Congress and President Reagan are stumbling toward what is clearly the right approach to income tax policy.
That approach is toward an income tax with fewer and more limited exclusions and deductions, commensurately lower rates and as much stability and simplicity as can be attained under the realities of our political process.
Our present income tax is a camel with too much straw on its back. Raising a substantial percentage of gross national product in an irregularly inflationary economy by a progressive income tax with reasonable evenhandedness and simplicity is in itself a tough job.
It is the only job we can expect the federal income tax to perform. The key to sensible tax policy is to recognize and apply this conclusion.
The history of our federal income tax demonstrates the correctness of the conclusion. Until World War II, the tax was paid only by a small percentage of the population. Paying for the war required extension of the tax to nearly everybody above the poverty line and substantial increases in tax rates.
For the next 20 years, the objective of Congress in tinkering with the tax law every few years was to make it work better in raising the needed funds in a reasonably evenhanded and simple manner. The early deductions and credits, which later came to be called "tax expenditures," were not intended when introduced to be subsidies stimulating business or individual behavior. They were simply means to define "taxable net income" correctly (for instance, allowing the deductions for state and local taxes, medical expenses and casualty losses) or to accommodate the tax to those of other countries (deferral of tax on foreign corporate income and the foreign tax credit).
Use of the income tax as an incentive began in the Kennedy administration, in response to President Kennedy's campaign promise "to get the country going again." Congress accepted his recommendation that the investment tax credit be introduced as an explicit incentive to capital investment. Unfortunately for sensible tax policy, the introduction of the credit was followed by a spurt of economic growth. The experiment seemed to work.
Other developments then combined with the apparent success of the investment tax credit to set Congress off on a 20-year binge of tax incentives. One such development was the retirement of Ways and Means Committee Chairman Wilbur Mills and the partial shift of control over tax legislation from the Joint Committee on Taxation and its staff to the Ways and Means and Senate Finance committees and their members, members' staffs and committee staffs.
All of these centers of tax initiative found irresistible the oportunity to shape public policy through the Internal Revenue Code. They perceived that public housing, relocation of businesses, older building rehabilitation, research and development, export sales, conservation of energy, group medical and legal services and a host of other national objectives could be furthered much more easily through manipulation of the Internal Revenue Code than through the cumbersome process of designing a government direct spending program and authorizing and appropriating the funds for it.
The culmination of the opportunistic use of the Internal Revenue Code to achieve public objectives other than revenue raising was the Economic Recovery Act of 1981. Stimulated by the double-digit inflation rates of that period, the two houses of Congress competed with each other to enlarge exclusions, deductions and credits to an unprecedented level.
The method Congress chose to cope with the fact that double-digit inflation erodes the real value of depreciating those assets purchased with equity capital was to expand front-loaded deductions and credits -- those that benefit the purchaser at the time of purchase.
Many capital intensive firms did not have enough taxable income to absorb these bunched benefits. Congress considered it unfair and economically unsound for companies such as IBM to get the benefit of these incentives to capital formation, while companies such as Bethlehem Steel did not. Congress cured this unfairness by yet another narrowing of the income tax base through a device called the tax benefit transfer lease.
It was intended to, and did, permit and encourage profitable companies, such as General Electric, to purchase the tax benefits of less profitable firms. What the policy makers overlooked was the fact, which should have been obvious, that an income tax policy that permits a profitable firm to pay no taxes is bound to be a tax that millions of citizens will avoid or evade by nearl any means they can find.
The fact that the "compliance gap," which is estimated at roughly $100 billion a year, represented a large share of our alarming annual federal deficit has helped restore clarity to thinking about income tax policy. TEFRA in 1982, DEFRA in 1984, and the 1986 Revenue Act -- which almost surely will be enacted -- are complex and imperfect steps back toward an income tax for revenue only.
The 1986 act will satisfy no one completely. Like its predecessors, it will be extraordinarily complex. It will bring substantial pain to the industries that have become most dependent on the tax incentives of the '60s and '70s. Withdrawal always causes pain. It is the necessary price of moving once again to an income tax whose objectives are supported by most taxpayers and tax practitioners, objectives approved by the American Bar Association in February 1985. Such a tax will have a broad base, lower rates, fewer exclusions and as much stability and simplicity as the political processes of our democracy will allow.