IF YOU BELIEVE REPUBLICAN POLITICIANS and others in the conservative movement, the issue of tax reform is a sure winner. The debate, it is said, is not about whether tax reform will cross the finish line in the next few years, but about which horse -- the flat tax or the national sales tax -- is the safer bet.
I think we need to find a better wager. I doubt that either a flat tax or a national sales tax will pass Congress. Indeed, I'm surprised by the degree to which policy wonks and politicians in safe seats have dominated the tax-reform debate and steered it toward theory and fancy.
Here's the most important thing to remember: Opponents -- be they special interests or populist demagogues -- will not be responding primarily to the notion of a single tax rate on income or sales. They will instead be hollering about the more complicated issue of how to define the tax base, regardless of the rates.
Tax reform must necessarily pick fights with powerful interests, such as doctors, lawyers, realtors, insurance agents, and bankers. There's no way around that, at least if reformers are to stay true to their principles. The reason is simple: Both the flat tax and the national sales tax would expand the scope of federal taxation to forms of economic activity that now escape it.
The flat tax, for example, would sweep away the current bias in the tax code that favors health insurance, managed care, and other third-party payers of medical bills. More broadly, non-wage benefits given to employees currently escape tax on both the workers and the firms. This is a major reason that non-wage benefits have grown significantly as a share of total worker compensation over the past several decades.
All flat-tax proposals would end this bias by subjecting non-wage benefits to the business tax. A dollar of health-insurance premiums would be taxed the same way as a dollar of wages paid directly to workers. But expanding taxation to include managed-care contracts, employer-provided life insurance, day-care assistance, and other non-wage compensation will make lots of industries and professions hopping mad. They are benefiting from a screwy tax code; they know it; and they'll fight hard to keep it that way.
Advocates of the national sales tax might view this problem as an argument against income taxation. But their own plan creates even worse problems. A sales tax would have no choice but to tax services, such as legal assistance, medical care, child care, and investment advice. That is the only way to bring in enough revenue to levy a relatively low (15 to 20 percent) rate.
Service industries -- including law firms and health-care providers -- represent about one-fifth of private economic output, a huge and growing share of total employment, and tremendous clout in Washington and state capitals. Throw in the financial-services industry and the realtors, and you have a recipe for political disaster. Not even its function as a sizable import duty would give the sales tax enough industry support to fly.
Proponents of the flat tax and national sales tax have fallen all over themselves explaining why adopting a single rate is fair. Flat-taxers say that theirs is the only way to treat everyone equally and to reduce economic distortions caused by punitive rates. At the same time, many of them promise generous family deductions to make the system effectively progressive while marginally flat. National-sales-taxers promise rebates for poor taxpayers to accomplish the same objective.
Both groups are missing the point. According to opinion polls, people generally agree with the idea that someone making twice as much income as they should pay twice as much tax. A single marginal rate doesn't concern them nearly as much as the possibility that rich "coupon-clippers" whose income derives mainly from investments will escape tax altogether.
Now, economists who back the flat tax or national sales tax will argue that their plans do tax investors -- the flat tax by taxing profits and interest payments at the business level, the sales tax at the point when the investor spends the money. But arguments such as "I'm paying my taxes at the business level" or "I'll pay my taxes 10 years from now when I buy a yacht" don't have much political value. If you don't believe me, try them out on your friends.
I suspect average taxpayers want to be reassured that, every year, rich investors will have to fill out a form and send it (and possibly a check) to the tax collector, just as they themselves will. For any tax reform to have political legs, it must guarantee that all Americans interact with the tax system in a roughly equivalent fashion, even if they are, for various reasons, paying different effective rates on their income.
Tax reform remains a critical issue and a viable way of galvanizing the conservative coalition. But the answer is not to construct an intricate new system that must be passed intact. Tax reformers should instead settle on a few discrete goals and design modest proposals that have political constituencies of their own. Here are a few ideas:
Focus on payroll taxes. For many, if not most, taxpayers, payroll tax for Social Security, Medicare, and unemployment insurance is greater than the federal tax liability. Remember that the bottom 50 percent of Americans pay an average effective federal income-tax rate of about 4.5 percent. They don't have a big personal stake in income-tax reform (or at least are unlikely to perceive such a stake).
The notion of diverting some payroll taxes into personal savings accounts, or trading cuts in payroll taxes for cuts in future benefits, may well generate wider enthusiasm than a flat tax or national sales tax. The benefits are easier to understand, and they accrue directly to taxpayers in the form of dollars or assets. Another option would be to make payroll taxes deductible on federal income-tax returns.
Focus on savings. The complicated tax cuts of 1997 were modest and mostly wrongheaded, but they demonstrated the political value of designing tax cuts so that they have powerful constituencies. The idea of making college tuition tax-deductible and giving out additional tax credits for some students and their families was a half-solution at best, but brilliant politics. It attracted the support of academia, CPAs, financial advisers, and the investment industry. Is there a way for the Right to pursue a similar course without surrendering its principles?
Absolutely. Provisions in last year's budget deal allow "back-ended" IRAs for higher-education savings as well as penalty-free IRA withdrawals for college tuition, medical expenses, and mortgage deposits. Because the initial deposits in these accounts are not tax-deductible, the tax benefits are limited to tax-deferred interest or capital gains.
Far simpler to explain -- and far better as economic and social policy -- would be the creation of educational savings accounts (ESAs) that would not only exempt earnings from tax but allow families to take tax deductions for deposits and pay no tax on withdrawals. ESAs could be used to fund all educational expenses, from preschool to graduate school to even job training. In effect, private education savings and spending at all levels would become tax-free.
This is justifiable on tax-policy grounds. One of the defects of the flat tax (and the national sales tax, if applied to all goods and services) is that it is unfair to investment in human capital. While plant, equipment, or other physical capital would receive tax deductions -- on the appropriate grounds that to do anything less is double taxation, because earnings on the investments are also taxed -- investments in human capital such as education and training, which also generate future taxable income, would continue to get taxed two or three times. Giving at least a limited tax exemption to education spending and savings is, in fact, to enforce tax neutrality between present and future consumption.
The ESA is not the only way to cut taxes by creating rather than alienating political constituencies. Medical savings accounts, home-ownership accounts, and unemployment savings accounts (to replace the current, deeply flawed unemployment insurance system) would naturally attract the political support of the financial institutions and mutual funds likely to manage this money, as well as the industries -- such as health care and real estate -- from which savers would eventually purchase services.
Finally, focus on cutting taxes. It should be obvious that tax reform that isn't also tax relief will go nowhere. Chopping away at federal, state, and local tax rates is a useful enterprise regardless of whether the tax system itself is significantly changed. The new governor of Virginia, Jim Gilmore, was elected with a mandate to end the state's property tax on automobiles.
His experience is a lesson for conservatives on how to package even a modest tax cut to great political effect. I'd like to see a populist assault on excise taxes, for example, as well as continued action to ratchet down tax rates on income, sales, and property and to install super-majority rules that will make future tax hikes difficult to pull off.
Today's tax reformers have their hearts in the right place. But they need to start using their heads. A tax system can look good on paper and still be impossible or inadvisable to adopt in practice. In the world we actually inhabit, mortgage deductions, charitable deductions, fringe benefits, a circumscribed tax base that excludes some forms of economic activity, and tax-code complexity are givens. They exist for a reason. And their defenders are unlikely to listen to true reason. Our task is to work around them -- and figure out ways to solve the most pressing problems of our biased and excessive tax system.
John Hood is president of the John Locke Foundation in Raleigh, N.C., and is the author of The Heroic Enterprise: Business and the Common Good.