McCain's X-Factor

While most observers are focused on John McCain’s proposed summer gas tax holiday, they have missed a much bigger idea from GOP’s likely presidential nominee: A massive tax reform—but one that, at least as it stands now, would be a huge windfall for business.

McCain would get to reform through profound changes in the corporate income tax. His goal is a variation on a Flat Tax called the X-Tax, which was first developed by the late Princeton economist David Bradford. The tax itself is pretty simple, but its consequences are dramatic. Businesses would be taxed on the difference between their sales and their cost of goods and services. They could also deduct their labor costs, but all financial transactions would be completely excluded from the system. That means companies could no longer deduct interest payments on money they borrow to buy equipment. In the textbook version, individuals would pay tax on their wages, but not on investment income, such as dividends or capital gains.

This is sometimes called a cash-flow tax and, unlike a true flat tax, it can be built around progressive rates. Bradford, like most smart economists, understood that the rates were the least important piece of this puzzle.

McCain isn’t going for the X-Tax right away, but he’s embraced some pretty big elements. For example, he’d allow companies to expense, or immediately write off, all their capital costs. He’d also lower the corporate rate from 30 percent to 25 percent. But, at least for now, he’d still allow businesses to deduct their interest payments. This would turn companies into massive tax shelters.

When I interviewed McCain’s chief economic adviser, Doug Holtz-Eakin, at a TPC forum earlier the month, he wasn’t shy about the ultimate goal. “It would be a step towards some of the reforms we’ve seen, particularly the Bradford X-Tax,” Holz-Eakin said. The idea would be to “capture as much of the cash flow as you can at the entity level.”

Holtz-Eakin, who is nothing if not a good economist, also readily admitted the problem. “It is a huge loophole to have expensing and interest deductions,” he said. A full-blown reform plan “would require coming to terms with it.” Yet, McCain has not yet proposed ending the deduction.

McCain may be working off a playbook written years ago by former Reagan Treasury official Ernie Christian. His plan, which he dubbed Five Easy Pieces, was a step-by-step transition to a consumption tax. McCain has embraced at least two—lower rates and expensing. Another piece would eliminate individual taxes on all investment income, but so far McCain will only say that he’d keep rates low on dividends and capital gains.

Will McCain bite the bullet on the interest deduction? Holtz-Eakin knows he must, sooner or later. But don’t look for it any time soon. After all, such a trade-off would create huge winners and losers among businesses, and that’s not something a GOP presidential candidate necessarily wants to talk about. At least not until after he’s elected.