The perils of tax reform: frankly, tiny and timid is better than big and bold

National Review, Dec 13, 2004 by Ramesh Ponnuru

WHEN President Bush said that he would appoint a commission to report on tax reform in the spring, conservative hopes for a fundamental overhaul rose. Could this finally be the moment for a flat tax or a national sales tax? The answer appears to be no. Early reports suggest that the commission will look at substantial tax-policy changes, but will not scrap the code and start over.

Conservatives should be relieved, not upset. Anyone who has filed a tax return knows that there are good reasons for reform. But there are also abundant reasons for caution. Conservative enthusiasts for reform have underestimated the political risks involved. The Bush administration has acted wisely in the three tax-reform decisions it has so far made: rejecting a comprehensive, big-bang tax reform; disavowing the idea of abolishing tax preferences for homeownership and charitable giving; and placing tax reform behind Social Security on the legislative calendar. It may find itself having to lower tax-reform expectations still further in coming months.

The perils of tax reform may be judged from what happened the last two times it was on the agenda in Washington: in 1986, and then again in 1995-96. In the former year, Congress took massive strides toward simplifying the tax code. Many tax deductions were eliminated. The broadened tax base made it possible to bring down tax rates. It was a great bipartisan victory. It was also a major setback for conservatives.

Congress adopted the liberal definition of tax reform, and broadened the tax base to include things it should not have included. The treatment of saving and investment was the chief problem. Taxing income when it is made, and then also taxing the returns on any of that income, creates a bias against saving. IRAs, by shielding some of that investment income from taxation, reduce that bias. Liberal tax reformers, however, regarded IRAs as tax breaks. The 1986 reform accordingly scaled them back. It raised capital-gains taxes, too, on the related theory that low taxes on capital gains are also a nefarious tax break. And it raised taxes on business investment. For most of the subsequent two decades, conservatives have been trying to undo the policy damage wrought by those changes. By retarding the growth of the investor class, the 1986 tax reform delayed conservatism's political ascent.

When Republicans took control of Congress in 1995, they were eager to reform the tax code again, but this time on conservative terms. Many conservatives--notably Dick Armey, Steve Forbes, and Jack Kemp--supported a flat tax. The flat tax would end the bias against saving by not taxing the returns on it. In effect, it would be a tax on consumption. People in almost all income classes would be taxed at the same rate (17 percent in most plans). There would be no deductions: not for mortgage interest, not for charitable giving, not for anything. The goal was to keep the tax code, as much as possible, from influencing people's economic decisions.

A minority of conservatives, including Bill Archer, then the chairman of the House committee on taxes, wanted even more: an end to the hated IRS. Their preferred solution was a 23 percent national retail-sales tax. Like the flat tax, the sales tax would have applied a single tax rate to all taxpayers and would have ended the bias against saving. The crucial difference was administrative: A sales tax would relieve most people of the need to have any contact with the tax collector.

The guiding assumption among conservatives seemed to be that once their economists had agreed on an ideal tax plan, it would be Congress's job to pass it. But Congress did not seem eager to play this role. Nobody ever came up with a practical strategy for getting comprehensive tax reform enacted in either its flat-tax or sales-tax variety. Newt Gingrich appointed a tax-reform commission that produced an excellent analysis of the benefits that would flow from adoption of a flat tax. Nothing came of it. Congress never even voted on a flat-tax bill.

FIVE EASY PIECES

Years of getting nowhere taught conservatives the virtues of incrementalism. After George W. Bush took office, Grover Norquist, head of the tax-cutting group Americans for Tax Reform, argued that conservatives should drop the idea of legislating a flat tax all at once. Instead, he advocated five discrete steps toward the flat-tax goal: abolishing the estate tax, the capital-gains tax, and the Alternative Minimum Tax; enacting universal IRAs to shelter most saving from double taxation; and allowing businesses to deduct the full cost of their investments as soon as they make them. Supply-siders, adapting a phrase of Ernest Christian, a Republican tax lawyer in Washington, quickly dubbed the strategy "five easy pieces."

Norquist's approach is still basically correct. Conservatives have more power in Washington than they did in 1995--but they still don't have nearly enough to enact comprehensive tax reform, and trying would endanger what power they do have.