Lots of tax plans, but no clear solutions

Democratic approach

President Barack Obama, despite little success with Congress, has centered his tax reform proposals on closing loopholes and raising tax rates for top earners. He continues to push his plan as he ramps up his 2012 re-election campaign.

The loopholes that riddle tax legislation have long been a target for reformers. Because the tax system is overseen by politicians, over the years they’ve created thousands of such tax exemptions and credits.

Some are clearly intended to benefit generous political donors. An often-cited example is the suspension in 2004 by Congress of a duty on imported ceiling fans at a time when Sandy Springs-based Home Depot was the nation’s largest importer of ceiling fans — and was also one of the nation’s largest political donors. More recently, a wide array of loopholes allowed General Electric, whose chairman, Jeffrey Immelt, serves as an economic adviser to President Barack Obama, to escape all of its 2010 federal income tax liability.

Other loopholes have broader policy goals and wide popular support, such as the mortgage interest deduction that seeks to encourage home ownership by rewarding buyers with a big break on their income taxes. But estimates put the cost of all the various tax breaks at $1 trillion a year, and they add to the complexity of a system that is already hard to figure out because it taxes different sources of income at different rates.

Obama contends that the U.S. corporate income tax rate — high by world standards at 35 percent — could actually be lowered if enough of the business tax cuts were canceled or reduced. But eliminating more popular breaks for individual taxpayers would be far more difficult, as Obama learned when he came under a barrage of criticism in 2009 for briefly floating the idea of eliminating the deduction for charitable contributions.

Obama’s plan also calls for returning to the personal income tax rates in effect before 2001 for top earners. Ending the tax cuts Congress approved that year at the urging of President George W. Bush would raise tax rates to 36 percent from 33 percent for individual income over $200,000 and to 39.6 percent from 35 percent for family income exceeding $250,000. Estimated savings would be $700 billion over 10 years.

Republican lawmakers, the majority of whom have signed a pledge to oppose all revenues increases, are unanimous in their opposition to the plan, and some Democrats oppose it, too. They say it would penalize owners of small firms who report business income on personal income tax returns.

Flat tax

An alternative favored by many conservatives, the flat tax would radically simplify the income tax system by imposing a single, uniform rate.

The debate is not over whether the system would be simpler, but if it would be fairer.

Under the current system, income tax rates are progressive. People who make more income pay a larger share of that income in taxes — so long as the income in question is from earned sources such as wages. Income from interest and dividends is taxed at lower rates, which explains why a billionaire investor such as Warren Buffett can have a lower effective tax rate than his salary-earning secretary.

But Buffett isn’t the only one getting a break. Some 46 percent of Americans pay no income tax at all. In fact, many lower-income families qualify for the Earned Income Tax Credit that rewards them for working with refunds that often amount to more than they paid into the system.

That redistribution of wealth via the income tax is at the core of the debate over fairness. Those who believe free enterprise should be as unrestricted as possible say such wealth redistribution puts an undue burden on the rich and discourages job-creating investment.

They say the flat tax could be made more progressive by exempting people who make less than a threshhold amount, while still keeping a single tax rate.

Fair tax

Under the Fair tax, the entire basis of the federal tax system would shift to consumption instead of income. The income tax would be replaced by a hefty national sales tax, ranging to 30 percent or more, depending on how it is calculated.

There are many arguments in favor of such an approach. For one thing, it would eliminate the disparity Buffett noted — he almost certainly spends more than his secretary, so he would pay more tax. Since spending would be taxed, savings would be encouraged. And the burden of collecting the tax could be shifted to states, which already have sales taxes, getting rid of the Internal Revenue Service.

A sales tax, of course, would lean much more heavily on the poor, who by necessity spend a greater share of their income than the well-off. So people at every level would receive monthly “prebate” checks based on their annual spending and family size, distributed by the existing Social Security system.

Critics, however, say such a system would generate less revenue than the current tax structure, in part because people would find a myriad of ways to avoid paying such large sales taxes. They also contend that the monthly payment system is ripe for abuse. The result, they say, would be an enforcement nightmare — and a tax regime that would be anything but fair.

Hybrids

Atlanta businessman Cain spurred the current debate about taxes by building his campaign around a 9-9-9 tax proposal that combines elements of both the flat tax and Fair tax. It calls for a 9 percent national sales tax, a 9 percent flat income tax and a 9 percent flat tax on business income. He says it is intended as a transition to the Fair tax.

Analysts and the other Republican presidential candidates quickly pointed out that if the tax was as simple and straightforward as Cain’s original proposal, it would also be extremely regressive, taking as much from the poor and middle class as the rich, and leaving them, by comparison, much worse off.

Cain responded by proposing a 9-0-9 tax for the poor, exempting them from the income tax. But that fails to take into account the fact that the poor would still be hit hard by the sales tax. And it also leaves the middle class paying more.

There is another problem with Cain’s plan: Economists say it would generate about $500 billion less in federal revenues than the current system — though supporters contend that the economic investment it would generate would more than make up for that gap.

Perry’s plan encounters the same criticism —and even moreso because it would allow people to choose between current income tax and a 20 percent flat income tax. If people choose the plan that would most benefit them, the rich would opt for the 20 percent flat tax, the poor and many in the middle class would stay with the current system and federal revenues would plunge.

But Perry, like Cain’s supporters, argues that his plan — which would also cut the corporate income tax to 20 percent, eliminate taxes on Social Security benefits, dividends, capital gains and on estates and inheritances and keep the mortgage interest deduction — would free up billions of dollars for new investment. The result: enough revenue to offset any losses.

Where it comes from

Federal revenue comes from three main sources:

• Individual income taxes. They accounted for $956 billion, or 44 percent, of federal revenues for the 2011 fiscal year.

• Payroll taxes. Social Security, Medicare and unemployment taxes, deducted from paychecks and/or paid in part by employers, amounted to $806.8 billion, or 37 percent of the 2011 total.

• Corporate income taxes. The $198.4 billion collected from private businesses was 9 percent of the total.

• The remaining 10 percent ($213.1 billion) came from sources that include excise taxes on alcohol, cigarettes, gasoline and other commodities, import duties and miscellaneous fees.

• Altogether, federal revenues added up to $2.2 trillion for the 2011 fiscal year. But spending was $3.8 trillion. The $1.6 trillion difference is the deficit — the amount revenues fell short.

Article of faith

In the end, the debate over taxes may come down to whether voters believe that simplifying the tax code and cutting tax burdens would generate a surge in revenue that ends the post-recession doldrums and lifts all ships.

Obama, for one, doesn’t buy it. His and government economists’ insistence on an accounting that didn’t include such growth projections was one reason he was unable to reach an agreement with Republicans on tax reform last summer.

A deeper choice is implicit in differences between the Democratic and Republican approaches — a choice between government as we know it and a government that, like the conservative tax plans, is by necessity stripped down and simpler because the tax system won’t support anything more elaborate.

That choice comes back to the visions that have traditionally defined the differences between the two parties: a society where a strong central government lead the fight to limit poverty and ensure equity, or one in which government is kept to a minimum in belief that the free market, unrestrained, will generate sufficient wealth for all to moderate such social ills.

-- Bill Steiden

Sources: Wall Street Journal, POLITICO, Washington Post, Guardian, Economist, Office of Management and Budget