Let’s Revamp the Tax Code–But How?

Congress has made almost 1,500 adjustments to the tax code since 1996. This tinkering has forsaken the principles of simplicity, fairness and efficiency espoused by serious reformers of both parties.

However, because taxes are deeply embedded in the nation’s economic and social structures, tearing out the entire system all at once and replacing it with a flat tax would create difficult problems in transition and in the redistribution of tax burdens across people and activities. The ultimate gains in simplicity and growth would not be nearly as large as advertised. A national sales tax would have similar problems plus additional compliance headaches.

A better approach is to reestablish the widely-held principles of tax reform by modifying the income tax, not replacing it. The basic idea is to broaden the tax base while reducing effective and statutory tax rates, along the way making the system simpler, eliminating loopholes, removing hidden taxes and improving tax administration.

Here’s how the structure of taxes could be improved dramatically. Have most individual taxpayers pay a 10% to 12% rate and the rest (including businesses) face a 25% to 30% rate. Remove or phase out almost all itemized deductions, credits, “corporate welfare” and other subsidies. Retain the earned income credit, to encourage people to work, and the charitable deduction, to encourage private philanthropy in an era of government downsizing. Raise the standard deduction significantly. Abolish the individual and corporate alternative minimum taxes or greatly increase the exemptions. Eliminate the phase-outs of personal exemptions and limitations on itemized deductions. Tax realized capital gains as ordinary income.

The roughly 10 separate targeted saving incentive programs, like Roth, education and conventional IRAs, should be consolidated into one. Simplify pension nondiscrimination rules. Give all depreciation deductions in the year the asset is purchased. Partially or fully integrate the corporate and individual taxes.

The administration of taxes could also be greatly improved. With the changes above, most people could choose a no-filing alternative whereby the correct amount of taxes would be withheld from their paychecks, especially if people have the option of having taxes withheld on interest and dividend payments. Require Congress to obtain estimates of the compliance costs of any new tax provision and see what the new tax forms and associated worksheets would look like before passing any new levy.

Yes, these are small steps compared with throwing out the whole code. But we should not let the things we cannot do stop us from doing the things we can.