Real Relief

Tax cuts are nice, but a new report underscores the need for fundamental reform.

As Congress works out the details of the $1.35 trillion tax cut plan, a congressional committee has reminded us that we need more than this to fix the tax system. The non-partisan Joint Committee on Taxation recently released a 1,300-page study that proposes dozens of tax simplification steps. While a good starting point for needed reforms, the report underscores why Congress should move to scrap the current income tax and install a simpler system.

Consider the dimensions of the current federal tax mess, as documented by the committee: The federal tax code contains 1.4 million words. By my estimate, the Bible contains just 0.8 million words.

The tax code itself is only part of the mess. The federal tax system requires more than 20,000 pages and 8 million words of regulations from the Treasury to explain how the tax laws passed by Congress are supposed to be applied.

The IRS produces 649 separate tax forms and schedules with a combined length of more than 16,000 lines and publishes 340 other publications with more than 13,000 pages. Federal tax rules are so confusing that taxpayers contact the IRS with questions about 117 million times each year. The Treasury's Inspector General recently found that one-third of taxpayer phone calls do not get through, and of those that do the IRS gives incorrect answers 47 percent of the time.

While it is easy to blame the IRS, the real source of these problems is the complex tax laws passed by Congress. Congress imposes its largest tax on "income," which is notoriously difficult to measure and getting more difficult all the time. For example, U.S. corporations now have ownership stakes in more than 20,000 foreign affiliates. It's increasingly difficult to accurately calculate the portion of global net income that is subject to U.S. taxes.

On an individual level, broadened ownership of financial securities is subjecting more Americans to the headaches of capital income taxation, particularly capital gains taxes. A tax system that instead had a domestic consumption base would reduce these difficulties. Congress is also to blame for mucking up the tax code with a proliferation of "phase-outs," "ceilings," and other limitations on who gets to receive special tax breaks. There has been a parallel increase in the use of the tax code for "social engineering," which is steering narrowly focused tax credits and deductions to politically favored individuals and industries. Again, a flat-rate consumption-based tax would rid the tax code of most of these complex provisions.

The current tax code's complexity imposes a steep cost. The Joint Committee's report notes that tax complexity increases time and financial costs to taxpayers, reduces taxpayer compliance, reduces perceptions of fairness and increases the costs of government administration. The total administration and taxpayer compliance costs of the income tax are about $150 billion per year or more, about $1,500 for every household in the country. The Joint Committee proposes reforms that would begin to bring back some sanity to the tax system. One important proposal is repealing the alternative minimum tax (AMT) on individuals and businesses. The AMT is essentially a separate income tax system parallel to the regular income tax. Supporters promised it would bring greater fairness to the tax system. Instead, it has created a huge amount of extra paperwork, new costs, and planning difficulties for families and businesses.

The Joint Committee also proposes ending most of the "phase-outs" under the individual income tax. These are provisions that deny those with middle and higher incomes tax benefits enjoyed by other taxpayers. Phase-outs complicate tax calculations and increase marginal tax rates. The report suggests repealing phase-outs on itemized deductions, personal exemptions, the child credit, individual retirement accounts, and other provisions to simplify the income tax for about 30 million families.

Hopefully, Congress and the administration will receive a number of messages from this report. First, they should do no further harm with this year's tax legislation. Tax changes should be favored that increase economic growth and reduce complexity, such as income tax rate cuts and estate tax repeal. Second, after passage of this year's main tax bill, a major effort needs to be mounted to codify the Joint Committee's proposals to simplify the current system.

With lower rates and a simplified system, it will be easier to then move towards replacing the income tax with a pro-growth consumption-based system.