Tax Ideas from Flat to VAT

Looking for ways to make the bite on income less unfair

Once again, the dread mid-April deadline looms. It is time for the annual agony of Form 1040. Struggling through the labyrinth of loopholes, millions of Americans will complain this week that they must be paying more than their fair share of taxes. They will grumble anew about fat cats who can afford high-priced accountants to find tax shelters.

Since 1950 the percentage of federal revenue that comes from the income tax has risen from 40% to 48% (see chart), and politicians sense that public resentment is coming to a boil. In his State of the Union address, President Reagan said he had asked the Treasury Department to devise “a plan of action to simplify the entire tax code, so that all taxpayers, big and small, are treated more fairly.” The Treasury plan will not be ready until after the election, but at least half a dozen proposals are already percolating in Congress. The Democratic presidential candidates support tax reform, and it could become a major campaign theme in the fall. Says Democratic Congressman Jim Jones of Oklahoma: “I think both sides will be trumpeting tax simplification, lower rates and fewer tax shelters.”

A compelling reason for revamping the tax system is the need to raise substantial new revenues to help close a federal budget deficit that threatens to top $200 billion. The budget gap may stall the economic recovery by pushing up interest rates. Last week banks raised the prime rate that they charge corporate customers from 11.5% to 12%, the second rise in three weeks. The Federal Reserve Board reinforced the trend by raising the discount rate it charges on loans to banks from 8.5% to 9%.

If Congress cut down drastically on the number of deductions allowed, it could raise revenue and simultaneously lower tax rates. One of the most sweeping strategies of this kind is the so-called flat-tax proposal put before Congress last year by Democratic Senator Dennis DeConcini of Arizona. Devised by Economist Robert Hall and Political Scientist Alvin Rabushka of the Hoover Institution at Stanford, the plan would eliminate all deductions and tax everyone at the same rate, 19%. Currently, rates go as high as 50%. The Hall-Rabushka proposal would let all taxpayers subtract a “personal allowance” from their income that would amount to $8,500 for a family of four. This provision would mean that poor families would continue paying little or no tax.

Corporations would also pay a 19% rate, rather than their current maximum of 46%. They could deduct the cost of new equipment immediately instead of writing it off over several years. But companies would actually pay more than they do now because they would lose many tax breaks, including the deduction of interest expense. Hall and Rabushka estimate that their plan would lift the Government’s annual revenues by about $100 billion and close half the budget deficit.

Though simple and evenhanded, the Hall-Rabushka plan has at least two features that probably doom it politically. First, it calls for a low 19% tax rate on even the richest of taxpayers. Second, it does away with many tax preferences, like the deduction of mortgage interest, that millions of Americans rely upon.

Two Democrats, Congressman Richard Gephardt of Missouri and Senator Bill Bradley of New Jersey, are pushing a less radical tax-simplification strategy. Their plan would set three rates: 14% on individual incomes up to $25,000; 26% on amounts ranging from $25,001 to $37,500; and 30% above that level. About 80% of taxpayers would be in the 14% bracket. The Bradley-Gephardt plan eliminates many loopholes, but keeps such popular tax breaks as deductions for mortgage interest and charitable donations.

A pair of Republicans, Congressman Jack Kemp of New York and Senator Robert Kasten of Wisconsin, are preparing a bill similar in many ways to the Bradley-Gephardt plan, but the top rate would be 25% instead of 30%. Says Kemp: “I think the chances are fifty-fifty we’ll pass something.”

Some experts argue that trying to reform the income tax system to raise more revenue will be a politically futile exercise. Charls Walker, a former Deputy Treasury Secretary in the Nixon Administration and now chairman of the American Council for Capital Formation, suggests that the U.S. adopt a value-added tax (VAT) similar to the kind used in most West European countries. A VAT is a tax levied on goods at each point of the production and distribution chain according to the value added at that stage. A tax on refrigerators, for example, would be collected from the manufacturer, the wholesale distributor and the retail appliance dealer. Ultimately, of course, consumers would pay the tax in the form of higher prices.

A 5% VAT would produce $60 billion in 1985. Says Republican Congressman Barber Conable of New York: “The VAT raises significant amounts of money and hides it in the price structure—a politician’s dream.” A VAT is harder to evade than the income tax, which is one reason it is used in Europe, where income tax cheating is common. The Internal Revenue Service says it lost $81.5 billion in 1981 because people concealed income.

The main objection to the VAT is that it would fall heavily on the poor, who spend most of their income on basic items like food and housing.

One solution would be to exempt such essentials from the tax. Walker suggests that low-income people could get income tax credits or rebates to counterbalance the VAT.

No one expects tax reform to make much headway in an election year, but the White House may give it a big push in 1985. Says Walker:

“If Reagan is reelected, he’s got nothing to lose. If a Democrat becomes President, he sure doesn’t want the deficit albatross around his neck when he runs again four years later.” For once, tax increases, if wrapped in tax reform, could be good politics.

—By Charles P. Alexander.

Reported by Gisela Bolte and Neil MacNeil/Washington