Tax tinkering time-honored, not always successful

Author: Jonathan Wegner

Published: February 13, 2005

Whereas President Bush has talked about his plans to simplify the tax code, Clyde Kramer can actually show you what a simpler tax code looks like.

Clyde Kramer said the IRS instruction booklet has grown from 18 pages in 1966 to 128 pages this year.

Kramer, 71, has 40 years of tax returns squirreled away in a box simply labeled "Past Years."

"I just decided to save them. I thought I'd sit down someday and see how things have changed," he said.

They've changed a lot, Kramer said. He held up his rather flimsy, yellowed 1966 return as a good, albeit musty, example of tax simplicity. The instruction booklet that year ran just 18 pages, a full 110 pages shorter than the instructions for this year's returns.

"That's where you're at in 2004."

The hefty 2004 tax booklet dwarfs the relatively streamlined packets of the 1960s, but Kramer said he knows that the powerful nostalgia for simplicity is powerless against lobbyists and Congress.

His is an opinion seconded by many tax historians.

"Even if in a fit of madness they pass the flattest of flat taxes, the political imperative will always drive the members of Congress to change it," said Joe Thorndike, a historian with Tax Analysts, a nonprofit tax advocacy group in Arlington, Va.

Calls for simplification began in 1916, three years after the income tax was created to fund World War I, Thorndike said. By 1926, the first commission to discuss simplification of the tax code had been assembled.

Thorndike believes the complexity of the tax code is an inevitable consequence of America's complex society.

That's also why he thinks recent calls by the Bush administration for tax simplification are red herrings. The Bush administration's proposed incremental tax changes would do little to simplify the system, Thorndike said.

"It may be much more about pursuing other ends, like moving toward a consumption tax."

From Donald Duck to AMT

During World War II, the Treasury Department asked Walt Disney to produce "The New Spirit," a propaganda film that promoted paying the new "victory tax," the nation's first broad-based income tax.

In the short film, a radio announcer asks Donald Duck whether he will do his part for victory by paying his taxes on time.

As the film shows American factories churning out giant guns and menacing bombers, the narrator booms, "Taxes to bury the Axis! Taxes to sink the Axis!"

An enthusiastic Donald Duck chimes in, "Taxes to beat the Axis!" He fills out his 1040 and writes a check, which he hand-delivers in a dash from Hollywood to Washington, D.C.

The cartoon helped encourage millions of Americans to feel patriotic in joining Donald to pay income taxes for the first time. Previously, only about 15 percent of Americans had been subject to income tax.

New laws in 1942 and 1943 made income tax withholding mandatory and transformed the income tax from "a class tax to a mass tax," said Steven Bank, a University of California-Los Angeles law professor and tax expert.

Income taxes originally were intended to fund the war, but when the conflict ended, politicians found it difficult to wean themselves from the new revenue. Moreover, Americans had grown accustomed to paying the tax.

However, the Disney-inspired enthusiasm for paying the tax waned. Blank said politicians quickly discovered the political expediency of creating deductions, credits and loopholes, especially as tax rates remained extremely high (the top bracket in 1964 was 91 percent) following the war.

"They couldn't save the system from themselves," he said. "Congress was enacting credits and deductions all over the place, and at the end of the day, you have a lot of wealthy people taking advantage of it."

A 1969 congressional hearing revealed that 155 Americans with incomes in excess of $200,000 had paid no income taxes.

Congress received more letters that year about those untaxed Americans than about the Vietnam War. It spurred the creation of the Alternative Minimum Tax, a parallel tax system intended to ensure the wealthy paid some income tax.

The AMT has since become an albatross itself, Thorndike said.

The AMT excludes many of the deductions and exemptions that lower taxes for middle-income earners. It taxes at rates of 26 percent to 28 percent and requires computing your taxes twice.

In 1970, about 19,000 taxpayers were subject to the tax. Because the AMT hasn't been adjusted for inflation over the years, it could ensnare 36 million taxpayers by 2010 if left unchanged, according to the Tax Policy Center, a nonpartisan think tank.

The 2001 Bush tax cuts made it more likely that middle-income families would be subject to the AMT. That means the cost of eliminating the AMT has tripled from $47 billion to $141 billion, the amount that it produced in taxes for 2003, according to the Tax Policy Center.

By 2008, eliminating the AMT would cost the government more in revenues than eliminating the traditional income tax, according to the Tax Policy Center.

Some believe the traditional conditions for major changes to the tax code - moral outrage or total war - simply do not exist now, Bank said.

However, Eugene Steuerle, a tax expert at the nonpartisan Urban Institute think tank, believes the AMT may soon become "a juggernaut" so burdensome to millions of taxpayers that public outcries will force politicians to make major changes.

"We often get reform when the political price for not acting becomes greater than the political price for acting," he said.

Tax cuts and simplification

The tax code grew more complicated in the 1970s. Loopholes in the system led to the extensive use of tax shelters by high-income individuals.

"You had doctors owning chinchilla farms, dentists owning jets for tax losses, just lots of crazy things. You couldn't be a professional and not feel like a chump without participating in some of these shelters," Bank said.

Top tax rates hovered at 70 percent for much of the 1970s. President Reagan pushed Congress to slash the top tax rate to 38.5 percent in 1986 in what became known as his supply-side tax cuts.

However, Reagan also expanded the tax base by eliminating many popular exemptions and exclusions. It was a significant simplification, Bank said.

Some of the changes hurt people like Clyde Kramer. He pointed out that formerly a taxpayer had to spend only 1 percent of his adjusted gross income on prescription drugs to deduct the expenses. Now he must spend 7.5 percent of his income to qualify. He said he and many aging Americans would benefit from such deductions now as medical costs rise.

He also noted a complicated feature known as "income averaging" that saved him $200 in taxes in 1978, although it took almost half an hour just to figure out how to compute it.

"They make you work for it," he said.

Tax experts question whether it is the right time - especially given a federal deficit hovering around $400 million - for Bush to press to make his tax cuts permanent and to push through additional tax reforms.

"You have this dilemma, one side wanting to build in expenditure increases and one side wanting to build in tax cuts. It's almost like a game of chicken," Steuerle said.

He continued, "Since 1997, Congress has done nothing but identify winners in the tax system, whether it's the drug bill, farm credits or tax cuts. The agenda has turned toward deficit reduction and structural reform. Those items identify losers, (the people who are) going to pay for government."

Thorndike said proposals like the child tax credit and elimination of the marriage penalty already have found broad support, but provisions like the elimination of the estate tax and the lower rate on dividends are likely to be vigorously fought across party lines, Thorndike said.

Savings accounts

Today, Americans can save in several accounts that offer tax-deferred or tax-free growth on investments for education, retirement and medical expenses.

These include 401(k)s, 403(b)s, traditional and Roth individual retirement accounts, 529 college saving plans, Coverdell education savings accounts and health savings accounts.

Each has a different goal and features different rules and incentives for deposits and different penalties for early withdrawals.

Bush has proposed consolidating these plans into one major lifetime savings account that families could invest in and withdraw from at their discretion.

It appeals to taxpayers because it simplifies their planning for health care, retirement and education expenses; politicians like it because it would likely accelerate tax revenues as families pay taxes to transfer dollars from traditional IRAs and 401(k)s, Bank said.

"It will be sold as a simplification effort, but it's a little bit of a Trojan horse. By inducing people who weren't going to pay tax until their 70s, by inducing them to pay right now, it's really a device that helps pay for some of the other things," he said.

Tax changes

Most major changes to the U.S. income tax system:

1862: Congress implements first income tax to fund the Civil War. Top rate is 5 percent.

1872: Income tax eliminated.

1913: Income tax for high earners instituted to fund World War I. Top rates peak at 77 percent.

1942: Tax base expanded to include middle-class workers to fund WWII.

1943: Tax withholding made mandatory.

1964: Top income tax rate peaks at 91 percent.

1969: Congressional hearing reveals that 155 wealthy individuals paid no income tax. Alternative Minimum Tax implemented for individuals earning more than $200,000.

1986: Tax Reform Act of 1986 simplifies tax code by reducing number of brackets, tax rates, exemptions and deductions. Top rate cut to 38.5 percent.

2001: Congress implements temporary tax cuts, some of which have been extended to 2013.

More to come?

President Bush has appointed a commission to recommend changes to the tax code. His three main objectives:

? Reform or eliminate the Alternative Minimum Tax.

? Make the tax cuts passed in his first administration permanent.

? Create lifetime savings accounts that allow penalty-free withdrawals but otherwise work like Roth IRAs, shielding capital gains and dividends from taxation.