U.S. Tax Reform Needs Rate Cuts

This article appeared in the National Post on November 1, 2005.

President George Bush's tax reform panel is set to propose two interesting plans. Plan A is a simplified income tax. Plan B is a more radical consumption-based tax. Both plans have features that would reduce tax code complexity and promote growth. However, the plans are missing a crucial element of supply-side tax reform: substantial rate cuts.

First, the good news. Plan A would simplify the income tax by consolidating savings incentives and ending itemized deductions. Businesses would get simplified rules for depreciation and foreign earnings. The plan would boost growth by ending the double taxation of dividends and allowing individuals to exclude 75% of capital gains from tax.

Plan B is structured like the Steve Forbes flat tax, but it has four tax rates instead of one. A pure version of Plan B would tax just labour income at the individual level and capital income at the business level. It is "consumption-based" because individuals would not be taxed on the returns to savings and businesses would immediately write off, or expense, investments. That would be a very pro-growth tax structure.

However, responding to class warfare concerns, the panel added a 15% tax for dividends, interest and capital gains on top of the pure Plan B. With this compromise, it is not clear that the plan is much better than Plan A. However, for businesses the use of cash-flow accounting and the equal treatment of debt and equity would increase efficiency and reduce tax sheltering. And as panel members noted, business expensing would spur capital investment, increase worker productivity and raise American wages.

The bad news is that substantial tax rate cuts are missing from the proposals. Under Plan A, the top individual tax rate would be cut from 35% to 33%. Under Plan B, it wouldn't be cut at all. Under both plans, the corporate rate would be cut only modestly from 35% to 32%.

Yet if "tax reform" means anything, it means big cuts to marginal rates. The bipartisan Tax Reform Act of 1986 cut the top individual rate from 50% to 28% and the top corporate rate from 46% to 34%. The need for rate cuts is more acute today than in 1986. Reformist governments around the globe are cutting marginal rates and putting pressure on antiquated tax systems like ours. Eastern Europe is enjoying a flat tax revolution. The average corporate tax rate in the 10 European Union countries in that region is just 21%. The average rate across all 25 EU countries is 27%. The corporate rate of 32% proposed by the Bush panel doesn't pass muster in today's competitive world economy.

For individuals, both of the panel's plans have highly graduated structures with four rates. The panel rejected the principle that people should be treated equally under the law with a single tax rate, and it endorsed the highly skewed distribution of the current tax burden. Even if the panel didn't want a single rate, it should have settled on a simple two-rate structure, as in the 1986 reform.

The panel's plans include many needed fixes. They illustrate how we can make an awful federal tax code simpler and more efficient. But policy-makers should be more aggressive in responding to global trends and cutting marginal tax rates further than the tax panel has proposed.