On November 1, 2005, the President’s Advisory Panel on Federal Tax Reform issued its final report and received a chilly response from the proponents of tax reform (too much tax, and too little reform).  However, its proposals constructively addressed key issues that could lead to a simplification of the tax code—to the extent that our huge federal deficits will allow.

The panel proposed two plans: the “Simplified Income Tax Plan” and the “Growth and Investment Tax Plan.”  The former provides simple-minded socialists with what they demand: a slightly more efficient and tolerable improvement of the current progressive income-tax-based IRS code, which is inherently inefficient and unreformable.  The latter incorporates a radical change by substituting a border-adjusted and consumption-based cash-flow tax for the corporate-income tax, an icon of the liberals.  This is significant, because it represents the first time that border-adjusted taxation—the most necessary step toward true reform—has appeared in a public document.

Both plans are committed to maintaining progressivity in the income-tax code.  The current six personal tax brackets (with a top rate of 35 percent) would be condensed to four, with a 33-percent top rate, under the Simplified Plan.  Alternatively, three brackets and a 30-percent maximum were proposed for the Growth and Investment version.  Both plans would eliminate the marriage penalty and the alternative minimum tax.  Phaseouts of exemptions, deductions, and credits would cease.  Deductions for state and local taxes would no longer be allowed, and the home-mortgage-interest deduction would be replaced by a home credit based on regional average home size, at rate of 15 percent.  Healthcare premiums would be universally deductible (not just for employee plans, as at present) but capped at $11,000.  Social Security taxes would be levied on incomes above $44,000 but would no longer have a marriage penalty.  Not commendable is a relative increase in tax credits for unwed motherhood compared with those provided for intact families.

The panel also attempted to simplify and expand opportunities for tax-free savings for retirement, health, education, and housing.  “Save for Retirement Accounts” (with a $10,000 annual limit) and “Save for Family” for education, medical, and new homes (also a $10,000 annual limit) would moderately increase saving that is free of double taxation.  However, taxation of investment income differed significantly between the plans.  The Simplified Plan excludes all domestic (U.S.) dividends from taxation, excludes 75 percent of corporate-stock capital gains, and taxes interest as at present.  The Growth Plan taxes dividends, capital gains, and interest alike at 15 percent, resulting in higher composite marginal tax rates on investment than those under the Simplified Plan.

The net effect of both plans is limited by the political prerequisite that a composite plan be tax-revenue neutral and retain the current tax code’s progressivity.  Both plans meet these criteria based on Fiscal Year 2006 projections.  By 2015, both plans are slightly more progressive—that is, upper-income earners would see an increase in their already excessive share of personal tax levies.  The disparities in taxes paid on similar incomes are somewhat reduced, but, since there is little or no composite change in taxation on upper incomes, which represent returns on intellectual and physical capital, neither plan can be expected to increase saving or investment radically.  The elimination of double taxation on dividends, capital gains, and interest under the Simplified Tax Plan, but not under the Growth and Investment Plan, results in marginal tax rates that are higher by half on investment returns, nullifying the benefits of introducing consumption taxation to encourage savings.

The primary differences between the two plans center on the taxation of commerce.  The Simplified Plan taxes small businesses on cash accounting after expensing of equipment at a 33-percent maximum rate.  Large businesses (corporations, but also partnerships, LLCs, and S corps) would be taxed at a 31.5-percent maximum rate.  Only sole proprietorships would be excluded.  Depreciation (rather than expensing) would be retained at “simplified” rates.  Interest paid and received would be deductible and taxable, respectively, as at present.  The income tax would be “territorial,” paid only on U.S. profits.

The Growth and Investment Plan taxes all businesses other than sole proprietorships at a uniform rate of 30 percent.  This business tax is a modified subtraction-method value-added tax that exempts employee compensation, taxing only cash flow, or value added by capital.  The tax is border adjusted by exempting exports and taxing imports.  Employee compensation is exempted to prevent the tax code from becoming less progressive.

There are potential problems with this cash-flow tax.  The WTO may deem that the removal of labor from value added alters its qualification as an indirect tax allowing border adjustment.  An additional—and, perhaps, more serious—problem is the effect of a 30-percent tax if it is judged to be acceptable for border adjustment.  It would be the highest border-adjustment rate in the OECD: The average rate is 17.7 percent.

It would be more advisable to put compensation back into the business tax base and credit employers for contributions to social insurance.  This would put the highly regressive employer payroll tax in the general tax pool as a quid pro quo.  The result would be the business-transfer tax base, which would qualify for WTO border adjustability.  A 17.5-percent rate would generate sufficient tax to meet the requirement of tax-revenue neutrality.

Such a plan would foster extraordinary growth and investment—most particularly, in a resuscitated manufacturing sector.  The panel was in the right church, if not the right pew.  With a little tweaking, the goal of border-adjusted consumption taxation would be the most important reform in taxation since the sorry day the United States adopted the income tax.