Forced to Use Current System as Base, Tax Reform Commission Was Crippled from the Start

"The current (federal) tax system is indefensible – it is beyond repair – it is impossibly complex, outrageously expensive, overly intrusive, economically destructive, manifestly unfair, and it severely limits economic opportunity for all Americans." Those were the words of the National Commission on Economic Growth and Tax Reform in 1996, which I was privileged to chair.

The Kemp Tax Reform Commission (of which Treasury Secretary John Snow was a valuable member) recommended to the Congress and the president that the current Internal Revenue Service code be repealed in its entirety: "It is time to replace this failed system with a new simplified tax system for the 21st century – a single low rate, taxing income only once with a generous personal exemption." Additionally, the Tax Reform Commission recommended that the new system be "sealed with a guarantee of long-term stability, requiring a two-thirds vote of the U.S. Congress to raise the rate."

The commission’s report isn’t the whole book on tax reform. It was the second chapter, following one published in 1976 by the Treasury Department under Secretary Bill Simon during the Ford administration titled "Blueprints for Tax Reform." The blueprints made two great contributions and provided a solid analytical foundation upon which the Kemp Commission based its work.

The commission elucidated the blueprints’ emphasis on defining a neutral tax base that does not tax income multiple times. Multiple layers of taxation on work, saving and investment – taxes on wealth at death piled on top of taxes on capital gains, piled on top of taxes on interest and dividends piled on top of taxes on corporate profits and taxes on wages – weaken the link between effort and reward, dry up new capital, depress productivity and kill job creation. Double, triple, quadruple and quintuple taxation of income creates a bias in favor of consumption and against thrift and risk-taking. It prevents the flow of investment to new enterprises and would-be entrepreneurs, and encourages companies to take on extra debt and not hire new workers – a huge problem for manufacturing.

The commission estimated that high marginal tax rates combined with multiple taxation of work, saving and investment act as a double-barreled shotgun aimed at the economy. Professor Dale Jorgenson of Harvard University estimates the current tax system costs the economy 15 percent to 20 percent in lost output annually. That’s why all the empirical evidence demonstrates that lower rates mean higher revenues over the long run.

A single, low rate also would be more "progressive," increasing the share of taxes paid by upper-income individuals. While steeply graduated rate schedules may look "progressive" on paper, they create disincentives to work, save and invest, which affect the rich the most. Steeply progressive tax rates raise less revenue from the rich than low, single-rate systems. Since the Bush tax-rate reductions on capital gains and dividends, the share of total taxes paid by the rich rose. Paradoxically, if you want to "soak the rich," lower the tax rates.

Now we await chapter three in the book on tax reform, the report of Bush’s Federal Advisory Panel on Tax Reform co-chaired by former Sens. Connie Mack and John Breaux. While the president instructed that reform options should increase economic growth, the panel has been handcuffed by not being allowed to take the growth effects of their recommendations into account when calculating the revenues generated by the reform, which means tax rates must be much higher than really necessary.

 One of the Advisory Panel’s recommendations is not really its own but rather the fulfillment of the president’s mandate in his executive order creating the panel to "use the federal income tax as the base for its recommended reforms." This option, by definition, fails the test of the Kemp Commission by attempting to salvage the unsalvageable, leaving in place most of the distortions in the current tax code. This option also fails to reduce the top marginal tax rate of 35 percent and maintains a steeply graduated rate structure, incentive crushers both.

I was disappointed that the panel decided to offer the president only one additional option, which the panel misnames the "Progressive Consumption Tax." It begins from one of the model tax systems explored in the blueprints – the so-called Bradford X-Tax on consumed income – but immediately distorts it by imposing an additional level of taxation on saving, investing and entrepreneurial risk-taking. It also fails the tax-rate criterion laid down by the Kemp Commission by maintaining a steeply graduated tax-rate schedule with an inordinately high top rate of 35 percent.  Even John Maynard Keynes maintained as a general principle that tax rates should not exceed 25 percent.

 Bush has said he will make tax reform a top domestic priority next year.  Before he makes a decision on which particular reform measure to send to the Congress, I hope he not only reviews the work of the Treasury blueprints, the Kemp Commission and his own Advisory Panel but also reaches beyond these sources.  I urge him to consider all the pure and hybrid tax systems identified as economically equivalent, any one of which would be vastly superior to the existing system, before making his decision.

Finally, in devising a legislative proposal to send to Capitol Hill, I hope the president resists the temptation to pre-negotiate with himself.  Compromise is an essential ingredient of the legislative process, so it is vitally important that the president provide the Congress the best possible proposal from which to begin the inevitable negotiations.