Just three weeks ago The New Republic derided him as "Senator Hackwood" for his appalling sellout of tax reform. Now Finance Committee Chairman Bob Packwood seems to have heard the clarion call of "statesmanship" -- the same one heard last year by House Ways and Means Chairman Dan Rostenkowski.
Generations of psychohistorians will ponder what has been going on inside Packwood's head for the past month. First he and his committee staged a spectacular two-week orgy of special-interest giveaways (newspaper headline: "Drive to Simplify Taxes Runs Into Complications"). Then, on April 18, he announced it was back to "square one" (headline: "Tax Bill Is 'Moribund'"). Next, on April 24, he dramatically proposed the ultimate tax reform ("Packwood Would Eliminate Itemized Deductions"). The next day, April 25, he called a press conference to declare that this new plan wasn't his at all, it was just a piece of paper handed to him by some fellow he'd run into in the men's room -- actually, the staff director of the Joint Tax Committee -- and he wasn't sure whether he supported it or not ("Packwood Denies Authoring Flat Tax"). The following week he proposed his current plan ("Packwood, Tax Plan Are Born Again"), and in the wee hours of May 7 a dazed Finance Committee voted its approval.
Packwood's plan is a radical version of the basic tax-reform principle: cut out deductions and loopholes and use the saving to reduce marginal rates. Two important features of Packwood's plan that will cause the loudest protests are a rule to curtail tax shelters and an end to the special break for capital gains.
Ending the distinction between capital gains and ordinary income is a matter of both fairness and efficiency. Capital gains are three-fifths deductible, meaning that the current top capital gains tax rate is only 20 percent. By contrast the lowest tax rate on wage income, including Social Security, is 18 percent (or 23 percent if you include the employer's Social Security contribution as well). Almost half the declared income of people making more than $200,000 a year is in the form of capital gains. And most capital gains of wealthy people are never taxed at all, because of an obscure rule that measures the gain on inherited property from the moment it was inherited, rather than the moment it was purchased
But ending the capital gains differential isn't simply a matter of giving wage earners an even break. There are good "supply-side" reasons for it too. High rates aren't the only way the tax system distorts incentives and creates inefficiency. The same bad effects come from having different tax rates on different kinds of economic activity. This leads people to invest their money for tax purposes in ways that don't make true economic sense.
In the coming debate, you'll be hearing a lot of mystical mumbo-jumbo about capital gains being the seed corn of prosperity. Keep in mind that there is no metaphysical distinction between capital gains and ordinary income. In fact, thanks to the capital gains break, vast energies are devoted to turning the latter into the former. Discouraging people from making economic decisions based on tax considerations is one of the main purposes of tax reform.
Packwood's proposed rule against tax shelters will have the same healthy effect. The key to a tax shelter is generating a lot of paper "losses" and subtracting them from your real income. Packwood's bill would forbid the deduction of most passive investment "losses" except against income from that same investment. This change is expected to bring in an extra $10 billion a year. Once again, though, the point is not just fairness but efficiency. Many times $10 billion a year in capital is misdirected by tax-shelter considerations.
The magic elixir that creates phony "losses" is depreciation -- the deduction for the wearing out of business buildings and equipment. The overgenerous depreciation rules enacted as part of the 1981 Reagan tax cut created a tax-shelter explosion. These same rules have enabled many corporations to pay little or no income tax over the past few years. The House tax bill addressed both these problems directly by reforming the depreciation rules. Packwood's bill leaves depreciation intact, along with a variety of special breaks for individual industries. But it prevents individuals from abusing these rules by limiting tax shelters, and it prevents corporations from abusing them through a fairly stiff minimum tax.
To a lot of people who aren't rich, Packwood's proposed top income tax rate of 27 percent sounds pretty good. The fact that closing loopholes would bring in billions of dollars in extra revenue, even at 27 percent, shows how many rich people aren't even paying that much at present. From here on out, if anyone opposes tax reform, ask him if he paid 27 percent of his income in taxes last year. Then tell him how much you paid.