THE FINAL REPORT OF PRESIDENT Bush's Advisory Panel on Federal Tax Reform reveals a Republican party shell-shocked by the hostile reception to its Social Security reform plans and deeply ambivalent about the direction to take on tax policy. The underlying drama, rarely acknowledged, is whether the party should move away from Ronald Reagan's approach to these issues.
A broad-based, low-rate income tax was integral to Reagan's 1977 vision of a "New Republican Party . . . not limited to the country-club big-business image that, for reasons both fair and unfair, it is burdened with today." Reagan said then that he hoped to "attract more working men and women"--a goal served both by lowering rates, as in his 1981 tax cuts, and broadening the tax base, as in his 1986 loophole-eliminating reform.
But less than a decade later, the party was already moving back toward that "country-club big-business" image that Reagan so regretted. The 1995 National Commission on Economic Growth and Tax Reform, chaired by former Rep. Jack Kemp--who had convinced Reagan on the 1981 tax cuts and played a key role in the 1986 reform--and including now-Treasury Secretary John Snow, unanimously recommended shifting from a broad-based income tax to a flat tax effectively limited (over time) to labor income alone.
The current panel, chaired by Connie Mack, the former Republican senator from Florida, and John Breaux, the former Democratic senator from Louisiana, examined several approximations of the Kemp Commission's plan, but rejected these after concluding that they would violate President Bush's charge to come up with a system that raised about the same revenue as current law without greatly changing the distribution of the tax burden by income class. (A revenue-neutral 1995-style flat tax would have lowered the burden on those with incomes over $200,000 and raised it on those with incomes below that amount.)
Instead, the Mack-Breaux panel has recommended twin plans. The first would simplify the current income tax, which has acquired some 15,000 pages since the 1986 reform, without greatly changing tax rates. (Today's six brackets from 10 to 35 percent would be replaced with four brackets--15, 25, 28, and 33 percent.) The simplification would consolidate the plethora of existing personal credits and savings deductions and get rid of the Alternative Minimum Tax, enacted in 1969 to snag non-taxpaying millionaires, but expected to snag more than 50 million taxpayers in the next decade. These changes would be paid for by limiting deductions for mortgage interest, charitable deductions, and health insurance, and by eliminating the deduction for state and local taxes. On the business side, the plan would end the double taxation of corporate dividends and taxation of foreign income, simplify depreciation, and tax corporate profits at 31.5 percent.
The second proposal shares many of these features, but combines progressive tax rates on labor income (15, 25, 30), a flat rate of 15 percent on interest income, dividends, and capital gains, and a flat 30 percent rate on business cash flow (after investment in property, which is "expensed").
The initial response has been underwhelming, but in this respect, the Mack-Breaux panel resembles the Reagan 1986 reform, which was greeted with derisive laughter when the president proposed it in his 1984 State of the Union address and pronounced dead-on-arrival countless times before it finally passed. The 1995 panel's proposal, in contrast, was widely hailed at first for its simplicity, but self-destructed when Steve Forbes campaigned on it in the 1996 Republican presidential primaries and many middle-income voters discovered that any revenue-neutral version would raise their taxes.
Critically missing from the Mack-Breaux twin proposals are significant marginal tax-rate reductions, general acclaim for which in 1986 drowned out the bellows of all the gored political oxen. That reform cut the top rate (which had been 70 percent when Reagan took office) from 50 to a nominal 28 percent. As I have argued previously in these pages ("Taxes, Social Security, and the Politics of Reform," Nov. 29, 2004), there's only one easy, economically beneficial and popular way to achieve similar rate reductions today: Eliminate all remaining deductions favoring property over labor income, and tax both alike, allowing only a refundable credit based on family size (a "human maintenance" credit matching the deduction for property maintenance). When I proposed this to the Kemp Commission I calculated that the revenue-neutral tax rate under such a plan would be a flat 16 percent, but only an up-to-date Treasury estimate could confirm this.
There are two political obstacles. The first is general confusion, even among experts. On the day the Mack-Breaux panel's report was delivered, two of the panel's members, Edward P. Lazear and James M. Poterba, framed the basic choice this way in the Wall Street Journal: "Tax systems are income-based or consumption-based. Income taxes apply to labor earnings and capital income. Consumption taxes apply to spending, and they do not tax the return to saving or investment." Here is the confusion: The same analysis applies to people (so-called human capital) and to property (so-called nonhuman capital), yet the panelists would tax the investment spending or income of the first more heavily than the second, as if only property were capital and as if spending were synonymous with consumption. Even worse, because of a general failure to take seriously the issue of human capital formation, much spending on children that should properly be considered as an investment in human capital would be taxed as consumption.
The first obstacle, confusion, feeds and is fed by the second, factional ideology. As James Madison pointed out, faction is endemic to representative government, and faction depends on what we now call ideology. Ideologues are constantly vying to take over political parties, and their ideologies are fictions designed to serve the interest of a faction. Generally speaking, the Democratic party's constituents have depended disproportionately on labor income and the Republican party's disproportionately on property income. Democratic party ideology assumes that you can tax the bejeezus out of property income and yet somehow investment in property will take care of itself. The corresponding Republican ideology assumes that you can tax the bejeezus out of workers' income without reducing investment in people. I refer to this as the "Stork Theory," because it assumes that workers will just spring from out of the blue as if brought by a large stork. This theory is belied by plummeting birth rates in Europe and Japan, where labor income is heavily taxed.
The choice between taxing property and labor income equally or favoring one over the other cannot be finessed. As both Abraham Lincoln and Ronald Reagan knew in their bones, because both had switched parties themselves, the way to beat the other party is to attract, not destroy, its constituents. The recent GOP tax reform record is not inspiring, but despite the stumble on Social Security, President Bush still has three years to pick up Reagan's economic mantle. If not, it will remain on the ground waiting to be picked up by 2008 presidential candidates--from either party.
John D. Mueller is director of the economics and ethics program at the Ethics and Public Policy Center. He served as an adviser to the 1995 National Commission on Economic Growth and Tax Reform.