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Junk The Income Tax!

House Ways and Means Chairman Bill Archer doesn’t believe in tax “reform,” he says, because the current system isn’t reformable. Better to wipe the slate clean and create something that works, But what? And how do we to get from here to there?

BILL ARCHER ONCE CONSIDERED HIMSELF AN ARDENT TAX REFORMER. NOT ANYMORE. HAVING SERVED ON THE tax-writing House Ways and Means Committee for 25 of his 26 years in Congress, most of them as a minority leader, the Republican congressman from Houston now thinks the current tax system is a dragon economic growth and beyond tinkering. Once a flat taxer, he now disagrees with friend and fellow Texas Republican Dick Armey over what should replace it. Armey vociferously argues for a flat tax. Archer thinks the flat tax died with Steve Forbes’ failed bid for the nomination. He allows that a flat tax would be simpler than the current system, but argues that it would leave in place the iniquitous IRS and the burden of record keeping that intimidates ratepayers.

In the following CE forum, held in partnership with Deloitte & Touche LLP, Archer outlined the prospects of tax restructuring. The Institute for Research on the Economics of Taxation’s Stephen Entin, a former deputy assistant secretary of the U.S. Treasury, detailed the technical challenges in attempting such a switch and its implications for business.

Under discussion are four proposals (see table below for a summary comparison). One is Majority Leader Dick Armey’s flat tax, which would abolish all loopholes and deductions; eliminate withholding, capital gains, and estate taxes; and institute a 17 percent flat tax. A variant is the USA Business Tax put forward by Sens. Sam Nunn (D-GA) and Pete Domenici (D-NM), which has two parts: a low, flat tax on all businesses including corporations, partnerships, and proprietorships allowing unlimited deductions for capital investment; and a progressive personal income tax allowing large exemptions, a deductible family living allowance, and an unlimited deduction for personal savings. Archer favors a consumption tax, such as a national retail sales tax, which eliminates the role of the IRS and helps savers at all income levels accumulate wealth. It is a first cousin to Sam Gibbons’ (D-FL) value-added tax idea, which is closer to the system used widely in the European Union.

Whatever the alternatives, a fundamental consumption taxes are criticized for regressivity. Yet, those who earn wages and spend them are taxed twice. If the same wages are invested in a risky business, they are taxed a third time. And because capital gains are not indexed for inflation, they are taxed a fourth time. Is this system fair?

Although neither Archer nor Entin reckons any of the current proposals will see a vote in the 104th Congress, they both underline the public’s growing dissatisfaction with the current system’s cost and complexity. A Reader’s Digest poll showed that most Americans think the maximum fair “take” of their personal income going to the state, local, and federal governments should be no higher than 25 percent of personal income. This was true of all respondents, regardless of income level.

In the coming national election, the tax system’s effect on economic growth will be an issue with more heat than light. As Entin implies here, one should not confuse tax rates with tax revenues. In both the Kennedy and Reagan administrations, a lowering of rates produced more revenue, a fact that was proven when West Germany, Hong Kong, and the U.K. followed that program. Even socialist Sweden realized that increasing marginal rates yielded less revenue, as people chose to exchange income for leisure. Louis XIV’s finance minister, Jean Baptiste Colbert, once remarked that the art of taxation was plucking the goose with a minimum of complaint from the bird. Expect more hissing in the coming months.

NO MORE IRS

Rep. Bill Archer (R-TX): We have to ask some fundamental questions before we can formulate a solution to the tax problem in this country. First, does the current income tax system best serve this nation? No one on the House Ways and Means Committee thinks so. While we must accept the premise that we have to collect revenues to pay government bills, the issue is how much and where does it come from?

Next, if the current system isn’t any good, can we fix it? The empirical data gathered over the years show that every effort to fix the system has resulted in a worse code than the one we had before. And, finally, is the idea of an income tax inherently flawed? I think it is. Those who espouse the flat tax believe that if we could only simplify the income tax by having one tax apply to everyone, we would have a good tax code. In theory, that may be true. But in reality, that would leave the IRS in everyone’s lives. You’d still have to keep all the records and be prepared to defend the numbers you submit to the government. Anyway, a purified flat tax will never pass. Shortly after Steve Forbes presented his proposal, people started clamoring about needing mortgage interest deductions, charitable deductions, and state and local tax deductions. It’s the same thing all over again. And anyone who believes differently isn’t living in the real world.

To create jobs, grow, and move into the future, we need a new tax system, one that generates the greatest possible incentive for saving in the U.S. And it must be fair. Most Americans believe that any income tax is inherently unfair, because the more affluent will find loopholes to get around paying it. The underground economy doesn’t pay any taxes, costing us $200 billion a year and shifting a 15 percent higher tax burden onto those of us who pay our taxes.

We need a tax code that will give us every possible advantage in competing in the world marketplace, because if we don’t win the battle there, America will ebb as an economic entity, and real income will drop. Thus, we need a federal tax that is border adjustable, meaning it can be removed from the price of your product when it is exported and charged to incoming foreign products when they enter this country. No income tax can do that.

That’s why I believe we have to throw the income tax overboard. Instead of taxing saving, we must tax consumption of goods and services. A tax on spending effectively reduces the cost to the manufacturer, so the product can be exported at 15 percent to 17 percent less in price, and that same percentage can be charged to incoming foreign goods. Obviously, under my proposal, businesses still have to be vehicles for the collection of the revenues to pay the government’s bills, but they would not have to deal with all the compliance issues and the way counter productivity negatively impacts foreign source income-and best of all, no one would have to deal with the IRS.

I’ve asked witnesses for the Ways and Means Committee, “What would you give not to deal with the IRS every year?” The answers are pretty interesting. One said, “Each year, I would pay the federal government what I pay my tax preparer to fill out all the forms and file them for me.” One woman went even further, saying, “I would give my firstborn child.” I do my own income taxes every year, and I firmly believe that if every member of Congress had to do his or her own taxes, we’d have a very different tax system by now.

If we tax consumption, America will become a sponge for saving, productivity, and job creation. And we will beat the bejabbers out of our foreign competition. A global investment consultant I know surveyed his Japanese clients and found that if we implemented my proposal, 80 percent of them would build their factories in the U.S., and 20 percent of them would move their international headquarters here. We are talking about a massive economic sea change for the U.S. Not only is the effort worth it, it is doable today.

MAKING THE TRANSITION

Stephen J. Entin (Institute for Research on the Economics of Taxation): Each of the tax proposals floating around Capitol Hill-including the flat tax and Rep. Archer’s consumption tax-has different ways of addressing certain issues, such as double taxation, which in today’s system results from the alternative minimum tax. This issue can be handled in one of two ways: Either you treat income that is saved the way we treat pensions in that there is no tax on the saved income until you spend it. Or you treat it like municipal bonds, whereby there is no deduction for saving, but the interest isn’t taxed. The individual side of the Armey flat tax proposal works more or less the way we treat municipal bonds. The Nunn-Domenici USA tax and the sales tax work the way we treat pensions.

In addition, the proposals all raise different transition questions. The flat tax may generate a drop in interest rates, because business no longer deducts debt, and the lender doesn’t pay tax on it. This means we have to examine certain consequences: What do you do about existing debt? Do you have to refinance to get the lower interest rate? Is there a cost to refinancing? Does your bond have a call provision? Would it be better to grandfather it? There are costs to refinancing, particularly if a company doesn’t have a call provision on the bond or if it’s not as creditworthy as it was when it first borrowed.

We also have to consider the treatment of net operating losses, unused alternative minimum tax credits, and deductions for state and local taxes and payroll taxes on non-pension fringe benefits. If payroll taxes aren’t deductible, businesses face an effective increase in the apparent rate of the payroll tax, while some of the tax proposals give workers a reduction in the income tax. This would entail a shifting of the labor compensation package, so the burden doesn’t fall solely on the employer. In addition, some fringe benefits are built into contracts that have years left to run, and unions won’t want to renegotiate.

Another question arises about the treatment of unused foreign tax credits. What do you do when you’ve moved to a territorial tax system and are no longer taxing foreign source income? You probably could get away with getting rid of unused credits, but that may create competitive problems between companies.

Rep. Archer mentioned border adjustability. Most economists are skeptical that border adjustment has any effect on the aggregate economy. It will boost exports, but it also will boost imports, because if we’re shipping more and more products outside the U.S., it will be difficult to satisfy consumption inside this country. And there is no clear indication this would boost the total gross national product.

The bottom line is that any of the tax proposals-flat tax, VAT, sales tax, or USA tax-would be preferable to the income tax. I urge you as business leaders to get involved soon and help us deal with these transitional efforts. We’re going to need all the guidance we can get from the real world.

REGRESSIVE OR PROGRESSIVE?

Roger L Page (Deloitte & Touche LLP): Consumption taxes typically are labeled as much more regressive than the system we have now, meaning that the bottom 80 percent of income earners will suffer a tax increase, while the top 20 percent will get a tax decrease. Politically, how do you sell that to the American public?

Archer: This can be accommodated by both the flat tax Steve Forbes favors or by the consumption tax with a credit rebate or waiver system to take care of the lower-income people. It’s a shame we ever got into distribution tables, which is where your numbers came from, because they are skewed in so many ways and do not truly reflect the conditions for families in this country. This isn’t-and shouldn’t be-about income redistribution, it’s about spurring economic growth and job creation.

Edwin S. Rubenstein (National Review): Doesn’t having a credit rebate mean you can’t eliminate the IRS?

Archer: No. Programs today that help lower-income people-such as welfare-are not conditional on their filing an income tax at all. So there’s no need to have an income tax to be able to qualify people for a credit rebate.

GLOBAL MODELS

Arnold B. Pollard (CE): Which, if any, countries have a more intelligent taxation approach than that of the U.S.?

Archer: To some degree, the Europeans have an edge on us because they have a value-added tax that is charged to our products when they enter their countries and removed from the price of their products when they export. With all due respect to Stephen Entin and the ivory tower economists who say this will be offset by exchange rates and that border adjustability is not important, my common sense tells me they’re wrong. If they were right, then there is no comparative advantage for any country that has a lower production cost. It would be offset by monetary exchange rates. If we remove from the price of our products a cost of doing business, which is the price of government, and we can sell our product for less, that cost is no longer part of our process. For them to say, “Oh, that’s all offset by exchange rates,” doesn’t help our country. If that were so, everything should be in balance today, but it’s not.

Charles H. Brunie (Oppenheimer Capital): You want to copy a 50 percent share of GNP in Europe when they have a VAT of one-third? One of the worst investments I ever made was to buy some Danish mortgage bonds. They went from a 6 percent VAT to 26 percent in six years. That scared the bejeezus out of me.

Entin: I don’t think trade economics is ivory tower stuff; it was out there slogging in the trading pits 200 years before the rest of economics was invented. Taxes on income or consumption or value-added are taxes on the labor and the capital that make the products. It’s a tax on work. In the international sector, yes, if we had a net tax cut on exported goods or if we had an across-the-board net tax cut on all goods and services we produce, we would lower our cost of production. But we have to have a tax increase to average it off. There’s no net tax cut involved in lowering that cost on one type of product. Why would you want to place a higher tax on the worker producing a widget for sale in Athens, GA, than for the person one step down the assembly line who’s producing the same widget for sale in Athens, Greece? You divert more of your labor and capital to producing for export. We’d be producing less for consumption here, so we’d have to import more. Thus, exports would rise, exchange rates would go up a bit, and imports would rise to match. There’s no increase in the country’s total output, just a change in the mix. Comparative advantage is not the absolute level of wages. If some countries do this a little better than they do that or vice versa, they trade. The exchange rate makes it happen. But you can still have lower wages here than there if across the board, this country’s production is less than that country’s. The exchange rate balances the productivity differential.

The problem is that the CBO does not correctly tie tax changes into what we know is going to happen in the economy. It uses an obsolete theory invented over 60 years ago that wasn’t right then and still isn’t right now. We have to take the dynamics into account, such as economic growth, wages, and interest rates. Unless there is a radical rethinking of the world and a good tie-in with the tax change, you’re not going to get the information you need to convince the Democrats that the consumption tax is a good thing in the income redistribution game.

BUILDING A PLATFORM

Maxwell E. Bublitz (Conseco Capital Management): What’s going on in the Republican Party regarding the creation of a tax platform for the convention in August? Archer: I don’t know what will happen, but Bob Dole clearly will drive what goes into the platform. My guess is that he will be as cautious as possible without stepping out and taking any heat, and that the end result will be something along the lines of the Kemp Commission’s recommendation, which doesn’t prohibit a consumption tax, but is construed by most people as supporting the flat tax.

Frank N. Liguori (Olsten Corp.): If Dole were to win the election, which way do you think tax reform would go?

Archer: I don’t know. But if I and the people aligned with me succeed in building a consensus, I think Bob Dole will go along with a consumption tax if he is elected president.

Liguori: What happens if Bill Clinton remains in the White House?

Archer: If there is massive grass-roots support for a consumption tax, I think President Clinton would sign it. Otherwise, there’s no way he will go for it.

Ronald D. Watson (Custodial Trust): State and local governments seem to have a considerable investment in the current progressive income tax system. Is there likely to be enough of a drop in interest rates under your proposal to bring them on board or will they be impediments to its adoption?

Archer: Politically, this is going to be a problem for us. But from what I have seen in the cursory economic studies, interest rates will decline to a degree that governments will not pay more for their projects, but they also won’t have an advantage.

Entin: That’s true. They capture through the lower interest rate the tax saved by the individual buyer on an after-tax basis. If the corporate bond ceases to have a tax premium on it, the rate will come down to the municipal rate but not vice versa. The same phenomenon would occur with mortgage interest reduction, and the realtors are panicking. But they really should not worry about the interest rates and the market adjusting; the tax premium quickly will be taken out of interest rates through competition.

You don’t need a 600-equation model to figure out what’s going to happen to interest rates. There’s a perfect model of the U.S. economy: It’s the real world, which is modeling itself perfectly, thank you. Just pick up The Wall Street Journal any day of the week and look at the bond interest rate table. You can see the difference between a taxable and a non-taxable bond. That’s how much the taxable rate would come down, the difference between corporate bonds and municipal bonds, which is 2 percent, plenty to satisfy the municipal bond people and the home buyers.

Robert Abrams (former New York State Attorney General): In the last six months, we saw a tremendous focus on restructuring and the flat tax, but it somehow seems to have fallen off the radar screen, to the point that Dole isn’t really talking about it in any significant way. Is it possible to bring about this restructuring?

Archer: The problem with the flat tax is that it leaves the IRS in American lives. The other thing is that Steve Forbes was a terrible messenger for it, because he is a rich individual living off his unearned income telling people, “Don’t worry, a tax has already been paid on it.”

We never seem to learn from history. We’ll never be able to hold a flat tax. We went to a relatively flat tax in 1986, with two rates. But 1990, it already was growing again, and by 1993, it was in full blossom. While I would vote for a flat tax-because it is an improvement-if that’s all we could get, I really don’t think it’s the right solution.


 A WHO’S WHO OF FORUM PARTICIPANTS

Robert Abrams is a former New York State Attorney General.

Rep. Bill Archer (R-TX) is chairman of the House Ways and Means Committee and serves on the Joint Tax Committee.

Wallace Barnes is chairman of Chula Vista, CA-based Rohr, an $805 million aerospace company.

Charles H. Brunie is chairman of Oppenheimer Capital in New York, an investment management firm with more than $40 billion in assets under management.

Maxwell E. Bublitz is president of Conseco Capital Management, a Carmel, IN-based financial-services company with $28 billion in assets under management.

Donald G. Carlson is chief of staff of Rep. Archer’s Office.

Charles A. Dickinson is chairman of $2.1 billion Solectron Corp., a Milpitas, CA-based assembler of electronic equipment.

Stephen J. Entin is a resident scholar at the Washington, DC-based Institute for Research on the Economics of Taxation, and a former deputy assistant secretary of the U.S. Treasury.

Barbara Hackman Franklin is president and CEO of Washington, DC-based Barbara Franklin Enterprises, an international consulting and investment firm. She is also a former U.S. Secretary of Commerce.

Harry E. Gould Jr. is chairman and president of Gould Paper Corp., an $830 million paper distributor in New York.

Francis E. Jeffries is chairman of $100 million Phoenix Duff & Phelps Corp., a Hartford, CT-based investment-services company.

Frank N. Liguori is chairman and CEO of Melville, NY-based Olsten Corp., a $3 billion home health-care and staffing-services provider.

Roger L. Page is a partner in Deloitte & Touche LLP, a $2.2 billion accounting, auditing, tax, and management consulting firm.

Fred N. Pratt is chairman and chief executive of Massachusetts-based Boston Financial, a $45 million real-estate investment company with $6 billion in assets under management.

Edwin S. Rubenstein is the economics editor of National Review.

Ronald D. Watson is chairman, president, and chief executive of Princeton, NJ-based Custodial Trust, a financial-services subsidiary of The Bear Stearns Cos. that holds $75 billion of customer

About J.P. Donlon

J.P. Donlon
JP Donlon is the Editor-in-Chief of Chief Executive magazine.