commentary that has made the budget process so difficult.
The writer is vice president of The Washington Post Co.