Could a Flatter Federal Tax Plan Actually Work?

A centrist plan with a progressive twist could be a bipartisan compromise. And it could help balance the budget.
by | February 9, 2012

Presidential candidate Mitt Romney has an image problem: He's rich. This is not a good year to be rich when you're running for president — not while demonstrators are attacking the top 1 percent wealth-holders. Although he won't apologize for his success in amassing a fortune working at private-equity firm Bain Capital, his credibility on tax policy is strained right now. Anything he does to benefit the rich looks like it's self-serving.

Maybe it's time for Romney to pull a "Nixon-goes-to-China" jiu-jitsu campaign move and propose a viable compromise tax structure that is simple, pragmatic and progressive — and requires him and fellow capitalists to make a personal sacrifice. He can outflank his GOP rivals as well as the incumbent president with a visionary tax plan that actually can work and truthfully help balance the budget.

Tax ideologues in the GOP advocate a low-rate flat tax, and candidate Romney has wisely resisted that strategy as favoring the rich and worsening the budget deficit. Many Republicans would also like to see investment income taxed at lower rates than the current law will soon require in 2013. Romney is trying to avoid straying too far from those primal urges inside his own party. But he can take a page from Ronald Reagan's playbook: adopt the basic idea of a low flat general tax rate and then add a single dose of progressive taxation for the upper crust (himself included) to avoid hypocrisy. The result would be a tax plan that most Americans would consider simpler and fairer than the loophole-ridden code that lobbyists have cobbled together over two generations. Loyal GOP conventioneers as well as fiscal realists would stand up and applaud.

A flat base tax. First, Romney should propose a basic flat tax rate of somewhere in the 15 to 19 percent range, to be dialed downward when the national budget deficit is fixed and dialed higher to the upper limit when budget deficits require sacrifices from everybody. (Presently, individual income taxes represent about 15 percent of all projected taxable income in coming years, but the budget is not balanced.)  We need to start at the upper end because the federal budget must be balanced first, before we start giving away widespread tax cuts — but that should be the ultimate reward for eventually getting our fiscal house in order. To achieve the lower rates for the middle class and the top cats, almost all itemized deductions must go, except for mortgage interest and medical expenses. The standard deduction would be replaced by a uniform household tax exemption.

Low-income exemptions. To avoid penalizing lower-income Americans, the lowest one-third of tax returns should be free from federal income taxes altogether by exempting the first $20,000 of income, so that the effective income tax rate for the average U.S. household earning $50,000 would be less than 12 percent of total income. All taxable income — including investment income — would be taxed at the same uniform 15 to 19 percent rate for everybody but the wealthiest households who would pay a higher rate.

A lower, but comprehensive, top rate. At the upper end, the top 2 percent of taxpayers in their respective household categories should then pay a 28.4 percent rate on all their income above those levels. (I have chosen that unusual number quite deliberately, as you shall see below.) So should others with taxable investment income in excess of $200,000 regardless of other sources. Deductions and exemptions would be phased out for taxpayers in the top 3 percent, which is also roughly $200,000 per household for all sources. These features would retain the progressivity of the current federal system, while eliminating the tax preferences and loopholes that allow the wealthiest Americans like Warren Buffett and Mitt Romney to pay at lower tax rates than the people who work for them.

The other remaining GOP contenders have already advanced their own proposals, which typically include general rates in the range described above for everybody, but without an upper tier — which flat-tax zealots would oppose on principle. Rick Santorum's proposal is a close cousin, with a similar logic but a lower base rate that won't produce enough revenue at a 10 percent level to balance the budget. All of them have generally supported a trade-off of fewer deductions in exchange for a lower marginal rate, however, so compromises should be feasible in this approach.

As with Santorum, I have deliberately chosen the 28.4 percent top tax rate because that was precisely the top rate under Ronald Reagan's tax reforms of 1986. Very few Republicans can argue straight-faced that their iconic hero was wrong about the top tax rate when he streamlined federal taxes back then. What many have forgot is that Reagan also agreed to equalize the tax rates on investment and ordinary income, just as I have suggested. It's hard to see why today's GOP faithful would reject my Reagan-revival tax rate as part of a package that eliminates loopholes and deductions.

President Obama should be able to readily support this approach as well, because this streamlined two-tiered approach maintains the current system's progressive features while eliminating complexity from the system and protecting low-income households. The income threshold for the top tax ratepayers (the top 2 percent) is straight out of his recent State of the Union address.

The Reagan rate is almost double the rates that Romney and Buffett pay now under the lame-duck 15 percent capital gains and dividend tax rates of the Bush plan. In fact, a 28 percent rate on capital gains would have to be phased in over three years to avoid a selling stampede on Wall Street if the rates were to jump all at once. Accelerated tax-avoidance selling would hurt everybody including the little guys, our pension funds and millions of middle-class IRA portfolios.

The obvious problem for liberal Democrats is that many of them now instinctively oppose any tax rate that Republicans propose. Their initial reaction would be that the top rate can't be reduced, even if itemized deductions are eliminated for the wealthiest. They must be reminded that the Affordable Care Act's Medicare tax surcharge on investment income already adds another 3.8 percent on top of the highest investment income tax rate for wealthy investors. So they will extract an effective rate of 32.2 percent on investments and leave no loopholes for the rich, which exceeds the President's proclaimed (State of the Union) 30 percent target for taxes on the rich That's a 115 percent increase on investment income taxes rates, with a much broader base to boot. As I've said before in a predecessor column, anything steeper than that will drive many Yankee investors to offshore tax havens which only worsens our budget deficit; some are already heading there.

Bonus: No more AMT. This system will also eliminate forever the despised, haywire Alternative Minimum Tax (AMT) by capturing all kinds of investment income at the upper rate, but only for the very wealthy. Commodity traders, private equity barons and hedge fund managers would pay uniform taxes on all their income, like everybody else, and those making a lot of money will pay higher taxes on average. Middle class taxpayers and most retirees would still enjoy low rates on investment income. Even the affluent middle class will pay the lower general tax rate on most of their investment earnings. Municipal bonds would remain tax-exempt except for those issues now subject to the AMT, which would then be subject to investment tax rates for wealthy investors. With muni rates now trading above Treasury bond yields, it's hard to argue that the lower federal tax rates will hurt the muni market, and private-activity bonds would still require a yield premium over general obligation debt for infrastructure, as it should be.

State and local taxpayers would lose their federal income tax deductions for their sales, property and local income taxes, which could theoretically stiffen voter resistance to local tax increases. However, somebody would have to prove to us that a local tax levy was ever passed because it was federally deductible. Those in high-tax states like California and New York would still benefit from the lower federal tax rates on ordinary income.

I realize that many readers have diverging views of tax policy, and that most readers of the Governing e-letters are state and local officials who don't themselves set federal tax policy. But it's worth thinking more deeply about how federal tax reform could work, and how it would impact state and local finances. What I find most ironic today is that the difference between the President's recent proposal and the Reagan legacy rate is so narrow that in substance a compromise would be readily achievable, yet their rhetorical gap is wider than the Grand Canyon.

Don't ask me to hold my breath waiting for these suggestions to emerge from either party's national conventions, unless the Romney people see a political opportunity to harken back to Reagan rates and take the moral high ground by putting his money where his mouth is. Until September, both sides will pander to their bases, and not the middle, even though that is where the November election will be won. And the Beltway tax lobbyists will do everything in their power to preserve their preference-laden system despite its massive and unnecessary costs of compliance. So would wealthy donors to both political parties who now enjoy low capital gains tax rates that will expire before the next inaugural. Nonetheless the lame-duck Congress is highly likely to pass a compromise tax bill after the November election, before the Bush tax cuts expire December 31, if neither party gains control of both houses.

Those who knew me in the 1980s would be either shocked or amused to see me invoke Reagan-era tax rates as optimal tax policy in 2013, but I've run the numbers and this viable compromise formulation makes economic sense in today's competitive global capital markets as well as Main Street. Successful investors (myself included) will ultimately pay more in taxes under this structure, but as Justice Oliver Wendell Holmes once observed, that's the "price of civilization" and tax equity.

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