President's Tax Reform Panel Flunked Its Test

Two weeks ago, the President’s Advisory Panel on Federal Tax Reform issued its final report. Although our federal tax system is in dire need of restructuring and simplification, the panel’s approach is a non-starter. It proposes a lot of pain for very little again. The likelihood that it will form the basis for congressional action is virtually nil.

The panel proposed two alternative tax plans for restructuring the federal corporate and individual income tax systems. One is called the Simplified Income Tax Plan and basically keeps the income tax, while making a number of changes. The other is called the Growth and Investment Tax Plan. It is essentially a consumption-based tax system. However, the two plans have many features in common.

Among the most controversial elements in both proposals are elimination of the deduction for state and local taxes, a severe scale-back of the mortgage interest deduction and sharp limits on the exclusion for employer-provided heath insurance.

In return, the Alternative Minimum Tax would be eliminated for both corporations and businesses, and there would be a small reduction in the top income tax rate. It would fall from 35 percent on individuals today to 33 percent under the simplified plan and 30 percent under the growth plan. The corporate rate would fall from 35 percent to 31.5 percent under the former, and 30 percent under the latter.

These are extremely modest benefits in return for very substantial pain for many taxpayers — not to mention politicians. I know. I have written many articles over the years explaining why it would be desirable to do things the commission has recommended.

The mortgage interest deduction encourages families to overinvest in housing at the expense of other investments, such as stocks and bonds that would provide capital for business expansion and modernization. Ideally, we should level the playing field such that the tax code does not bias investment, so that capital can seek the best returns determined by market conditions, not the government.

The deduction for state and local taxes encourages states and localities to impose higher tax rates than would otherwise be politically tolerable. The deduction also encourages excessive consumption through local governments — providing services, such as trash collection, that could easily be done by the private sector.

The exclusion for health insurance has deeply distorted the market for health care, encouraging people to consume far more of it than they would without a de facto tax subsidy.

When I made these arguments in the past, I quickly ran into a political buzz saw. The mortgage interest deduction, for example, has deep support among homeowners who fear that its elimination would cause their home prices to fall. That is because the deduction is capitalized into home values, strongly influencing the prices people are willing to pay for houses. And the 1.2 million-member National Association of Realtors, one of the most powerful trade associations in Washington, will fight to the death to keep the mortgage interest deduction.

State and local governments will fight equally hard to keep the state and local tax deduction, fearing, rightly, that it would constitute a de facto increase in the state and local tax burden. When the Reagan administration floated this idea back in 1984, governors and mayors blanketed Capitol Hill, forcing it to withdraw this recommendation when its tax reform proposal was sent to Congress in 1985.

Needless to say, any tampering with the health insurance exclusion will bring forth massive opposition from workers, employers, insurers and health-care providers.

The only way one could even hope to begin to take on such hugely popular tax provisions would be if there were a really large payoff at the end. The prospect of a flat-rate income tax of 20 percent or so might provide such a payoff. But even with that as compensation for the lost provisions, it would be a very difficult political battle.

Unfortunately, the tax commission is offering virtually nothing in return for giving up extremely popular deductions and exclusions. We would be hardly any closer to a flat rate if its proposals were adopted than we are now. Elimination of the misguided AMT would be all to the good, but at present fewer than 3 percent of people pay it. Although the AMT is scheduled to rise in coming years, hardly any of those who will benefit from its repeal know who they are and will be greatly outnumbered by those who will suffer from the lost deductions.

In short, the tax commission proposals are deeply imbalanced politically. Therefore, there is no chance whatsoever that Congress will adopt either one. The Treasury Department and the White House may find some way to salvage a more politically attractive tax reform proposal from the commission report, but unfortunately, they have little to work with.