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JANUARY 17, 2005

Bait And ...

One of the great episodes in the lives of policy wonks everywhere--
and, let's face it, they don't have many--occurred when Ronald
Reagan signed the Tax Reform Act of 1986. It was an almost
shockingly beneficent piece of legislation, lauded by economists
and political scientists across the ideological spectrum. It did
not, however, happen without a fight. Passing tax reform--which
lowered tax rates and cleansed the tax code of countless loopholes,
credits, and other acts of unjustifiable favoritism--forced Reagan
and his allies to fight for nearly two years against an army of K
Street lobbyists seeking to preserve their clients' privileges. It
was a rare moment when the GOP's principles smacked up against the
interests of its donors, and principle won.The battle was chronicled by Wall Street Journal reporters Jeffrey
Birnbaum and Alan Murray in the classic book Showdown at Gucci
Gulch. The book records not only the ultimate triumph of reform but
also the times when it seemed that lobbyists would kill it. One
such moment is captured in a passage that has particular relevance

On April 10, the [Senate Finance] committee adopted a crazy-quilt
depreciation system that ostensibly gave more generous write-offs
for machinery and equipment that were used in "productive" purposes
than those that were not. This dubious distinction was the
invention of lobbyists Charles Walker and Ernest Christian and
their heavy-industry allies in the Carlton Group that represented
major rubber, steel, aluminum, and petroleum producers. The system,
in fact, was largely a ruse to mask the committee members' frenzy to
aid the industries they were beholden to.

What makes this particular episode relevant is that the ironically
named Ernest Christian has been popping up in the news lately. Two
years ago, the old tax lobbyist formulated a strategy, called Five
Easy Pieces, for overhauling the tax code in five steps. White
House staffers took to the proposal, and, with some slight
adjustments, the Bush administration has adopted it as its approach
to overhauling the tax code. "Christian and [GOP strategist Grover]
Norquist say they believe the White House has signed on to the
incremental approach of the Five Easy Pieces, and may even be
pursuing them in order," reported National Journal two years ago.
The Washington Post echoed in 2003, "Placed against the tax cuts of
the past three years, Christian's agenda is beginning to look like
a road map."

The Five Easy Pieces strategy postulates that the long-time
conservative goal of a sweepingly radical tax overhaul, such as
replacing the income tax with a flat tax or a national sales tax,
runs too much political risk. Instead, Christian has argued,
conservatives can achieve the same goal by doing five things:
cutting marginal tax rates, eliminating taxes on capital gains and
dividends, allowing more generous treatment of business investment,
doing away with the estate tax, and establishing tax-free personal
savings accounts. The three major Bush tax cuts to date have
achieved the first four pieces, partially or completely.

Two days after winning reelection, President Bush told a press
conference, "We must reform our complicated and outdated tax code"
and told reporters that "tax reform" was an issue on which he
intended to spend his "political capital. " It has since emerged
that Bush intends to appoint a commission whose recommendations he
will try to enact in 2006. But the thrust of his plan is already
clear. He hopes to lock his prior tax cuts permanently into place
and use his second term to enact tax-free personal savings
accounts, the final element of Five Easy Pieces. These steps, taken
together, would indeed radically transform the tax code by
rendering virtually all investment income tax-free. With capital
virtually exempt from taxation, the burden of supporting the
federal government would fall almost entirely on labor. It would
amount to a reversal of the principles of progressive taxation that
have held sway for the last century. And it has very little to do
with what most people mean by "tax reform."

Bush's plan to complete this transformation has been widely
described by its proponents and outside observers as "tax reform,"
and it has been compared in the press to Reagan's 1986 effort. But
Bush's goal is different from--and, in many ways, the opposite
of--tax reform. The fact that Reagan's tax reform entailed a death
struggle against tax lobbyists, and that Bush's "tax reform"
strategy was literally devised by a tax lobbyist, is merely one

The remarkable thing about the 1986 tax reform law is that it put
into practice purely academic notions of how public policy ought to
work. Economists agree that the most efficient income tax would
treat all kinds of income equally, rather than giving lower rates
to certain kinds of income, or exempting those businesses that use
political clout to gain special treatment.

By the mid-'80s, the tax code had grown thick with differential
treatment. Tax breaks for real-estate investment, for instance, had
spurred massive construction of unneeded office buildings. By
taking advantage of special tax breaks, the developers could make
money even if the buildings sat empty. It was like those factories
in the old Soviet bloc pumping out products that nobody wanted to
buy. That's what happens when government regulation, rather than
market demand, dictates investment.

On top of the costs to economic efficiency, the tax code was also an
affront to simple fairness. Two different families earning the same
level of income could pay vastly different tax rates simply because
one had certain categories of income (such as capital gains) deemed
more favorable, and therefore taxed at lower rates, by Washington.
Corporations faced even wider disparities. Some businesses paid the
top statutory rate of 45.6 percent, while many others avoided
taxation altogether. A corporation's tax rate depended to an
enormous degree on how much influence its lobbyists wielded in the

Fairness and economic principle alone were not, of course, enough to
bring the Reagan administration to champion tax reform. Several
other factors came together. Reagan's reelection campaign, fearing
that Democrats would seize upon inequities in the tax code as a
campaign issue in 1984, preemptively announced that Treasury
Secretary Don Regan would head a commission on tax reform that
would announce its findings after the election.

Most people, including most Republicans, figured Regan's study would
go nowhere. But Regan took his task seriously and persuaded the
administration to back it. Tax reform gave Reagan the chance for a
huge second-term accomplishment. The appeal of tax reform is that,
by eliminating great swaths of special privilege, it could at once
slash tax rates (the top rate fell from 50 to 28 percent) while
shifting a greater share of the tax burden onto the affluent.
Republicans liked the first part, Democrats liked the second.
Facing massive deficits, the White House knew it could win large
rate cuts only if it paid for them by closing loopholes.

Due to the superficial similarities--tax-cutting Republican
presidents facing huge deficits and seeking a second-term
legacy--some Washingtonians have suggested that Bush may follow in
Reagan's footsteps. "No sooner had Bush claimed victory than he was
promising to push ahead with still-undefined plans to reform and
simplify the tax code, as Ronald Reagan did during his second
term," reported The Washington Post shortly after the election. But
there is a crucial difference: Reagan's administration had a number
of influential moderates--Regan, James Baker, Richard Darman--while
Bush's does not. Some of them, like Baker, were mere pragmatists,
caring more about winning legislative victories than their
ideological content. Others, like Regan, were motivated by an
actual desire to bring fairness to the tax code. President Reagan,
Lou Cannon's definitive biography, describes Regan stoking the
president's righteous anger against the unfairness of the tax code.
"The tax system we now have," he told Reagan, according to Cannon,
"is designed to make the avoidance of taxes easy for the rich and
has the effect of making it almost impossible for people who work
for wages and salaries to do the same."

Reagan is remembered as a radical conservative with close ties to
business, and that was certainly true by the standards of his day.
Yet the conservative revolution he ushered in was still in its
infancy. The then-moderate GOP establishment was strong enough to
wield major influence over his policies. The Reagan White House had
a close relationship with the business lobby, but not the sort of
iron-clad alliance that exists today. And Reagan did not
automatically dismiss outside criticism as liberal media carping. In
1984, Robert McIntyre of Citizens for Tax Justice released a study
showing that 128 out of 250 large, profitable companies had paid no
federal income tax in at least one of the previous three years. At
least some Reaganites found that embarrassing. "You could shame
Reagan's people," recalls McIntyre. "The Bushies have no sense of

It has become difficult to find Bush supporters who even approve of
Reagan's tax reform, let alone harbor any desire to repeat it. In a
recent National Review article, Ramesh Ponnuru explicated the
current conservative position. The 1986 tax reform was "a major
setback for conservatives," he wrote. "Congress adopted the liberal
definition of tax reform, and broadened the tax base to include
things it should not have included.... For most of the subsequent
two decades, conservatives have been trying to undo the policy
damages wrought by those two changes."

So how have Bush and his supporters managed to pass off their
position as "tax reform"? One reason is that they have exploited a
somewhat obscure but crucial conceptual misunderstanding.

Bush's supporters claim that his present and future tax cuts, taken
together, would bring about a consumption tax. "With each
incremental change to the tax code that Bush has put in place, or
has proposed, we take another leap toward a flat-rate consumption
tax system. I call this Bush's stealth flat-tax plan," gloated
Republican activist Stephen Moore in The Weekly Standard last year.
And mainstream reporters have taken the same view. "Many
Republicans and some of his campaign advisers view his call as one
that would replace the income tax with a system that would
basically tax personal consumption, effectively eliminating levies
on investment and savings," reported The New York Times.

Framing Bush's plan this way has lent it a certain credibility among
policy elites. Most economists agree that a consumption tax, if
properly executed, would do a somewhat better job than an income
tax of cultivating economic growth. An income tax taxes how much
you earn, whether through wages or through savings (rent, stock
portfolios, et cetera). A consumption tax taxes only the income
that you consume. Economists believe this could improve growth by
encouraging people to save more, which would lead to more investment
capital. The trouble is that Bush's goal of exempting investment
income from taxation would not actually result in a consumption
tax. It would result in something far worse.

A consumption tax requires a tax not only on wages but also,
indirectly, on existing capital. Under an income tax, you pay taxes
on the income you earn from your savings, but you don't pay any tax
when you consume those savings. A consumption tax does the reverse:
You pay nothing on the income you earn from your savings, but you
do pay a tax when you try to consume it.

Switching from an income tax to a consumption tax would effectively
impose a huge double tax on all existing capital assets. Suppose
that the government replaced the income tax with a national sales
tax, which is one kind of consumption tax. Now imagine you have a
bank account that has been earning interest. Under the old system,
you had to pay taxes on the interest you earned on those savings.
With a national sales tax, though, you would have to pay taxes
again when you pulled the money out of the bank and spent it on a
new car.

The reason existing assets get hit twice is that they are caught in
the switch. Under an income tax, they get taxed on the front end.
Under a consumption tax, they would get taxed on the back end. The
savings that exist at the time of the switch would get taxed at
both ends, while future savings would avoid this penalty.

That may sound unfair. And, to some extent, it is. But the
unfairness, in a way, is exactly the reason economists like it.
Taxes impose the least drag on the economy when they do as little
as possible to change people's behavior. One way to design an
efficient tax is to concentrate on taxing things that people can't,
or are reluctant, to change. This can be unjust. Economists suggest
that a poll tax, where every citizen pays a fixed sum, would be
highly efficient-- the only way to avoid it is death, which most
people find highly undesirable-- though brutally unfair.

Switching from an income tax to a consumption tax would work for a
similar reason. It penalizes people who have saved money in the
past. That's where the efficiency comes from: It punishes behavior
that can't be changed (in this case, because it has already
happened). As Brookings Institution economists William Gale and
Peter Orszag wrote in a recent Tax Notes paper, "A key finding in
academic analysis is that almost all of the economic benefit from
moving to a consumption tax derives from the one-time tax it places
on existing assets."

The one-time tax on existing assets is not only the most
economically efficient part of a consumption tax, it is also the
one part that most hurts the wealthy. (The underlying principle
here being the well-known fact that wealthy people have more money
than poor people.) It may, therefore, not come as a complete
surprise that Bush's plan omits this feature entirely. Bush's plan
doesn't impose a onetime tax on existing assets. Instead, he would
leave the structure of the income tax in place, but exempt
virtually all investment income from taxation. The government would
tax wage income that is consumed, but it would not tax savings
income that is consumed. That's not a consumption tax, that's what
economists call a wage tax. And the same academic analyses that
find a consumption tax better than an income tax at promoting growth
also find that a wage tax would be worse than an income tax at
doing the same. Bush's plan, in other words, is the worst of all
worlds: a pie that grows more slowly and is sliced up less

As Gale and Orszag write, "[T]he system that emerges from the Bush
tax cuts has many of the worst features of both the previously
existing tax system and a fundamentally reformed system. The tax
cuts will generate none of the potential growth effects of
fundamental reform, and in fact will reduce long-term economic

Bush's effort to transform the income tax into a wage tax will harm
the tax code because it is reverse tax reform: Rather than
broadening the base of income subject to taxation, it narrows it.
This forces higher tax rates on wage income. (Eventually,
anyway--in the meantime, it means further deficit spending. )
Bush's plans amount to massive loopholes for investment income.
Conservatives argue that they are merely removing a "double tax" on
income that has already been levied at the corporate level. But the
corporate income tax has itself been whittled away to the point
where it resembles Swiss cheese that is more hole than cheese.
Corporate tax revenues have dropped from 4.1 percent of Gross
Domestic Product in 1960 to 1.3 percent today. With the estate tax
slated for extinction, capital gains and dividend taxes slashed,
and Bush proposing huge new tax-free savings vehicles, most
investment income will never be taxed at all.

There is, therefore, something almost comically nave about the
speculation that Bush is planning to embark upon Reagan-style tax
reform. "Bush's second term does appear to be a ripe time for tax
reform," reported the Post a few weeks after the election.
"Corporate tax revenue, measured against the size of the economy,
has fallen to levels not seen since 1983, in part due to the
proliferation of new loopholes and offshore tax havens." From the
perspective of the Bush administration, of course, the decline in
corporate taxation is exactly what they're aiming for. As the
techies like to put it, it's a feature, not a bug.

A fundamental misunderstanding of Bush's intentions also underscores
the fanciful notion that Democrats might, or ought to, cooperate
with him. (The week after the election, the normally astute Los
Angeles Times Washington correspondent Ron Brownstein opined on
CNN, "Tax reform may be one [area] where there may be some
bipartisan cooperation; it's a less ideological issue.") Of course,
Democrats would have an obligation to join hands with Bush if the
president wanted genuine tax reform: closing loopholes and
preferences, lowering rates, and preserving the progressive nature
of the tax code. But, in Bush's GOP, the earnest tax reformers have
long since been eclipsed in influence by the Ernest Christians.

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