Make It Less Complicated to Pay Taxes

Tax-cut proposals are flying fast and furiously these days. Each of the four leading presidential contenders has endorsed some combination of income tax-rate cuts and targeted subsidies for health, education, retirement saving, small business, farmers, married couples, nonprofit institutions, seniors or research and development. Congress and the administration are floating similar ideas.

These proposals pursue worthy causes, but they will end up intensifying citizens’ frustrations because they don’t do anything to simplify the tax system. While Americans argue endlessly about whether taxes are too high and who should pay them, the one area where agreement is universal is that the system is too complex.

The resources required to keep records and file returns already cost American families an additional 10% to 20% over what they actually pay in income taxes. Yet the plans put forth by the president, Congress and the candidates represent a Faustian deal--cutting taxes by making them more complex. Special treatment of certain types of income or spending is inefficient, inequitable and the source of numerous additional problems.

Targeted tax subsidies undermine citizens’ confidence in the fairness of the system by treating similar activities differently. Subsidies that are reduced or completely phased out as income rises create complicated rules and reduce incentives to work and invest more. Although tax credits reduce payments and make the government appear smaller, this is an illusion. The intrusiveness of government is just buried in the tax code rather than displayed obviously as a spending program.

And subsidies breed demand for more subsidies. The college tax credits enacted in 1997 quickly led to calls for federal subsidies for K-12 private schooling. Can funding for home schooling be far behind? Likewise, now that withdrawals from IRAs can be made for educational spending, why not for the car to get the student to school or the computer on which homework is done? Where does it end?

Unfortunately, even simple cuts in income tax rates can create problems. The rate cuts proposed by George W. Bush, for example, could ensnare millions of taxpayers in the mind-numbing complexities of the alternative minimum tax.

We are not condemned, however, to live with ever-more complicated taxes. The key is to make fewer distinctions across economic activities and personal characteristics. Taxes should be imposed on a broad income base at lower rates that do not vary across sources of income or types of expenditure. Simplification also involves accepting rough justice rather than pursuing the futile quest for perfect equity. A simpler and sounder tax code could be found by adopting the following reforms:

* Relieve between 40 million and 50 million households of the need to file tax returns. With small changes in withholding rules, this could be done for households that do not take itemized deductions and have income only from wages, Social Security, IRAs, pensions, unemployment insurance, interest and dividends.

* Cut the top rate from 39.6% to 30% and tax capital gains as ordinary income. Lowering the top rate would raise economic activity and reduce tax avoidance. Eliminating the differential between capital gains and other income would close down a significant amount of sheltering activity.

* Raise the standard deduction significantly. This would reduce the number of households that have to itemize their deductions.

* Confine the alternative minimum tax to operators of real tax shelters by drastically raising the exemption and indexing it for inflation. Do not force people onto this tax by virtue of their personal exemptions, standard deductions or state and local taxes.

* Remove the restrictions on itemized deductions and personal exemptions that affect high-income taxpayers. These are needless complications that raise little revenue.

* Make the tax credits for children, child care, education and adoption completely refundable, so that low-income households get the full value of the credit even if their income tax liability is zero. Eliminate the phase-outs of these credits as income rises.

* Consolidate and simplify all IRAs and related plans into one account with simple and clear contribution and withdrawal rules.

These steps would simplify April 15 for millions of households. They would reduce headaches of tax filing, and make taxes fairer and more conducive to economic growth. A simpler system would provide a lasting legacy that could be shared across all economic classes, and that would constitute far more sensible reform than enshrining one more interest group’s favorite tax break into law.