Among the hundreds of testimonies and citizen letters reviewed by this commission, one of the most compelling was that of Van Woods, owner of Sylvia’s Restaurant. Mr. Woods and his family run a successful soul food establishment in the heart of Harlem, a community with painfully high unemployment. In concluding his testimony to the commission, he said, “Opportunity is the ability to look in the face of my son and say: ‘I don’t know if you will succeed, but you can.'”
The objective of this commission, the aim of its members, is to help make that promise a reality — not just for Mr. Woods’ children, but for every child in every neighborhood in America’s 21st century.
In submitting these recommendations, the commission does not seek to toss yet another piece of legislation on the table. Nor was its goal to pick and choose among existing plans, or worse, create a hodgepodge compromise from elements of existing alternatives. What we are offering to the American people and their elected officials is a set of standards – a quality control – that any new plan must meet if it is to meet the bold objective of replacing the current tax code with a fair and simple system. The preceding chapter provides one half of the check-list: the principles that any new system should embody. This chapter provides the other half: key recommendations that any new system should follow.
The core recommendations of the National Commission on Economic Growth and Tax Reform are:
* Adopt a single, low tax rate with a generous personal exemption
* Lower the tax burden on America’s working families and remove it on those least able to pay
* End biases against work, saving, and investment
* Allow full deductibility of the payroll tax for working men and women
* Require a two-thirds super-majority vote in Congress to increase tax rates
We believe that, with a pro-growth, pro-family tax system, we can achieve these goals within the context of budget equilibrium. The commission believes that this new tax system can satisfy our six working principles:
* Economic growth through incentives to work, save, and invest;
* Fairness for all taxpayers;
* Simplicity so that anyone can figure it out;
* Neutrality so that people and not government can make choices;
* Visibility so that people know the cost of government; and
* Stability so that people can plan for their future.
The following pages explain the core recommendations in light of these principles, and explore some of the trade-offs involved in reaching a system that meets these goals. This chapter also touches on a few of the corollary points that flow from these main recommendations. Staff discussion papers are provided for those who seek more detail on the concepts involved.
Single Tax Rate. A single rate is a fair rate. One tax rate, coupled with a generous personal exemption, together produce a progressive average tax rate. Low income taxpayers would owe little or no tax. But everyone who earns enough to cross the threshold of the exemption would face exactly the same tax rate on any additional income.
A single-rate system is not only fair, it also can satisfy the principles of simplicity, visibility, and stability. A single rate is clearly simple, and it is highly visible: one rate — as opposed to the current, confusing mess- will stand out and be remembered by all. A simple, visible system also can be stable: by keeping our eyes on the single rate, we can keep politicians’ hands off it.
Nobel Prize-winning economist F.A. Hayek described economic redistribution through multiple tax rates as “the chief source of irresponsibility” in politics and “the crucial issue on which the whole character of future society will depend.” A system of graduated marginal rates violates the principle of fairness — that if a law applies to citizen A, it must equally apply to citizen B.
Take, for example, two wheat producers, each farming the same-sized plot of land. One of them produces 1,000 bushels of wheat; the other, through harder work and more careful land management, produces 1,200 bushels. To tax the income represented by the additional 200 bushels of wheat more heavily than the income represented by the first 1,000 would be demonstrably unfair to the more productive farmer. And yet, that is the nature of a multi-rate tax system: it takes more from people for their hard work, creativity, and success.
The added output — and the resulting added income — of one taxpayer does not diminish his neighbor, and is not earned at his neighbor’s expense. Indeed, it expands economic opportunity, increases the availability of goods and services, and helps others be more productive as well.
True progressivity requires a low tax rate coupled with a generous personal exemption. This would grant low-income Americans an “economic head-start” — allowing them to begin their climb toward economic independence before they are asked to shoulder their share of government’s cost. The larger goal is to move beyond merely maintaining low income Americans at subsistence level livelihoods toward giving them an opportunity to permanently escape poverty.
Here, as elsewhere, there are trade-offs involved. The goal of protecting those least able to bear the burden of taxation conflicts with the principle of visibility: those exempt from taxes don’t see the price of the government services we all pay for. The commission believes that the costs — both economic and moral — of burdening low-income people with taxes that can bar them from reaching their fullest potential outweigh competing concerns. By offering low-income Americans a window of economic opportunity, the personal exemption can help liberate those whom the public sector has failed to help and the private sector has failed to reach.
Lower Tax Rates. The commission recommends that the single rate be as low as possible. We encourage the adoption of such a low rate within the framework of budget equilibrium. Furthermore, we strongly urge that the rate be lowered over time as a growing economy yields rising revenues. We recommend that added revenues be considered, not as more Monopoly money for Washington, but as a “growth dividend” to be paid out to the American people.
Eliminate biases against work, saving, and investment. The principles of fairness and neutrality require that all income be taxed the same, whether it is used for consumption or saving, whether it is produced in small businesses or large corporations, and whether it is earned by employees or the self employed.
Under the current system, income that is used for consumption is taxed once, while income that is saved is taxed again and again. For businesses, complex depreciation rules mean that income from investment in buildings and equipment is overstated. This forces people to pay taxes before they have recovered the cost of their investment.
BIAS AGAINST SAVING AND INVESTMENT
Multiple taxation creates a huge bias against saving and investment that must be eliminated in a new system. Consider, for example, the effect of the current system on a family in the 28 percent tax bracket that earns an extra $1,000.
Of that $1,000, they will pay $280 in federal income tax and keep $720. If they spend that $720, say, taking the family to Disneyland, they incur no further federal tax, no matter how many times they ride the Space Mountain.
But suppose, instead, they decide to invest the income in stocks to create financial security for their future. Bad move, says the current tax code.
First, they already had to pay income taxes to have the $720 to invest. Second, the company in which they invest wll generally pay tax at a 35 percent rate on the returns on the amount invested. Third, if the company pays dividends, the family will pay a 28 percent tax on the dividends they receive. Alternatively, if the company retains the after tax income for reinvestment or finds other ways to boost future eaernings, the stock price will rise. The future earnings will be taxed, and if the family sells the stock, it will pay a capital gains tax on a 28 percent rate (see below). Fourth, if they hold the proceeds of the sale until death, they will be subject to an estate tax that can go as high as 55 percent.
Both the investment in the stock market and the investment in the family trip produce returns — one yields warm memories of the past, the other provides real hope for the future. The returns on the investment in the trip are not subject to tax; the returns on the investment in the stock market are. (Staff discussion papers contain further information on the tax code’s bias against savings and investment.)
The box above provides an example of the problems created by the current tax code.
The biases result in less work, savings, and investment, lower productivity and wages, fewer jobs, less income to spend on housing and education, and fewer assets to furnish income in retirement than would otherwise be the case. As the example at left demonstrates, these biases affect every family that is trying to save for the future.
In order to end these biases, the tax system must either let savers deduct their savings or exclude the returns on the savings from their taxable income. It must end double-taxation of businesses and their owners and permit expensing of investment outlays. it must also address the following issues:
Capital Gains Taxes. If a new tax system is to eliminate biases against savings and investment, it must also abolish separate taxation of capital gains. As commissioner Ted Forstmann said, “The biggest depressant on the rate of capital formation is the risk of confiscation by the government.” The United States now imposes some of the highest tax rates on capital of any developed nation — a 28 percent tax on long-term capital gains unindexed for inflation. Compare that with a 16 percent rate in France; a 1 percent rate in Japan; and a zero tax on capital gains in Hong Kong, Germany, South Korea, Singapore, and Malaysia.
The result is to punish risk-taking, shrink the pool of capital needed for investment, and deprive would-be entrepreneurs of a chance to climb the ladder of economic opportunity. “The tax on capital gains,” argued President Kennedy in 1963, “directly affects investment decisions, the mobility and the flow of risk capital…the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth in the economy.”
By shrinking the supply of available seed corn, the capital gains tax acts as a future tax on wealth to be realized, businesses to be built, and jobs to be created. Those hardest hit are not the wealthy — who by definition have their capital gains, their wealth, behind them — but rather all those who have yet to realize their capital gains: the poor, the young, and minorities.
“Death” Taxes. It makes little sense and is patently unfair to impose extra taxes on people who choose to pass their assets on to their children and grandchildren instead of spending them lavishly on themselves. Families faced with these confiscatory taxes often find themselves forced to sell off farms or businesses, destroying jobs in the process. “We must help to save the family farm, ranch, and business,” said Commissioner Jack Faris.
Unfortunately, family businesses often get hit hardest because they can’t afford to hire expensive lawyers and accountants. As Douglas Darch of Wake Forest, North Carolina testified to the commission: “There is something wrong with a tax system that results in the systematic dismantling of small businesses to meet estate tax obligations.”
The tragedy is that while these taxes cause much suffering for taxpaying families, they generate a relatively small amount of revenue. Estate and gift taxes appear to count for less than 1% of federal revenues — but even that low figure is exaggerated and misleading. Professor Douglas Bernheim of Stanford University testified before the commission that the estate tax may not really raise any revenue at all, because more income tax is lost from “estate planning” than is ultimately collected at death.
Full Deductibility of Payroll Taxes for All Working Americans The Commission recommends that federal payroll taxes be fully deductible – both for employers and employees. Many employers and employees pay more in payroll taxes than they do in federal income taxes. Making these taxes deductible for both employers and employees will reduce obstacles to hiring more workers and will fuel America’s job growth into the 21st century.
Under the current tax system, workers pay income tax on their Social Security tax — a tax on a tax. Employers can deduct their half of the payroll tax, but employees cannot. The combined burden of both income and Social Security tax is particularly hard on workers with incomes too high to be eligible for the Earned Income Tax Credit (roughly $25,000), but too low to be below the threshold where the Social Security tax stops being taken out of paychecks (about $63,000).
When employer and employee payroll taxes of 15.3% are taken into account, workers in the 28% tax bracket actually face a brutal marginal tax rate of more than 43% on any additional income they earn. A single low tax rate would help relieve this demoralizing tax penalty on work and saving. But it still leaves a tax on a tax.
Making the Social Security tax deductible would help reduce the combined marginal tax rates on middle-income taxpayers who get hit by both taxes. A one-earner couple with a $40,000 income currently pays tax as though the couple really received the entire $40,000 – even though they have already paid over $3,000 as their share of the payroll tax, leaving less than $37,000 on which they could possibly pay income taxes. By making the payroll tax deductible, income taxes would be calculated on the basis of working families’ real net incomes.
This need for change was highlighted in a citizen letter to the commission from Spencer Riedel of Flagstaff, Arizona, who described the Social Security payroll tax as “a huge heartache…Is there no way to stop this ‘hidden’ tax?…If we could eliminate this unfair mandated tax, our business would hire two more people.”
A Two-Thirds Majority Vote in Congress To Raise The Tax Rate. The commission recommends that the new system be guaranteed both stability and longevity by requiring a super-majority vote of both houses of Congress to raise the rate.
In hearings across the country, one depressing but all-too-familiar response from taxpayers could be bluntly paraphrased as: “Change, schmange. That’s what you guys said the last time you talked about tax reform.” The roller-coaster ride of tax policy in the past few decades has fed citizens’ cynicism about the possibility of real, long-term reform, while fueling frustration with Washington. The initial optimism inspired by the low rates of the 1986 Tax Reform Act soured into disillusionment and anger when taxes subsequently were hiked two times in less than seven years. The commission believes that a two-thirds super-majority vote of Congress will earn Americans’ confidence in the longevity, predictability, and stability of any new tax system.
The goal: A single low rate on income with a generous personal exemption, a lower burden on working families, an end to biases in the tax code — all set in the stone of a congressional super-majority. The recommendations in this chapter form the core framework for a new 21st century tax system.
Deductions and Exclusions Concerns about special provisions in the existing tax code have the potential to derail debate over the merits of a new tax system and the tremendous benefits it could bring to the American economy. There are important social and economic consequences of certain deductions and exclusions. The commission believes they should be considered with an eye to their impact on the tax rate, the costs to the Treasury, and the consequences of change — and within the context of the values of the American people. For example, the home mortgage interest deduction has spurred home ownership in America; an important goal of our commission is to spread ownership to give more people a stake in the system. And, at a time when America needs a renaissance of private giving and commitment to overcome those social problems which government programs have either failed to improve or made worse — we need a system which encourages people to take more responsibility for communities and neighbors in need. We welcome debate over the best way to protect these institutions and preserve the values they represent within the context of the dynamic new tax system we envision.
Simplify International Taxation: Congress should consider a territorial tax system. The current system of taxing international business operations is one of the most complicated parts of the Internal Revenue Code. It leads to enormous costs of compliance and enforcement, raises little revenue, and damages the competitiveness of U.S. businesses operating abroad. Further, it encourages them to keep reinvesting profits abroad rather than bringing the money back home where it could be reinvested in America.
Whatever new tax system is chosen, there must be a clearer, simpler, and more certain determination, relative to current practice, of what income is foreign or domestic or what international transaction is taxable. In addition, attention must be given to the proper tax treatment of foreign source license fees, royalties, and other intangibles so as not to discourage research and development in the United States.
Strengthen Private Retirement Saving: The commission is particularly concerned that Americans are not saving enough for their own retirement. A tax system that eliminates the bias against saving is essential to encourage people to accumulate more assets throughout their lives. There is, however, no guarantee that all individuals or families will save enough to be secure and financially independent in their retirement, even under a new tax system.
With the problems facing public retirement programs, it is essential that private retirement saving be strengthened. Without sufficient retirement saving, many people will become dependent upon the government in their old age, necessitating either sharp increases in taxes on future generations or a significantly diminished standard of living. Providing strong encouragement for individuals and families to take responsibility for their own retirement will go a long way toward preventing uncontrolled growth of government while ensuring a more comfortable, more secure, and more independent retirement.
Therefore, any tax system should encourage people to save for their own retirement. Further, the commission recommends that Congress begin the process of policy changes that will result in people taking more responsibility for their own retirement saving. Other changes within the overall income and payroll tax systems also should be considered.
One of the chief objectives of adopting a new tax system is to promote economic growth. If we are successful, the added growth will provide the tax revenues to pay for a portion of the change in the tax law. Failure to count these added revenues will make it appear more difficult to make the necessary tax changes.
One couldn’t catch the blossoming of a rose in a split-second single-frame exposure, or capture a speeding bullet with time-lapse photography. Similarly, the tools with which we anticipate and examine changes in government policies, including tax policy, must mirror the way the economy actually changes as a result of these actions.
When a bill is being debated before Congress, members are required to produce estimates of the costs of the legislation. For years, Congress has used what are called “static revenue estimates” to produce these figures. Static revenue estimates attempt to predict future government revenues by applying the new law to today’s economy as though it would not be affected by the new law. History has shown that these estimates are limited in their ability to predict revenues.
We recommend that Congress instead use estimates that measure the impact policy changes will have on people’s behavior and on future economic activity, and that therefore more accurately predict implications for future revenue collections. Use of this “dynamic” scoring, of course, must be based upon realistic assumptions regarding tax rates, tax revenues, and economic activity. It is essential to avoid overly optimistic as well as overly pessimistic projections. (Further details are provided in the staff discussion papers.)
The defenders of the status quo will say that our recommendations for a new tax system will mean a tax increase on the middle class or cause a flood of red ink.
We strongly disagree. The thinking behind our current tax system is a model that does not fit tomorrow’s world. Complainers fail to understand the new world that this new system will create. The tax reform we envision will create a different climate for economic growth. It will lift incomes. It will reduce interest rates. It will put people to work. It will reduce the use of tax shelters. It will reduce the need for social safety-net spending. It will foster millions of new businesses and jobs. In the process, the transition will help to pay for itself.
That doesn’t mean there will not be difficult issues to address during the transition. In particular, policy makers must take care to protect existing savings, investments, and other assets. Whatever the challenges this change presents, we believe that none of the issues is insurmountable.
Whatever equivocations there may be toward the future, we must not let them rob us of the unparalleled economic growth, the unimagined opportunities for human fulfillment and advancement that now lay trapped within the cage of the current system, waiting for us to open the door.
The recommendations outlined here can lay the groundwork for a pro-growth, pro-family tax code for America’s 21st century. As construction of the new system moves forward, there will be many decisions to be met and made along the way. While we have tried to raise a number of those issues here, and clarify others in the discussion papers, it is impossible to anticipate every question that will arise as we move toward a new system.
We urge that the American people participate in this debate at every step of the way. This is all the more crucial given the critical nature of the transition issues involved as replacement of the current system gets underway. Half a century ago, the economist Joseph Schumpeter described capitalism as inseparable from “the perennial gale of creative destruction.” In the transition to a fairer system and a freer market, the winds of change are bound to increase. Those who have a stake in the status quo will not welcome change; others may prefer the cramped confines of the familiar present to the uncertainty of a yet realized future.
If the taxpayer testimonies we listened to and letters we received bear any evidence of the broader mood of the country, we believe that Americans are overwhelmingly eager to make that change, ready for its challenges, and look forward to its
It has been a privilege for us to serve on this commission, and each of us has taken the responsibility very seriously. We have been educated and inspired by the many, many Americans we have talked with. While the tax system is in serious disrepair, the American spirit and will for change are stronger than ever. We thank Senate Majority Leader Dole and Speaker Gingrich for giving us this opportunity by delegating us to do this important work.
We quote in this report many of the citizen witnesses who wrote to us and who testified at our hearing. We thank them and the many expert witnesses who prepared testimony and answered our many questions about the intricacies of tax reform. We are very much indebted to the lawmakers who have spent years of their careers studying tax reform, inspiring serious debate on the flaws of the current system, and developing proposals for major tax reform. Among them: House Majority Leader Dick Armey, Ways and Means Chairman Bill Archer, Senate Budget Chairman Pete Domenici, Senator Sam Nunn, Joint Economic Committee Chairman Connie Mack, Senator Bob Bennett, and Congressman Dick Gephardt. Others whose work has been invaluable to the process include Senator Richard Shelby, Senator Richard Lugar, Senator Arlen Specter, ranking Ways and Means Committee member Sam Gibbons, and many others.
It has been said that every breakthrough in human understanding has come in the form of a simplification. The complex, bureaucratic tax code of the 20th century will not enable us to keep pace with the complex and rapidly changing world of the 21st century. A simplified tax code would have an instant impact on peoples’ lives -freeing up time, energy and resources currently wasted in costly compliance for productive endeavors.
The impact on the economy would be immediate and profound, putting the goal of a doubled economic growth rate within our reach. The moment the dead weight and distortions of the current tax system are lifted from our economy, the explosion of new investment, new businesses, and new jobs would transform the economic and social landscape of our country. A newly galvanized economy would create work for all those who wanted it, unleash unimagined innovations, act as a magnet for capital from all over the world, and boost wages and living standards for America’s working families.
We also believe that a new tax code can help replenish the wellsprings of public trust – in our government, in each other, and in ourselves. By treating citizens equally and with respect, a new tax code can restore faith in the basic fairness of the system. A simplified system will eliminate the fear that special advantages hide in complexity, while restoring citizens’ confidence in their own ability to comply with the code.
This vision of the future is rooted in both a realism about human nature and an idealism about human potential. We recognize that a new tax code, no matter how radical, cannot solve all problems. It cannot make fathers love mothers or guarantee children happy homes. Government reform, however vast or vaunted, cannot change hearts.
But it can lift hopes. At its best, it does this by seeking, as Lincoln did, “to elevate the condition of men — to lift artificial weights from all shoulders — to clear the paths of laudable pursuit for all.”
By freeing citizens from the costly encumbrances of the current tax code, by restoring the link between effort and reward, by allowing individuals to save and invest in their future, and by unleashing the pent up power of our economy, this new system can lead to Lincoln’s “new birth of freedom,” and launch us into the next American century.