Blockbuster tax reform: major proposals in Congress to overhaul the tax system will set off an extensive debate - includes related history of the income tax - Cover Story

Major proposals in Congress to overhaul the tax system will set off an extensive debate.

"My plan would make the tax system so simple that Americans could fill out their taxes on a postcard."

"We've got to tear the income-tax system out by its roots. We have to remove the Internal Revenue Service from the lives of Americans totally."

"[We] need to abolish the income-tax law of this land and substitute... an unlimited savings allowance."

Such proposals have generally come from reformers deemed out of touch with political and fiscal reality. But they are being advanced today by top elected officials with major roles in setting tax policies.

The certainty that recommendations for such fundamental change will become the center of a national debate over the next few years--the legislative firepower of their sponsors guarantees that--is an important measure of Washington's changed political environment.

The principal advocate of a flat-rate tax is Rep. Richard K. Armey, R-Texas, majority leader of the House of Representatives, whose plan is geared to a 10-line return for individual taxpayers--the postcard method of filing. He proposes a single rate of 17 percent, with capital gains and returns on savings and investments excluded from taxable income.

The call for abolishing the present income-tax system comes from Rep. Bill Archer, R-Texas, who, as chairman of the House Ways and Means Committee, is one of the most powerful individuals in government when it comes to drafting tax legislation.

The statement on behalf of replacing the current tax system with one that provides for "an unlimited savings allowance" was made by Sen. Pete V. Domenici, R-N.M., chairman of the Senate Budget Committee and one of Congress' most respected authorities on fiscal policy, and his partner in this bipartisan endeavor, Sen. Sam Nunn, D-Ga.

While the three key plans are being viewed as distinct and in some respects competitive entities, tax experts point out that all three are essentially based on consumption taxes because they favor money put into savings and investment over spending.

The prospect for serious consideration of such fundamental tax changes that have long been discussed but never accorded much chance of success reflects Washington's new reality, which stems from the sweeping Republican victories in the 1994 congressional elections.

Leadership positions and committee chairmanships were taken over by members committed to shrinking government by curbing taxes, spending, and regulation. It is not surprising, therefore, that the federal activity widely viewed as most symptomatic of intrusive government growth--the income-tax system--has become a prime target.

Business will, of course, have a major role in the debate on whether the tax system should be overhauled.

The individual proposals would affect different companies and specific industries in different ways. Some of the latter hold long-established views on some of the tax-overhaul proposals.

But the U.S. Chamber of Commerce, a business organization with a broad-based membership, says that a full-scale review of all the ramifications of alternative-tax initiatives is the appropriate response at this point. "It's clear that our current tax system has many problems, including complexity, costs to society, and the ever-larger underground economy," says the Chamber's President Richard L. Lesher. "So the Chamber is pleased that so many congressional leaders are taking the initiative to seek reform. The Chamber has formed a task force to evaluate the plans as they take shape."

Evaluation of the plans is also the approach taken by a lawmaker whose tax-policy clout equals that of the outfront sponsors of the overhaul measures. Sen. Bob Packwood, R-Ore., chairman of the Senate Finance Committee, plans to review the many competing proposals that have been advanced, but he has not taken a position on any one. Nor is he expected to do so for some time.

As chairman of the Senate's tax-writing panel, Packwood is giving priority to GOP pledges for immediate tax relief, but he has also begun a preliminary review of such proposals as the flat-rate tax and more tax-policy emphasis on investment incentives. While he was a principal author of the 1986 legislation that drastically simplified tax law, Packwood does not consider it the last word in tax reform and will include even that statute in a review of the present system, a Finance Committee source said.

Each of the major proposals will also come under increasing discussion in the business community as they are refined and their full implications, particularly for small businesses, become more apparent.

While the several proposals share the basic goals of simplification, fairness, and growth incentives, there is not likely to be a unified business position behind any individual plan anytime soon.

In fact, some of the leading proposals face the prospect of opposition from parts of the private sector.

For example, the National Association of Home Builders, in Washington, says it has "serious reservations" about a flat-rate tax that would eliminate deductions based on property ownership. The National Retail Federation, an association of retailers, in Washington, remains "adamantly opposed" to consumption-type taxes.

The crosscurrents in motion well before debate on alternative taxes demonstrate that crafting something as complex as a new tax system is no small task, either politically or fiscally, for Congress, business, individual taxpayers, and the country.

The current income-tax system will bring in total federal revenues of $1.34 trillion in this fiscal year, which runs through next Sept. 30. Of that amount, $588.4 billion, or 44 percent, will come from individual income taxes. Other revenue sources are Social Security and other insurance taxes and contributions, $484 billion, or 36 percent; corporate income taxes, $150.8 billion, or 11.2 percent; and excise taxes of $57.6 billion, or 4.3 percent. Miscellaneous revenues make up the balance.

Here is an overview of the principal proposals for an alternative tax-raising system that will be aired in this historic debate.

The Armey Plan

"A flat-rate tax," Majority Leader Armey told Nation's Business, "does everything that you want a tax code to do. It covers individuals' entire earnings--but only taxes them once. It is simple, direct, and honest. It would lower the tax burden on virtually all Americans, particularly families with children. And it would create a powerful incentive to save and invest."

Income would be determined by subtracting a personal allowance from salary, wage, and pension income. The balance would be taxed at a flat rate of 20 percent for the first two years the new system is in effect and 17 percent thereafter. Currently, the top effective rate is nearly 40 percent, and the average marginal rate is 28 percent.

Interest would be neither deductible nor taxable, resulting in a net increase in revenue collected, Armey says. He notes that more interest is deducted than taxed under the current system. The exclusion of returns on savings and investments from taxable income would also eliminate the present double taxation of that income, Armey says.

He would abolish the present withholding system, which he calls the most egregious "of all the deceptive government practices." Taxpayers would be expected to file their postcard returns monthly or quarterly to enable them to "measure the true cost of government against the benefits."

The personal allowance would be determined by filing status and the number of dependents. A married couple filing jointly would receive an allowance of $26,200; a single taxpayer, $13,100; and single head of household, $17,200. The personal allowance for each dependent (exclusive of spouse) would be $5,300. Those figures would be indexed to cost-of-living increases.

"Because of the generous exemptions," Armey says of his plan, "millions of taxpayers are taken off the rolls entirely, and middle-income Americans receive a tax cut."

Businesses would pay the 17 percent rate on the surplus of revenues over expenses. That levy would apply to corporate, partnership, professional, farm, and rental profits as well as to royalties. The tax base would be gross revenue less costs of goods, services, capital equipment, structures, land, and wages paid to employees. No deductions would be permitted for costs of fringe benefits, interest, or payments to owners. The expensing provision--full write-off of capital investments--would eliminate current depreciation schedules.

The majority leader says the initial 20 percent level would provide most Americans with a modest tax cut while limiting revenue losses. The plan would be kept revenue-neutral, he says, through spending cuts that it would also mandate.

Beyond that, the plan relies on the premise that tax cuts provide incentives for work and investments that increase incomes. "By the third year," the Armey plan says, "it will be abundantly clear that a low, simple, and neutral tax code will energize the economy and lead to greater revenue for the Treasury."

But like previous flat-rate proposals, Armey's has encountered the argument that it would be politically impossible to eliminate tax deductions related to home ownership and charitable contributions.

Armey responds that while sharp reductions in tax rates during the Reagan administration lowered the value of such deductions, home ownership and charitable giving grew because of economic growth stimulated by the tax cuts.

The idea of eliminating such deductions nevertheless remains controversial. Jay Shackford, public-affairs vice president of the National Association of Home Builders, says his organization would have "serious reservations" about eliminating mortgage-interest and property-tax deductions from the tax code. "Tax policies that encourage home ownership have produced great benefits to the nation in terms of social stability and stable neighborhoods," he says.

Because the availability of such deductions adds to the value of a home by making ownership more attractive to buyers, the economic ramifications of the abolition of such deductions would be substantial, Shackford adds.

"Of 100 million housing units in this country, some 65 million are owner-occupied," he says, noting that the latter have a combined value of $4 trillion. "For many of those owners, their equity is a form of savings, a nest egg for retirement or other purposes."

Meanwhile, Independent Sector, an association representing groups engaged in philanthropic fund-raising, says it would aggressively oppose the elimination of the deduction for charitable contributions.

Trends under various tax-law revisions suggest that "tax incentives really do make a difference," said Bob Smucker, vice president, government relations, of Independent Sector.

His association's research shows that 31 percent of charitable contributions, which now total $100 billion a year, were tax driven, he said.

A flat-rate tax on the order of the 17 percent suggested by Armey would reduce the tax incentive for contributions to 17 cents from as much as 40 cents, which current tax law results in, and cause "a substantial reduction in charitable giving," Smucker said. He added, however, that his organization would prefer retaining the charitable deduction at a lower tax rate to eliminating it.

Armey says past efforts to win congressional approval of a flat-rate tax have foundered because its advocates "weren't stubborn enough" and gave in to demands for retention of specific deductions. "Making that first exception is like introducing a virus into a computer system," he says. "Pretty soon it destroys everything."

The Archer Plan

If he succeeds in his goal of abolishing the present income-tax system, Ways and Means Chairman Archer would replace it with some form of consumption tax. He says the specifics of his plan are being developed and that he is determining "which type of design is best for the United States."

When that is done, Archer adds, he will launch the debate over alternative tax systems at congressional hearings, possibly this year.

But preservation of the present system is not among those options. "I have lost confidence that we can ever fix the income-tax system," Archer says. "We have to find a new concept." Tax-reform goals, he says, should include simplification, incentives for savings and investment, extension of tax compliance to the underground economy, and recognition of the U.S. role in a global economy where the nation "is in a competition that we must win."

"The present system fails on all of those counts," Archer says. "It seems clear to me that the only tax that can succeed in achieving those goals is some type of a broad-based consumer tax that completely and totally replaces the present system." Under the system that he envisions, "there is no tax on savings and investment. You don't pay taxes until you consume."

To aid U.S. competitiveness in world trade, Archer says, the taxes would not apply to U.S. goods being shipped for sale overseas but would affect imports destined for sale in this country. Those steps would be designed to be "GATT-legal," he says, meaning that they would be acceptable under the General Agreement on Tariffs and Trade, which sets international rules--including those involving tax policy--on trade.

While agreeing to consider a flat tax, Archer nevertheless says that he has "sort of matured" beyond that concept. "We are looking at a very different world in the next century," he says of the trade aspects of tax policy. "A flat tax cannot be waived at the border. It cannot be removed. Nor can it be charged to incoming products at the border."

His goal, he says, is a tax code "where the cost of our government can be off-loaded onto incoming foreign products when they enter this country .... If we can do that, we can build a margin of 30 to 40 percent differential between our products and foreign products." The result, Archer predicts, will be "better, higher-paying jobs for millions of Americans."

While Archer is not ready to specify what type of consumption taxes he will recommend, the two most frequently discussed are a national sales tax and a value-added tax, or VAT, which is widely used in European countries.

A sales tax, as residents of the many states using them are aware, is generally paid by the end purchaser at the retail level. Many states exclude certain basic items, such as food and prescription drugs, from the tax.

A value-added tax is assessed at each stage of the process by which raw materials are converted into products and then sold. The tax is based on the value added at each point. In computing the tax, companies along the production chain deduct the amount paid for materials from the amount for which the product was sold, paying a tax on the balance, which represents the value added.

A Congressional Budget Office report on potential new tax sources indicates that a VAT could be a source of vast new revenue. (See the chart on Page 24.)

The report estimates that a VAT levied at a relatively low 5 percent without exemptions could raise over $600 billion over the first four years it was applied, or $319 billion if food, housing, and health-care expenses are excluded from the tax.

Critics of a VAT say that its strong money-raising capability is exactly the reason it should not be considered. They say that Congress could simply notch up the rate a point or two every time it wanted more money. Archer replies that all taxes need to have limits placed on them.

The Congressional Budget Office notes that a VAT, "like any new tax ... would impose additional administrative costs on the federal government and additional compliance costs on business."

While Archer does not want to suggest that he is leaning toward a VAT as his preferred consumption tax, he says that his plan will be designed to eliminate excessive compliance costs from the tax system, not add to them.

But opposition to consumption taxes is strong just where it could be expected--in the retail sector. The National Retail Federation said in a recent letter to all members of Congress: "The retail industry has always strongly opposed any sort of consumption tax or `value-added tax' as being harmful to our industry, our 20 million employees--one in five workers in America--and our customers."

John C. Dill, the federation's senior vice president for governmental affairs, told the lawmakers that retailing is a $2 trillion industry that accounts for one-third of gross domestic product. He said that enactment of a value-added, sales, or other consumption tax "would produce massive upheaval in our economy, drastically shift the tax burden among various economic sectors and taxpayers, thereby producing `winners' and 'losers,' and would undoubtedly spawn numerous unintended consequences."

While Archer says that elimination of the present income-tax system would be a nonnegotiable prerequisite to implementation of his consumption-tax plan, an argument lodged frequently against the VAT is its potential for becoming an add-on tax, not a replacement.

The Congressional Budget Office report that cited the income potential of a VAT did so in the context of a broad menu of new revenue sources to reduce the federal deficit. The budget office noted that "a VAT might be preferable to an income-tax increase," a comment that did not rule out the prospect of having both types of taxes in effect.

The Domenici-Nunn Plan

In offering their tax-reform plan, Sens. Domenici and Nunn said in a joint statement that the current tax code "is doing a good job of discouraging savings." As a result, there are investment shortages that result in insufficient growth, stagnating incomes, and a loss of high-wage jobs, they added.

Specifics of their proposal--the Unlimited Savings Account (USA)--are still being drafted, but the sponsors have identified two major components:

Individual Taxes: Income would include wages, salaries, interest, dividends, earnings withdrawn from unincorporated businesses, proceeds from asset sales, and similar cash flow. There would be a "very generous standard deduction," probably in the range of $20,000 to $25,000 for a family of four.

The main feature of the proposal is an additional deduction for income put into savings. "That is the key," the senators say. "You save money, and you would deduct that money before you pay taxes. It is fundamentally different from what we do today."

The savings would be computed on a year-end to year-end basis. There would thus be no advantage to shifting money among various forms of savings and investment or to putting funds into savings accounts and investments with the intention of immediate withdrawal.

Deductions for home-mortgage interest and charitable contributions would be retained, and deductions would also be allowed for postsecondary tuition. The sponsors warn, however, that "there is a trade-off--the higher the number of deductions, the higher the rates."

In addition to the family allowance--the plan's equivalent of the standard deduction--lower-income taxpayers would receive a credit equal to the current Social Security tax, against the amount of income taxes due.

Business Taxes: All businesses, regardless of whether they are incorporated, would be taxed alike. After deducting expenses from gross sales, companies could further deduct the full costs of new plant and equipment--but not wages--for the year in which those expenses were incurred.

The balance would be taxed at "a low and flat rate," probably 10 percent or less. Taxing net cash flow rather than profits would be a fundamental change, the plan's sponsors say.

Businesses would also receive the credit against taxes due for their share of Social Security payroll taxes.

Products exported would not be taxed, but imports would be taxed on the same basis as products sold in this country.

Profits earned by U.S. companies overseas would not be included in their tax base, while profits of U.S.-based subsidiaries of foreign companies would be.

Although the Domenici-Nunn plan would eliminate about 75 percent of the current tax code's 700 sections, Domenici and Nunn point out that "in the final analysis, everybody pays taxes. That is not going to change. We are not offering a tax cut or tax increase. We are proposing a change in the way our democracy raises revenue."

They describe the principal message of their plan to individuals in these terms: "If you choose to defer some of your current consumption in favor of savings income for your future and the future of your children, the tax code will not penalize you for doing so."

And to business: "If you choose to invest your profits in a new machine or a new process that will help you grow and put more people to work, the tax code will help make this feasible."

While the Domenici-Nunn plan shares some key goals with the Armey and Archer proposals, it conflicts with those plans in aspects that will ensure heated debate when the question of an alternative tax system moves to center stage over the next few years.

Its call for progressive tax rates conflicts with Armey's bedrock view that a flat rate is crucial to simplicity and fairness. And the retention of some deductions in the senators' plan goes against the House majority leader's strategic view that allowing some deductions opens the door to a stampede of demands for similar protection for other tax-relief provisions.

And given the take-no-prisoners stand of Ways and Means Chairman Archer on what should be done with the IRS, he is not apt to look kindly on the Domenici-Nunn plan's claim to simplicity because "the administrative apparatus to collect the tax is already in place."

The plan will also be closely scrutinized by business owners and managers eager for tax-policy changes that encourage capital formation but who want to know more about adopting national policies specifically designed to discourage the consumption on which they rely for income and profits.

Because of the heavy agenda facing the new Congress, no sponsors of the major proposals for an alternative tax system are setting timetables or deadlines for consideration and discussion of their far-reaching proposals.

Given the vast economic, social, and political implications of fashioning a new tax system for the 21st century, tax-policy experts say that such a project could easily extend over a period of years.

Prospects are that the GOP leadership will have enough of a challenge in dealing with the complex issues on their legislative agenda while preparing for the 1996 presidential and congressional elections that will test the staying power of the party's 1994 successes.

No one involved in the issue shows any sense of urgency for immediate action, and all believe there should be a long process of grass-roots education and discussion as necessary preliminaries before the legislative process begins. That schedule is one that business generally prefers, given the tremendous impact that the various proposals would have.

The National Retail Federation sums up that approach when it tells members of Congress that while the tax code can be improved, they should approach its reform "in a manner that allows every citizen to gain a full understanding of the benefits as well as the drawbacks to any proposed change."

How The Income-Tax Burden Is Distributed*

* 1968: A 10 percent surcharge is levied on income-tax payments as the federal deficit, driven by Vietnam War costs, triples.

* Mid-1970s: "Bracket creep," a new factor in the tax system, comes into play as soaring inflation pushes millions of taxpayers into higher tax brackets even though their real income has not increased.

* 1977: Rep. Jack Kemp, R-N.Y., and Sen. William V. Roth Jr., R-Del., introduce a bill calling for a 30 percent cut in income-tax rates over three years to stimulate the economy.

* 1981: Soon after his inauguration, President Reagan calls for the largest tax cut in the nation's history. Congress essentially approves his plan, which cuts rates 25 percent over three years, indexes tax brackets for inflation, and applies the same rates to earned and unearned income.

* 1986: The top tax rate is cut to 28 percent from 50 percent, and the 14 tax brackets are reduced to two--15 and 28 percent. Application of some provisions puts some taxpayers with high--but not the highest--incomes in an effective 33 percent bracket.

* 1990: President Bush and Democratic congressional leaders agree to add a 31 percent bracket and limit many deductions. The change eliminates the 33 percent rate on one group of higher-income taxpayers but increases taxes on individuals at still higher income levels, who were paying 28 percent. The restrictions on deductions also increase tax liabilities broadly.

* 1993: At President Clinton's urging, Congress adds a 36 percent bracket. A high-income surtax results in an effective top rate of 39.6 percent. In addition, some of the 1990 deduction curbs that were scheduled to expire are made permanent.

* 1995: Taking control of Congress for the first time in 40 years, Republicans begin discussing such sweeping changes as a flat-rate tax or consumption taxes to replace the system that has evolved since approval of the 16th Amendment in 1913.

COPYRIGHT 1995 U.S. Chamber of Commerce
COPYRIGHT 2004 Gale Group