Commentary

Dual Option

This article originally appeared in the Washington Times on April 15, 2005.

As another unpleasant April 15 is upon us, President Bush has promised the nation’s beleaguered taxpayers that serious tax reform is high on his agenda.

The president’s tax-reform panel, headed by former Sens. Connie Mack and John Breaux, has been hearing testimony about the pathologies of the current code. Tax experts are urging the panel to recommend major simplification, tax cuts on saving and reforms to make U.S. businesses more competitive in the global economy.

These goals could be accomplished by scrapping the income tax and installing the flat tax of former Majority Leader Dick Armey. But if the president’s panel is seeking a more modest reform package, a good framework is the “dual-rate income tax.” Under the dual-rate plan, virtually all deductions and credits would be eliminated, and about 95 percent of families would pay a low 15 percent tax rate. A 27 percent rate would kick in for high earners above the Social Security wage cap of $90,000. The effect would be to provide a large tax-rate cut for middle-income families. For example, the marginal tax rate on singles with taxable income between $30,000 and $72,000 would fall from 25 to 15 percent.

The dual-rate plan would promote savings and economic growth by setting the top individual tax rate on dividends, interest and capital gains to 15 percent. The corporate tax rate would be cut from 35 to 15 percent. These changes would equalize and reduce the combined top rates on income from all sources.

Other features of the plan include retention of the earned-income tax credit, expansion of the personal exemption from $3,200 to $4,500 and liberalization of individual retirement accounts.

That sounds good, but what’s the catch? The catch is that Mr. Bush wants tax reform to be revenue neutral, neither raising nor lowering overall taxes. As a consequence, there must be trade-offs. Under the dual-rate plan, individuals would get substantially reduced marginal rates, but they would give up current breaks such as the mortgage-interest deduction. This trade-off makes sense because the tax system would be simpler, it would treat people more equally and the lower tax rates would spur economic growth.

For corporations, the large tax rate cut would be partly offset by the elimination of the business-interest deduction. This step would equalize the treatment of debt and equity, and it would reduce the incentive for companies to engage in Enron-style tax sheltering.

The dual-rate plan would also eliminate other corporate breaks to make up lost revenue. But it is important to note that a corporate-rate cut would create large “dynamic feedback effects.” As global investment poured into the United States to take advantage of the 15 percent corporate rate, federal revenues would increase. Currently, the U.S. corporate tax rate is the second highest in the industrial world, prompting companies to shift their profits offshore. Reforms need to tackle tax competition head on with a corporate tax-rate cut to get those profits flowing back stateside.

During the last major tax reform in 1986, business competitiveness was not a leading concern of policymakers. Indeed, the Tax Reform Act of 1986 included numerous provisions that reduced the ability of U.S. corporations to compete. Today, improved competitiveness is a key goal of reform.

In addition to a rate cut, corporate reforms should include “expensing,” or first-year write-off of investment. Reforms should also include “territorial” treatment of international investments to make the United States an attractive location for corporate headquarters.

The president’s tax panel must complete its report on reform options by the end of July. Mr. Mack and Mr. Breaux are skilled and serious reformers, but the panel does face political and policy constraints. The dual-rate tax plan provides a middle-ground reform for the panel to consider that moves halfway to a consumption-based flat tax. The dual-rate plan would simplify the tax code, increase tax equity and spur growth by cutting the corporate tax rate.

Mr. Bush has already taken steps toward tax reform with rate cuts, IRA liberalization and temporary capital expensing. With any luck, the president will have further cemented his tax-reform legacy by next April 15.

Chris Edwards is director of tax policy studies at the Cato Institute.