Drawing the Lines on Tax Reform

By Ed Magnuson

Whatever the plan, there are sure to be big winners and losers

On the surface, reform of the federal income tax, which has been debated for decades, would seem to be an idea whose time has finally arrived. The demand for change has been fueled by public indignation over reports that such highly profitable corporate giants as General Electric, Boeing, Dow Chemical and Transamerica have paid no tax at all in some recent years. There is widespread discontent over tax shelters that have brought investors $2 or $3 in write-offs for every $1 invested. The underground economy, which deals in cash transactions that leave no paper trail, permits its participants to evade some $100 billion in taxes a year and maybe more. Individuals and corporations spend billions annually for expert help on how to find loopholes and fill out complex tax forms. Responding to claims that all this is inequitable, President Reagan last January ordered the Treasury Department to "simplify the entire tax code, so all taxpayers, big and small, are treated more fairly."

Who can argue against a simpler and fairer tax, especially when the suggested reforms sound so appealing? More than 20 bills were introduced in the past Congress to remedy the situation, and the most prominent ones advocated a modified flat tax. Under most of these plans, deductions for the interest on home mortgages and donations to charities would be retained, but most others would be jettisoned, and tax rates would be lowered sharply. Where there are now 16 tax brackets ranging up to 50%, the major congressional plans suggest three at most, with the highest at 30%. The Treasury report, which will be given to the President next month, is expected to lean toward some such modified flat tax. Like most of the proposals, the Treasury plan presumably will be "revenue neutral"; it will net the Government the same amount of money as does the existing tax. Reagan recently repeated his campaign pledge that tax reform would be used as a disguised tax hike "only over my dead body."

Lower rates, no tax hike for anyone and no loss to the Treasury? It all appears to be a mirage. And it is. Even though Congress is not in session, lobbyists are already calling on staff experts and members of key tax-writing committees to press arguments against eliminating special-benefit tax breaks. Business interests are gearing up for an assault against reform on the logical assumption that they might have to pay more in taxes. Indeed, the realization is dawning that millions of Americans will have to pay more under any reform plan that could be passed by Congress. Even Indiana Republican Senator Richard Lugar contended that the President "misspoke" in declaring that no one would pay more. A common estimate is that nearly a third of all taxpayers will end up losers in the complicated game of whose tax break should be protected and whose taken away.

Two competing congressional tax plans illustrate the clash of various groups. A Democratic bill sponsored by New Jersey Senator Bill Bradley and Missouri Congressman Richard Gephardt is called the Fair Tax Act. A Republican proposal termed the Fair and Simple Tax Act is advocated by Wisconsin Senator Robert Kasten and New York Congressman Jack Kemp. The basic approaches:

Bradley-Gephardt. There would be three tax brackets, 14%, 26% and 30%, thus retaining the progressivity principle and avoiding the charge that a single flat rate is unfair to low-income earners, who spend a larger share of their income on such necessities as food, clothing and shelter. Four major tax breaks would be dropped: the deduction for state and local sales taxes; the special treatment of profits from capital gains, which now permits taxpayers in the highest tax bracket to shell out only 20% (capital gains would be taxed at the payers' regular rate); the exclusion from taxes of fringe benefits provided by employers to their workers (including life insurance and health and child care); and the deduction for interest paid on purchases of consumer goods. Deductions for home-mortgage interest, medical costs, charitable donations and state and local taxes on property and income would be retained but could be taken off at only the lowest (14%) tax rate. Corporations would have their top rate reduced from 46% to 30% but would lose such advantages as the credit for investments in new plant and equipment and accelerated depreciation of such property.

Overall, Bradley estimates, 70% of taxpayers would pay either the same as or less than they do at present. Roughly 80% of individuals would pay the 14% rate, which includes anyone with a gross income up to $25,000 ($40,000 on joint returns). A family of four would pay no tax if it earned $11,200 or less. Taxpayers who would be hit hard would include those who now have large deductions or who stand to benefit substantially from current capital gains rates. People living in cities where sales taxes are high, such as New York, Washington and Seattle, would be pinched. The changes in corporate taxes would benefit service industries, while hindering those that require expensive plant facilities to compete effectively.

Kemp-Kasten. A single rate of 25% would be in effect for individuals, but this would be modified for most workers by exempting 20% of all income from wages (up to a maximum of $39,600). The exemption of $ 1,000 for each dependent would be doubled, which would benefit large families. There would be no deductions for any state or local taxes except on property, but other common deductions would be retained. The maximum tax on capital gains would rise gradually over ten years to 25%. The corporate tax rate, as in Bradley-Gephardt, would be 30%. Accelerated depreciation would be kept, but the investment credit would be dropped.

While this plan generally would be more favorable to business than the Democratic proposal, it would be a shade more beneficial to the poor, exempting a family of four earning less than $14,375 from paying any tax. Both plans would protect Individual Retirement Accounts from taxation until the funds were withdrawn. But while Kemp-Kasten would provide for the indexing of its exemptions and deductions to inflation, Bradley-Gephardt would not. Sponsors of both plans say there would be no net gain in revenue for the Government nor any redistribution of the tax burden among income groups.

Irving Kristol, a senior fellow at the conservative American Enterprise Institute, arguing that the two proposals are close in intent and substance, urged the President last week to call the four legislators to the White House to hammer out a compromise. No one expects that to happen, however, since the Treasury Department will be pushing its own plan. Beyond that, even the seemingly minor differences in the bills loom very large when viewed from the perspective of those who would be hurt. The tax credit for new investments, for example, is worth some $29 billion a year to corporations; they see it as vital to a sustained recovery and would wage a fierce fight to keep it. Business also enjoys some $19 billion annually in tax gains from accelerated depreciation schedules. The total tax breaks for business under the current code will amount to $95 billion this year. Most of them were designed as incentives to encourage economic growth, modernize plants and in the end provide more jobs. Critics argue that many deductions either did not serve their purpose or are no longer needed.

Individuals benefit even more under the various tax credits, deductions and exclusions that were created to promote social and economic goals, such as home ownership and income after retirement. In all, these losses to the Treasury will amount to some $270 billion this year. The biggest single break is the deduction from income of company contributions to retirement plans, which gives workers a temporarily tax-free annual benefit of $53 billion. Retirement income is taxed when workers begin drawing it, but by then they are normally in a lower tax bracket. Home mortgage deductions amount to $25 billion annually, state and local taxes $22 billion, charitable contributions $13 billion. Many of these tax benefits are so widely accepted that a true flat tax seems impossible to enact. Even modifying any of the existing provisions is certain to stir resistance from those who would be hurt. For the individual taxpayer, notes retiring New York Congressman Barber Conable, "if the bottom line is that his taxes went up, that is not reform. That is fraud."

While the modified flat tax is favored by Secretary of the Treasury Donald Regan, the political obstacles are so great that other options may have to be weighed. The Treasury study is also expected to give the President the pros and cons of both a national sales tax and a value-added tax (similar to a sales tax but levied at each stage of a product's development and distribution).

In the end, many lobbyists contend, Congress will lack the stomach to attempt true reform unless a genuine crisis is perceived. Some see the huge deficit as that crisis and the need for Government revenue as a spur to help solve the problem. Contends Tax Lobbyist Charls Walker, a former Treasury official: "Fundamental tax reform can only be passed as part of a major deficit-reduction package. A revenue-neutral plan has no chance." That view could prove too gloomy, but if tax reform is to have a chance, the President will soon have to take the lead--and the heat.

--By Ed Magnuson.

Reported by Gisela Bolte/Washington

With reporting by Gisela Bolte