Tax reform and the President's second-term agenda.

In the run-up to the November elections--and, indeed, in his victory speech--President Bush promised that his administration would endeavor to enact fundamental tax reform. Very little attention was paid to these remarks, largely because the electorate was preoccupied with the larger issues of national security and the economy. But following recent moves to shake up the Bush economic team, Washington insiders now believe tax reform will join deficit reduction and Social Security reform at the top of the President's second-term domestic agenda.

The administration has toyed with the notion of fundamental tax reform for some time. In 2002, at the President's direction, the Treasury Department reviewed our current tax system, discussed its many shortcomings and developed several options designed, in Treasury's words, "to provide a tax system that is simpler, more efficient, and fair."

Treasury identified several flaws with the current system, including needless complexity, which makes the system susceptible to abusive tax-avoidance schemes. As Treasury noted, the tax code is virtually beyond comprehension, mandatory recordkeeping is confusing and onerous, and there are too many confusing tax forms, schedules and reports to fill out.

Treasury also found that the current system penalizes hard work, discourages savings and investment and hinders the international competitiveness of U.S. firms. While many of these problems were addressed in sweeping tax legislation recently enacted by Congress, some problems remain, especially in the area of international taxation. The many layers of rules in the current system arise out of the difficulties inherent in defining and capturing income for taxation purposes--especially for activities and investments that cross jurisdictional boundaries.

Many of the tax reform proposals likely to be advanced will attempt to address these problems. Major reform proposals will likely include the following:

* Flat consumption tax--This proposal would completely scrap the existing tax system for a broad-based, flat consumption tax. It would simplify the tax system and improve efficiency by reducing the distorting influence of taxes on economic decisions. The proposal would likely retain the use of credits and both personal and dependent deductions, but would exempt most capital income from taxation.

* Flat income tax--This system would greatly simplify filing for individuals and businesses. The reduction in marginal rates and the elimination of credits and deductions would facilitate completion of tax forms. Double taxation of corporate profits would be eliminated, but all capital income would remain taxable. Some complexity would remain, given the need for defining income for taxation purposes.

* Add-on value-added tax--This option, viewed as less radical than either flat tax proposal, would remove all but the highest-income individuals from the tax rolls, lowering individual and corporate rates, and broaden the income tax base. The system would compensate for these reforms by establishing a consumption tax in the form of a VAT. Supporters envision removing 90 percent of individual filers from the income tax rolls.

* Income value-added tax with Social Security tax integration--This would substitute a broad-based, flat-rate income tax for current individual and corporate income taxes, as well as the payroll tax. This proposal would eliminate all current credits, exemptions and deductions, replacing them with generous taxpayer and dependent exemptions that would remove most individual filers. Businesses would be subject to a flat-rate income value-added tax. The aim is to replace the current income and payroll tax with a simplified, progressive program would tax all income once.

* Reformed income tax--This would simplify the individual income tax by repealing the alternative minimum tax (AMT), consolidating and simplifying savings incentives, eliminating phase-ins and phase-outs and retaining only two filing statuses and rate schedules. Marginal tax rates would fall for most taxpayers. Business income tax would be simplified by conforming taxable income to book income, and by allowing a percentage of investment expenditures to be expensed.

The Treasury report identified several policy and political risks associated with implementing fundamental tax reform. Policy risks include the transition period, which would likely be disruptive and produce "windfall winners and losers." Additional policy risks include the possibility of "getting it wrong," and of implementing a new tax system that creates few, if any, economic benefits.

The political risks are more obvious--and more challenging. Undoubtedly, a new tax system will create a new set of winners and losers, and the losers can be expected to express their disapproval at the ballot box. In every country that has adopted a consumption tax, for example, the incumbent party has suffered in the subsequent election. While President Bush believes he has a great deal of political capital to spend, Congressional leaders may shy away from reforms that could--in the short term--anger constituents.

Mark Prysock ([e-mail]) is Director of Public Affairs and General Counsel for FEI.