Radical Tax Plan Is Fair and Efficient

Just three weeks ago Bob Packwood was derided as “Sen. Hackwood” for his appalling sellout of tax reform. Now the Senate Finance Committee chairman has produced an outstanding tax-reform plan that features lower rates than President Reagan’s and takes more poor people off the tax rolls than the Democratic House version.

Generations of psychohistorians will ponder what has been going on inside Packwood’s head for the past month as he weaved down the policy highway. First he and his committee staged a two-week orgy of special-interest giveaways to everyone from oil drillers to casket makers. The result would have been a tax code even more complex, unfair and inefficient than the one we have now. Then, on April 18, he withdrew that bill and announced it was back to “square one.” On April 24 he dramatically proposed a 25% top tax rate and virtually no deductions. The next day he called a press conference to declare that this new plan wasn’t his at all, it was just a piece of paper handed to him by some fellow he’d run into in the men’s room--actually, the staff director of the Joint Tax Committee--and he wasn’t sure whether he supported it or not. The following week he proposed his current plan, and the week after that a dazed Finance Committee had voted its approval.

Some say Packwood heard the clarion call of “statesmanship”--the same one heard last year by House Ways and Means Chairman Dan Rostenkowski. Some say he feared that by killing tax reform he was creating an issue for the Democrats in the fall election. (If Democrats retake the Senate, the Republican from Oregon is no longer Finance Committee chairman.) Packwood himself insists that he suddenly underwent a true intellectual conversion, from a belief in tax incentives to a belief that “we ought to get the rates as low as we can, (and) let economic efficiency guide decisions.” Whatever the motivation, we should all rally ‘round quick before he changes his mind again.

Packwood’s plan is a radical version of the basic tax-reform principle: cut out deductions and loopholes and use the savings to reduce marginal rates. It actually manages to preserve the most treasured deductions, such as the ones for mortgage interest and property taxes, while getting rates down to 15% for four-fifths of all taxpayers and 27% for the top fifth (families over $40,000 or so). The corporate rate would drop from 46% to 33%.

Packwood offers two important features that weren’t part of earlier versions: a rule to curtail tax shelters and an end to the special break for capital gains. These will cause a frenzy of high-powered protest as the bill goes to the Senate floor and then to the Senate-House conference.

Ending the distinction between capital gains and ordinary income is a matter of both fairness and efficiency. Capital gains are three-fifths deductible, meaning that the current top capital gains tax rate is only 20%. By contrast the lowest tax rate on wage income, including Social Security, is 18% (or 23% if you include the employer’s Social Security contribution). Almost half of the declared income of people making more than $200,000 a year is in the form of capital gains. And most capital gains of wealthy people are never taxed at all.

But ending the capital gains differential isn’t simply a matter of giving wage earners an even break. There are good “supply-side” reasons for it, too. High rates aren’t the only way the tax system distorts economic incentives and creates inefficiency. The same bad effects come from having different tax rates on different kinds of economic activity. This leads people to invest their money for tax purposes in ways that don’t make true economic sense.

In the coming debate, you’ll be hearing a lot of mystical mumbo jumbo about capital gains being the seed corn of prosperity. Keep in mind that there is no metaphysical distinction between capital gains and ordinary income. In fact, thanks to the capital gains break, vast energies are devoted to turning the latter into the former. Discouraging people from making economic decisions based on tax considerations is one of the main purposes of tax reform.

Packwood’s proposed rule against tax shelters will have the same healthy effect. The key to a tax shelter is to generate a lot of paper “losses” and subtract them from your real income. Packwood’s bill would forbid the deduction of most passive investment “losses” except against income from that same investment. (If you make a genuinely bad investment, you’ll still be able to deduct your full loss; you just won’t be able to deduct more than you actually lost.) This change is expected to bring in an extra $10 billion a year. Once again, though, the point is not just fairness but efficiency. Many multiples of $10 billion a year in capital is misdirected by tax-shelter considerations into wasteful investments that don’t make sense for the economy.

The magic elixir that creates phony “losses” is depreciation--the deduction for the wearing out of business buildings and equipment. The over-generous depreciation rules enacted as part of the 1981 Reagan tax cut created a tax-shelter explosion. These rules are what have enabled so many corporations to pay little or no income tax over the past few years. The House tax bill addresses both these problems directly by reforming the depreciation rules. Packwood’s bill leaves depreciation intact, along with a variety of special breaks for individual industries. But it prevents corporations from abusing them through a fairly stiff minimum tax.

The fact that shutting down tax shelters would bring in billions of dollars in extra revenue, even at 27%, shows how many rich people aren’t paying that much at present. From here on out, if anyone opposes tax reform, ask him if his top rate was less than 27% last year. Then tell him what yours was.