The election is over, and George W. Bush will be our president for a second term. Although certainly the president doesn’t totally control what happens in Washington, a president, and especially a re-elected president, can dramatically affect the agenda of discussion among Washington’s decision-makers.
One area where this is the case is in tax policy. In recent history, most major tax initiatives have come from the president, such as the tax increases in the early 1990s, the dramatic changes to the income tax code in the mid-1980s, and the tax-rate cuts of the early 1960s. So it’s reasonable to look to President Bush’s ideas about taxes for clues to the tax debates we’ll see in the upcoming years.
Bush made two major statements during the campaign and in his post-election comments about general federal tax policy. First, he wants to make the federal tax changes instituted in the last four years permanent. Most of the provisions for tax-rate reductions and changes to various tax credits and deductions passed since 2001 have expiration periods. The president wants the time limits removed.
Beyond this, the president has said he wants to simplify the federal tax system, and specifically the federal income tax code. This is where the fun begins, because the president has not indicated exactly what he wants. He has said he will look to the advice of a panel of experts for his recommendations.
What might the panel recommend? I, and most other tax-watchers, think they could go in one of two directions. Both directions are filled with political land mines and controversy.
One approach would be to keep the federal income tax but “flatten” and simplify it. This was the route taken in 1986. Then, both the level and number of federal tax rates were reduced. This is the flattening. But at the same time, the number of allowable tax deductions, that is, spending that reduces your taxable income, was also reduced.
There is substantial support from some quarters for this approach. The ultimate in the approach would be a “flat income tax,” where all income would be taxed at the same rate and all deductions would be collapsed into a single one based on household size.
The other direction is to scrap the federal income tax and replace it with a federal sales tax. Supporters like it because it would promote work and saving and, in some sense, could be viewed as a “voluntary” tax because it’s based on what people willingly spend.
Both approaches carry many questions, issues, and controversy. If the federal income tax is kept with lower rates but fewer deductions and credits, what deductions and credits would go? Every tax break has a political constituency behind it, so major fights could be expected on every proposed limitation.
Also, although flattening and simplifying the federal income tax could be done in a way that the total tax burden remained unchanged (in tax lingo, this is called “revenue neutral”), it’s inevitable that some individual households would pay more while others paid less. This would not go unnoticed in the debate.
A federal sales tax would possibly be even more explosive. Would all spending be taxed, or would spending on “necessities,” such as housing, food, clothing, and medical care, be exempt? If so, some economists estimate the sales tax rate on remaining items would have to be 20 percent and 30 percent. Would businesses and consumers accept this?
Then there’s the issue of alleged regressivity with the sales tax. A tax is called regressive if lower-income households pay a higher effective rate than higher-income households. Critics say this happens with the sales tax because richer households save a greater portion of their earnings.
Many economists disagree with this notion, for the simple reason that today’s savings become tomorrow’s spending. So even though someone saves $10,000 today and escapes paying sales tax on the money, she will pay sales tax in the future when she likely withdraws the money from an investment and spends it. Indeed, economists who have looked at the lifetime incidence of the sales tax find it to roughly be a proportional tax, that is, all income levels pay the same effective rate.
Expect tax reform to be a key part of the Bush agenda in the second term. But changing the tax system is never easy. Bush will have to convert his political capital into political muscle in order to succeed with the heavy lifting of tax reform.
Walden is a William Neal Reynolds distinguished professor at North Carolina State University and an adjunct scholar of the John Locke Foundation.