Tax Plan Reflects a Revolution at Work

The tax-reform plan being considered in the Senate, with rates of 15% and 27%, is a sign of the quiet revolution that has occurred in Washington over the last five years.

When Ronald Reagan took office, the federal government was taking up to 70 cents of every dollar earned by its citizens. President Reagan got a big argument from Congress when he proposed to cut tax rates 25% and adjust the tax code for inflation. Now, if the proposal of Sen. Bob Packwood (R-Ore.) is enacted, taxpayers will get to keep at least 70 cents on a dollar. And, instead of grudging approval, the plan was unanimously adopted by the Senate Finance Committee.

The key to this turnaround, quite simply, is that the Reagan tax cuts (first proposed by Rep. Kemp and Sen. William V. Roth Jr. (R-Del.)) worked. As supply-side theorists like Arthur Laffer had predicted, they sparked the strongest economic recovery in more than three decades, without inflation. According to Internal Revenue Service statistics, upper-income taxpayers are actually paying a higher tax and a larger share of the tax burden under Reagan than under President Jimmy Carter. Why? Because they are earning and reporting more taxable income at the lower tax rates.

As a result, ideas once considered radical are now part of the Washington mainstream. Virtually no one argues anymore, as was argued only a few years ago, that the best way to make the economy grow is to keep federal spending and tax rates high to encourage consumption. The idea that we should cut marginal tax rates to increase incentives for work, saving and investment began in the Republican Party. But tax reform is now a bipartisan affair. Sen. Bill Bradley of New Jersey and Rep. Richard Gephardt of Missouri saw no future in their party’s prevailing tax-and-tax politics, and have pushed for lower rates through tax reform.

Tax reform began as a way to apply incentive-oriented principles to the whole complicated federal tax code. In fact, some asked, why not have a flat tax rate on a broader tax base? Actually, there’s a good reason not to have a pure flat tax rate: It would raise taxes on low-income taxpayers and lower them too much at upper incomes. In fact, it wouldn’t really be a flat rate when the 7.15% Social Security tax was figured in. It is levied on the first dollar of wages, but stops at about $40,000.

There are a couple of ways to get around this problem. Our tax-reform plan, known as Kemp-Kasten, was a “modified flat tax”--a 24% flat tax, plus a deduction that cut the rate to 18% on the first $40,000 of wages. (The deduction was phased out at upper incomes.) Together with an increased $2,000 personal exemption, this raised the tax-free-income level for a family of four to more than $14,000. Taking a slightly different approach, Bradley-Gephardt and Reagan each proposed three progressive tax rates of up to 30% or 35%. All three plans were far simpler than is current law.

Then simplification became complicated: The House-passed tax bill had almost 400 pages of special-interest “miscellaneous” provisions, and Reagan vowed to veto it if it were not improved in the Senate. Taking this cue, Packwood turned loose the staff of the Joint Committee on Taxation, which had helped develop Kemp-Kasten and Bradley-Gephardt. The resulting plan, not unlike Kemp-Kasten, has two rates, a $2,000 personal exemption, and allowances for basic deductions such as mortgage interest and state and local taxes. It is both fair and simple.

The next steps for tax reform: Senate approval and a joint conference committee to iron out differences between the House and the Senate. The Packwood plan is generally superior to the House bill. But can the Packwood bill be improved? Sure. In fact, what it needs is the same kind of boldness on the business side as it took on the personal side.

By allowing businesses a larger deduction for depreciation but correspondingly smaller deductions for business interest, the tax code could do more to encourage equity investment and discourage wasteful borrowing and tax shelters. This would not only increase our national saving but would also reduce the trade deficit.

The plan also needs to retain more incentives for savings. And it is hard to justify the failure to adjust capital gains for inflation, thus taxing people even when they receive no real gain. No one now disputes that the government lost revenue because of reduced investment when the capital-gains rate was raised in the early 1970s, and gained revenue when the rate was lowered in 1978 and 1981.

The tax-reform debate is not over yet. Tax reform still has to survive attempts to water it down. But Packwood has rediscovered what true tax reformers have known from the beginning: that if we reduce tax rates into the 20% range, tax reform is overwhelmingly positive--and overwhelmingly popular.