Tax reform has been the Holy Grail of conservative economists since the early 1990s. But after years of conservative ascendance in Washington, the tax code remains a mess.
Two major problems plague the flat tax, the retail sales tax, and other "big bang" tax reforms. First, utopianism. Ending the mortgage interest deduction might make perfect sense on a blackboard. But putting at risk the most valuable asset many taxpayers have is the equivalent of policy making suicide.
Second, many free market economists treat families as an after-thought. As far as they are concerned, the tax code should be "neutral" about raising children. In effect, they say the U.S. government should be indifferent to whether the people that created it exist in the future. What these experts fail to recognize is that Social Security and Medicare have created a huge fiscal bias against raising children, "crowding out" the traditional motive to raise children to protect against old-age poverty, a bias that would exist even in a mandatory saving program.
We suggest a different approach to tax reform, one that achieves the major conservative policy goals of a simple, flatter, and fairer tax-and can be enacted with broad bipartisan support. The proposal would simplify the tax code-no more itemizing, no more alternative minimum tax-cut marginal tax rates on capital investment and high-income labor (the activities most sensitive to marginal rates), reduce the tax burden on the middle class and below, treat married couples as equal partners, and offset the anti-parent bias in Social Security and Medicare.
Rather than re-creating the tax code from scratch or imposing new taxes, we would make the following changes to the existing code.
First, remove impediments to capital investment. Cut the corporate tax rate to 32 percent and make cash dividends fully deductible at the corporate level (taxable as regular income for individuals). Reduce the corporate tax rate-currently the second highest in the industrialized world-to encourage equity financing of new investment, raising worker wages, and improving the competitiveness of U.S. firms.
Additionally, let firms expense 25 percent of plant and equipment in the year of purchase. Replace the separate tax structure for capital gains with a 100 percent exclusion for gains up to $5,000 and a 50 percent exclusion for long-term gains above that level. Eliminate the tax on inheritances.
Next, scrap the individual alternative minimum tax and every itemized deduction except two: mortgage interest and charitable donations. Make these two deductions available to all taxpayers, not just itemizers. Reduce the limit on the principal amount on which interest is to be deducted, but only to keep the total amount of mortgage interest deductions the same as under current law. Similarly, for the charitable deduction, adjust minimums, maximums, and verification standards to keep the amount the same as under current law.
After deductions, individuals face only two income tax brackets: 15 percent and 32 percent. Make the 15 percent bracket twice as wide for married couples as singles to acknowledge that husbands and wives share their incomes. Then apply credits based on family size to reduce taxes owed.
Replace the standard deduction and personal exemption for each filer with a nonrefundable credit of $2,000. (Married couples get up to $4,000; singles up to $2,000.) Replace the personal exemption for children, child credit, child care credit, and adoption credit by a new $4,000 credit per child that offsets both income taxes and payroll taxes. (Citizenship requirements would apply, and those taking the earned income credit could not take the child credit too.) Dependents not covered by the $4,000 credit get $500 instead. Given the generosity in the child credit, eliminate the "head-of-household" filing status and treat them as singles. Index the 15 percent brackets and filer credit for inflation; index the child credit for wages, like the Social Security tax base.
These changes would make a huge difference. The typical married couple with two children would get a tax cut of more than $5,000 per year.
Additionally, the plan promotes better health care by converting the employer deduction into a worker deduction with a cap, empowering consumers to purchase affordable health insurance.
The common arguments against a $4,000 child credit do not withstand scrutiny:
The child credit is a large transfer payment. Although it's called a "credit," it is not a lump-sum payment. It works like a deduction applicable against both income and payroll taxes. Taxpayers only get the full credit if they have enough earnings and taxes to offset.
Nonparents already pay for schools. When nonparents complain about having to pay school-related taxes, they are saying, in effect, that they were entitled to a free K-12 education without ever having to pay for one.
The proposal takes too many people off the tax rolls each year, increasing the public's appetite for more government spending. Workers move across income classes over time, which is why static tax distribution tables are often misleading. Given this dynamism, we should not be concerned with some workers falling off the tax rolls in a particular year, based on where they are in their life cycle. Parents will pay higher taxes when their kids grow up and parents with more after-tax income are less likely to demand government services.
For years, supply-siders and progressives have talked past each other. Our proposal lets both sides get their way. By using generous family-related credits and a reduced top marginal rate that kicks in at lower income levels, the tax code would become substantially more progressive. The rich would pay more but, with a lower top marginal tax rate, have better incentives to work harder and invest more. The middle class and those below would pay less and have their tax burden shifted away from the years when they need it the most, when they are raising children.
Cesar Conda, former assistant for domestic policy to Vice President Cheney, is a principal with Navigators, LLC. Robert Stein is a senior economist with First Trust Advisors, LP, and a former deputy assistant secretary for macroeconomic analysis at the Treasury Department.