We now have a large tax cut, but little tax reform. The primary objective of the $1.35 trillion cut passed Memorial Day weekend seems to have been to maximize revenue loss rather than to minimize tax distortions and disincentives. Not only did we end up with a package containing little bang for a lot of buck, but one that disappears into the sunset after 2010. Congress will have no choice but to revisit the issue, and it had better not wait until 2009 when anxiety about future tax rules will become unsettling.
The trouble with the tax law of 2001 -- like those of 1990 and 1993 -- is that Congress had no thought of its ultimate destination. It rushed into the debate with far too many political objectives and far too few economic principles. Specifically, it avoided discussion of the two most serious questions in tax reform -- what should be taxed and how. That is, what should be the tax base and the tax rate?
When it comes to the tax base, a large and growing majority of public-finance economists agree that tax policy should move toward taxing income devoted to consumption. That means ending, or at least minimizing, today's multiple taxation of personal and corporate savings. This would include taxes on profits, dividends, interest, capital gains and estates.
Economists of all stripes also agree that high marginal tax rates are the main source of tax distortions that suffocate economic growth. On tax rates, Congress at least got the direction right, if not the magnitude and pace.
Yet most of the plan fell short. For example, suppose we counted the liberalization of tax-deferred pensions and lightened taxation of estates as steps toward alleviating overtaxation of savings. Even then, only $187.6 billion of the $1.35 trillion tax bill, or 13.9 percent, could be counted as progress toward a consumption tax base. What about marginal rates? Reduction in the highest four tax rates meant a static revenue loss of $420.6 billion over 10 years. With only 14 percent of the tax cut devoted to treating savers more fairly, and only 31 percent devoted to reducing significant marginal rates, that leaves an amazing 45 percent of the new tax cut in some miscellaneous category -- disconnected from the two fundamental goals of tax reform.
If George W. Bush truly cares about reform, he must ensure that the next phase of the tax debate is focused on enacting those few changes that would make a big improvement in the tax climate for entrepreneurs and savers while costing the Treasury little or nothing:
Estate and gift taxes: The new law on estate and gift taxation inspires no long-term confidence. Instead of reducing the tax rate to 20 percent by 2008, Congress opted to keep the tax at 45 percent through 2009, while more than tripling the exemption. The result is an inefficient tax, one that does the most damage for the least loot. Congress also opted to keep the gift tax forever, a superfluous move if it is serious about killing the estate tax. The estate tax is repealed in 2010, but only for one year. In that same year, assets would begin to be inherited at their purchase price rather than market value (carryover basis), so heirs would inherit old capital-gains tax liabilities. The bookkeeping burden alone would be horrendous. If carryover basis were maintained after 2010, when the estate tax is automatically reinstated, then heirs could end up brutally taxed on both the value of inherited assets and old gains on those assets.
Corporate income: There has been no attention paid to the corporate income tax since 1986. Treasury Secretary Paul O'Neill says he'd like to abolish the corporate tax -- heresy among politicians but not among economists. But taxing corporations as we tax partnerships would be a tough sell. In the spirit of moving close to a consumption tax base, the administration should instead push for an end to the complicated and capricious depreciation of plants and equipment. Congress has wisely allowed small businesses to write off increasing amounts for capital investments as soon as the expense is incurred. That would be equally appropriate for capital outlays by all businesses, big or small. Expenses are expenses -- not income. Expensing would lose little revenue over the longer-run, because writing off more today means less in the future, and because improved investment means a larger economy and tax base.
Capital gains: Needless complexities and distortions arise from imposing a penalty rate of 35 percent on short-term gains. There is no justification for abusing tax policy to distort the timing of asset sales. There would be no revenue loss from taxing short- and long-term gains equally. Smart investors realize short-term gains only when they have offsetting losses. But the special penalty on realizing short-term gains seriously depresses turnover and liquidity, and therefore potential tax collection on trades that don't happen.
In this year's initial tax skirmish, the Bush White House willingly closed its eyes to some of the worst abuses of good tax policy. The Senate was almost invited to dump the brunt of its alleged revenue savings on "rich" families in the 31 percent tax bracket, whose marginal rate will now dip to 28 percent rather than to 25 percent. Since the White House voiced no strong concern about reducing estate tax rates, it became vulnerable to the symbolism of a one-year repeal in 2010 at the expense of high tax rates, retention of the gift tax, and a new tax on inherited capital gains.
Serious and lasting improvement in tax policy must first begin with a clear discussion and explanation of the ideal destination. Serious and lasting political leadership must refuse changes that do not move the country toward that destination, and that have no durability.