How not to fix the tax code

Nobody likes taxes. And lately, no one seems to like the tax code either.

The protesters in the Occupy Wall Street movement say the rich pay too little. Calling themselves “the 99%,” they argue that repeated tax cuts for the wealthy have contributed to the growing concentration of income and assets in the hands of the few. Their concern about income inequality is shared by congressional Democrats and President Obama, who’ve called for a 5.6% surtax on those making more than $1 million a year.

Republicans, by contrast, contend that businesses and “job creators” pay too much, hindering economic growth; to spur hiring, they want to cut corporate taxes and prevent any increase in taxes on the wealthy. Meanwhile, resentment has been bubbling up online about the fact that almost half of U.S. households pay no income taxes at all (typically because they are disabled, elderly or poor, a fact rarely mentioned by those who make this complaint).

In short, the U.S. tax system is a mess that only an accountant could love. But while Obama and his GOP rivals have called for an overhaul, only one major presidential candidate, Republican Herman Cain, has offered an actual plan. His “9-9-9” proposal shines a spotlight on many of the right issues, and his rapid (if possibly temporary) rise to the top of the GOP pack forces the rest of the field to spend more time talking about tax policy instead of the usual campaign trivialities. If only his plan weren’t such a bad one.

Critics on different sides of the ideological divide disagree on who benefits from the tax system’s deficiencies, but they identify many of the same problems. One of the biggest is that the tax code is far too complex. The exemptions, credits and deductions that have accumulated over the years may have been well intentioned, but they can be expensive, their effectiveness is often questionable, and they encourage taxpayers to game the system. A related problem is that the tax code gives companies a financial incentive to move their headquarters out of the United States, park earnings overseas and borrow money instead of selling shares to investors.

Cain’s proposal would address many of those shortcomings, and it’s simple enough to be explained in a few sentences. He would replace the current tax system with a flat 9% tax on individual income, a flat 9% tax on corporate income and a new, flat 9% federal sales tax on top of existing state and local levies. (Computer game players might recognize that formula: It’s the same as in 2003’s SimCity 4, which lets players build and grow virtual towns.) The plan would eliminate capital gains, payroll and estate taxes, along with almost every tax incentive and deduction. The main exceptions would be deductions for charitable donations and for living or operating a business in a low-income area.

By radically simplifying the system, Cain’s plan would make tax laws easier to enforce and harder to evade. That’s more fair than the current system, which rewards well-off companies and individuals that can afford to invest in tax-avoidance strategies. The elimination of deductions, credits and exemptions would also broaden the tax base considerably, enabling the government to raise more revenue at lower tax rates. But there’s no impartial analysis to back up Cain’s claim that his plan would raise as much revenue as the current system, and plenty of reason to doubt that it would.

An even more fundamental problem with the proposal is that its one-rate-fits-all approach shifts the tax burden sharply from the wealthy to the middle and lower classes. The current system gradually increases the tax rate on individuals and businesses the more they earn. Moving to Cain’s formula would effectively dun those least able to pay in order to spare those at the other end of the economic ladder, in the hope that the tax cuts for high earners would translate into more jobs, faster growth and higher wages. We tried a less extreme version of that approach in President George W. Bush’s first term, and the rising tide that resulted lifted only the yachts.

Granted, a national sales tax would be less of a drag on the economy than higher income taxes. But sales taxes hit lower-income households harder than upper-income ones because the former spend a greater percentage of their income than the latter. Cain’s approach treats simplicity and progressivity as if they were mutually exclusive. They are not.

Some Republicans are balking at Cain’s proposal for a different reason: They fear that once Congress created a national sales tax, it would keep jacking up the rate higher and higher. It’s the same reason many conservatives oppose a value-added tax, which would tax sales at each step from raw materials to retail products. Such taxes can have a disproportionate impact on lower income consumers too, but if they’re applied broadly, they can generate a substantial amount of revenue even at low rates. If Congress goes the consumption-tax route, a VAT would be a better choice than a tax just on sales to consumers.

Another fatal flaw in Cain’s approach is that it would fund Social Security out of general revenues rather than continuing the dedicated funding source it has today. Not that the current approach is working perfectly; unless Congress changes the funding formula or the benefit levels, Social Security will have to cut benefits sharply in about 25 years. But because it has an independent, “off budget” revenue stream from payroll taxes, Social Security isn’t affected by the annual budget battles or partisan shifts in priorities. That layer of political insulation is too valuable to give up.

Cain says his plan is just an interim step toward replacing all federal taxes with a national sales tax. That would magnify the worst aspects of the “9-9-9” proposal, placing even more burden on low-income taxpayers for the sake of those who don’t need the help. We give Cain credit for drawing a bull’s eye around the federal tax system and its biggest problems, and forcing his GOP rivals to respond. We hope Cain’s newfound popularity will prompt the rest of the field to come up with workable ideas for overhauling the tax code, rather than just promising more tax cuts.