Putting tax code on a diet

Author: Kathleen Pender

Published: December 16, 2004

Are we to believe that George Bush is serious about tax simplification?

In the past four years, Bush, with the help of Congress, has made the Internal Revenue Code read like a stack of John le Carre novels that have been torn up and sewn back together -- randomly.

Of course, our current leaders are not the only ones who have added tonnage to the tax code.

"People were complaining about complexity in the tax code as early as 1916, three years after it was created," says Joseph Thorndike, a historian with Tax Analysts, a nonprofit publishing firm.

Bush has gathered some top business minds in Washington this week to discuss his top economic priorities, including slimming down the tax code.

He should have invited Oprah Winfrey. She could tell him a thing or two about how hard it is shed excess pounds and keep them off.

Even if Bush succeeds in streamlining taxes, they won't stay that way unless special-interest lobbyists are banished from Washington and legislators stop using tax laws to achieve social goals.

The last time Congress simplified taxes was in 1986 under Ronald Reagan.

Before that, there were 25 marginal tax brackets for individuals, topping out at 50 percent.

The Tax Reform Act of 1986 reduced the official number of brackets to just two -- 15 and 28 percent -- although there was a bubble in the middle of the tax rate schedule that effectively taxed some income at 33 percent, according to the Tax Policy Center.

All income was taxed at those two rates, eliminating the tax differential between capital gains and wages.

The act was said to be revenue-neutral because it also ended a wide range of deductions, such as sales tax, personal interest (on everything but mortgages) and most medical expenses, says Mark Luscombe, a principal tax analyst with CCH.

It also ended income averaging, removed a small exclusion for stock dividends and abolished the ability to offset passive-activity losses against other income, which killed an industry of shady tax-shelters.

Although Reagan gets most of the credit for the 1986 act, "It was definitely a bipartisan effort," says Christopher Hennessy, a finance professor at UC Berkeley.

"I think Reagan would have preferred a consumption tax. If he couldn't get it, he'd take a simplified income tax, and especially liked that it promoted rate reduction," Hennessy says.

Alas, the code didn't stay simple for long. Congress passed tax acts in 1987, 1988, 1989, 1990 and most years thereafter.

Under the first President Bush, Congress repealed the 33 percent bubble rate but created a third marginal tax rate of 31 percent, which applied only to earned income, thus restoring a tax break for capital gains. It also began phasing out personal exemptions and itemized deductions for high-income taxpayers.

President Bill Clinton signed laws that added two more tax brackets, 36 and 39.6 percent, and created a host of new credits and deductions for education, children and adoptive parents.

In 2001, 2002 and 2003, the present President Bush pushed through laws that slashed marginal rates, added a 10 percent bracket, expanded tax breaks for college and retirement savings, and reduced taxes on dividends, capital gains and estates.

Because there is not enough money to pay for these tax cuts, they all expire after a varying number of years and carry phase-in and phase-out provisions and income limitations that have made taxes far more complex than they were after the 1986 reform.

And by failing to update the alternative minimum tax, Congress is forcing more and more Americans to compute their taxes under two separate systems.

Bush's sudden interest in tax simplification is puzzling when you consider that less than two months ago, he signed the American Jobs Creation Act of 2004, an early Christmas present for corporate America that Sen. John McCain, R-Ariz., called "the worst example of the influence of the special interests I have ever seen."

The 650-page act brings back things like income averaging, but only for fishermen (farmers got it back a while ago), and the sales-tax deduction, but only as an alternative to the deduction for state income tax.

"So much of the tax code is a result of people trying to get special treatment in Washington and Congress trying to do social engineering through the tax code. Why should we be promoting education savings and retirement savings through the tax code? It's supposed to be a revenue-raising tool," says Luscombe.

Some suspect Bush is using tax simplification as a front to get his tax cuts made permanent and move toward a system that taxes only consumption, not savings.

"It's hard not to be in favor of tax simplification. It's like being in favor of mom and apple pie," says Thorndike. "I'm skeptical (that) it's the principal motivation" behind Bush's tax-reform proposals.

Whatever the reason, achieving simplification won't be simple.

"The smart money would bet against tax reform, but the smart money bet against it in 1986," says Michael Graetz, a tax historian and professor at Yale Law School.

Graetz says Reagan achieved success "by having a clear proposal, exerting presidential leadership and obtaining important bipartisan support in Congress. "

If Bush is going to get "real simplification, he is going to have to have each of those elements," Graetz adds.

He says Bush does not have a clear proposal yet, but "he could get there."

Graetz has proposed exempting families earning less than $100,000 from income taxes, thereby eliminating 100 million out of 135 million tax returns.

People making more than $100,000 would pay a flat rate of 25 percent, but could deduct charitable contributions and mortgage interest. He would make up for lost tax revenues with a value-added tax levied on goods as they go through the manufacturing and sales process.

"You have got to get most people out of the income tax if you want to have any hope of keeping it simple," he says. "If not, the incentive to give a tax deduction for this or that is just too big to resist."

Knowing that simplification is not likely to stick, is it even worth trying?

Thorndike says yes.

"When April comes around, you will straighten up your closet even though you know 14 months later it will be a nightmare. But if you never straightened it up, it would be an even bigger mess," he says. By the same token, "It's a necessary task every once in a while to clean up the tax code."