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Many Unhappy Returns
They're Cutting Taxes. What They Ought to Cut Is the Code
By John O. Fox

I'm willing to take odds that come next tax season, Americans are going to feel more angry than grateful for the 10-year, $1.35 trillion tax cut Congress approved yesterday. I'm not just talking about the money. I predict we'll be fuming over all the paperwork we'll confront next April—even more tax forms, and even more than the current 144 pages of instructions, forcing more of us into even greater dependence on expensive experts to prepare our returns.

Buckle up for a bumpy ride, folks—our monstrously complicated tax laws are about to become far more complicated.

This isn't the way we should be heading. What the tax-laws need is not more pain relief or behavioral inducements, but major surgery. They need drastic simplification. Only weeks ago, Treasury Secretary Paul O’Neill recognized this when he said: "The [tax] code today encompasses 9,500 pages of very small print. While every word . . . has some justification, in its entirety it is an abomination."

Yet a new array of special provisions awaits us over the next 10 years. Each phases in or out depending on our incomes and the years in which that, particular provision applies. And, significantly, most favor some of us over others. Annual income tax savings for average taxpayers eventually will be close to $600; for the top 1 percent; the tax savings may average about $40,000 (half income, half estate tax).

Nearly half of all income—a staggering $3 trillion last year alone—is already legally protected from tax by at least 150 exemptions, exclusions, deferrals, deductions or credits. New provisions will further fuel the widespread impression that our tax liabilities turn more on our ability to avoid taxes than on our ability to pay them, leading us to believe that, when it comes to taxes, Congress does little more than play a game of political favorites. Otherwise law-abiding citizens have reacted to this conviction in recent years by cheating on their income tax returns in historic numbers. But the consequences are even more serious because of the central role taxes play in our relationship to government. By its unwillingness to craft a tax system guided by principles Americans can understand and respect, Congress has invited our fundamental distrust. It cannot restore our faith unless it gives us a system that treats all taxpayers equitably.

The essential problem is the extent to which Congress (Democrats and Republicans alike) uses the income tax not just to raise revenue, but also to advance vast numbers of social and economic programs. Toward this end, Congress has become just as interested in protecting income from tax as in taxing it. Initially this sounds great. But if we were told the full outcome of these efforts—that is, if Congress chose to disclose who benefits and by how much from the special relief provisions, and the likely impact of special provisions on tax rates and the economy—we might do more than get mad. We might well rebel.

The truth is that all these special provisions come at a price. The math is obvious: Because so much income goes untaxed, the rest must be taxed more heavily to raise the needed revenue. And a system that combines high tax rates with so many tax-avoidance opportunities too often slows economic growth by encouraging us to act in ways that allow us to avoid taxes rather than in ways—i.e., working, saving and investing—that maximize our economic return.

I am embarrassed to admit that for the first 20 years I practiced law in Washington, specializing in tax matters, I didn't recognize the compelling case for vastly simplifying our system. Regrettably, neither did most of the tax bar. We’d been trained in the nuts and bolts of taxation at law school. In our private practices, we proudly cited code sections and cases as we guided our clients through the tax maze. Rarely did we think about the implications of the laws on the society they governed.

My ignorance did not become apparent to me until 1985, when I prepared to teach an undergraduate course at Mount Holyoke College called "Taxation and the Values of Democracy." It was then that I discovered an invaluable publication of Congress's bipartisan Joint Committee on Taxation that estimated the revenue loss from each special provision of the tax laws.

This "Estimate of Federal Tax Expenditures" documented that the collective individual income tax savings from these relief provisions (approximately $545 billion last year) far exceeds the entire nondefense, discretionary budget of the United States (about $320 billion last year). Yes, you read it right. Congress engages in much more social and economic engineering through the individual income tax laws than through the discretionary budget process. I began years of research about who benefits from these programs. I learned about their inefficiencies and inequities.

I had assumed, for example, that excluding employer-paid health insurance from taxable income effectively promoted public health; that the deduction for property taxes on our homes helped deserving communities by enabling them to levy higher taxes; and that the home mortgage interest deduction was a major factor in helping renters become homeowners. But what I discovered was quite different.

At best, the exclusion for employer-paid health insurance saves low-and moderate-income workers only 15 percent of the premium cost, the level of their tax rate. But many of these workers—the very people most in need of insurance—don't benefit at all, because their employers don't offer health insurance or offer it only to some employees. On the other hand, much of the tax exemption—an estimated $325 billion over the next five years—subsidizes handsome policies for middle managers and executives who could afford the insurance without government assistance. Economists are especially critical of this policy because it drives up the price of both health insurance and health care in general by encouraging people, particularly middle-and higher income workers, to purchase excess insurance.

Deductions for property taxes and home mortgage interest are available only to itemizers. With only 30 percent of all taxpayers itemizing, the deductions serve less than half of the homeowner population in a given year. In 2000, this favored minority saved $19 billion from property tax deductions and $55 billion from mortgage interest deductions, driving up income tax rates for renters and non-itemizers. (By comparison, HUD's total subsidies for low and moderate-income housing average about $16 billion a year.) Yet the bottom half of all taxpayers enjoyed less than 2 percent of the tax savings, while the top 1 percent received about 21 percent of the tax savings.

Moreover, because wealthier communities have a higher percentage of itemizers, most of the savings from the property tax deduction benefits these communities. And because property taxes primarily fund local schools, the deduction—which allows for higher property taxes—largely favors already privileged schools.

The mortgage interest deduction is equally disappointing; primarily helping people who could afford to acquire a home without tax relief. Because the government is picking up part of the cost, it also drives up the price of homes and probably the interest charged by lenders, thereby making its net benefit for the average homeowner questionable. And surprisingly, all of the most highly regarded major economic studies conclude that the economy would grow faster without the deduction, which draws personal savings away from business investments that would be more productive for the economy at large.

So what's the alternative? A much simpler system that would tax far more income but at far lower tax rates. Then you and I, having equal incomes and the same size families, would be more likely to pay equal taxes, regardless of the source of our income, how it is paid, or how we use it. We would have far greater confidence that if we paid our fair share, others would, too. A system like this could reduce rates to no more than 10 percent for the great majority of taxpayers and to less than 30 percent for the top 1 percent of taxpayers, without sacrificing revenue.

Such a system should make most people happy. True conservatives should prefer it for raising the necessary revenue without having Congress micromanage every imaginable economic decision. True liberals should be equally willing to dispense with Congress's constant meddling, because Congress nearly always fashions special tax relief upside down, awarding most of the tax savings to those who need it least.

People would have to recognize, however, that this simpler, low rate system would be no free lunch. It would require sharply curtailing the favored treatment of fringe benefits and itemized deductions. Gone would be opportunities to convert compensation into long-term capital gains through stock options that unfairly favor employees of publicly held corporations; to receive nearly $80,000 of wages tax free just because you live and work abroad; to earn tax-exempt interest on state and local bonds, which favor the wealthiest individuals and the wealthiest states and localities; to sell one skyscraper after another tax-free, the sport of the Donald Trumps of the world, merely because you reinvest the proceeds in more real estate; to deduct state income taxes, which discriminates against residents of states that depend instead on sales taxes; to receive special tax breaks for higher education that favor people who have the ability to save and that also drive up the price of higher education for all; or for homeowners to deduct home equity loans, which arbitrarily allow them, but not renters, to deduct interest on loans they use to buy a car or to take a vacation.

President Reagan's January 1984 initiative provided ample precedent for this alternative approach to income tax policy. Reagan called on his treasury secretary to propose "a plan. . . to simplify the entire tag code so all taxpayers, big and small, are treated more fairly." The resulting document, Tax Reform for Fairness, Simplicity, and Economic Growth," offered a remarkable blueprint for overhauling the income tax, something cynics never could have imagined. The Tax Reform Act of 1986 that followed, although far from perfect, drastically simplified the laws overall. Unfortunately, Congress has since reversed course.

Perhaps President Bush, too, may ultimately call for a tax overhaul, rather than changes at the margins. Those cynical about such a possibility might revisit the 1976 movie classic "Network," and its frustrated television anchor, who summoned viewers to open their windows and yell, "I’m mad as hell, and I'm not going to take it anymore!" One after another, viewers did, forming a memorable chorus of outrage.

If enough taxpayers get mad as hell, President Bush and Congress may listen. They might even determine to fix the "abomination," for the sake of sound fiscal policy, and the sake of our democracy.