November 07, 2003, 11:29 a.m.
All in the (Tax-Reform) Family
New tax-free savings accounts are the next Bush push.

By John Hood

There was very good news this week for Republicans and for President George W. Bush's re-election prospects in 2004. But the news didn't originate from Frankfort, Kentucky, or Jackson, Mississippi. It came straight from the White House in Washington, D.C.

Don't get me wrong. The election of new Republican governors Ernie Fletcher in Kentucky and Haley Barbour in Mississippi was good news for Bush. Both of their Democratic opponents had tried to blame state fiscal and economic woes on the president, his fiscal policies, and free trade. Voters didn't buy this blame-shifting dodge, nor did they respond in the salivating manner for which resurgent protectionists in the national Democratic party had hoped.

But both states are already firmly in the GOP column for 2004. Much more important, in my estimation, were news reports on Wednesday that the Bush administration and its allies in Congress are preparing a major push for new tax-free savings accounts as part of a coherent, free-market approach to reforming entitlements and the federal tax code. The Wall Street Journal reported that the White House is zeroing in on two specific proposals that would together allow each family member to save as much as $15,000 a year and avoid double taxation of investment income on those savings.

One option, a "lifetime savings account," would allow individuals to put up to $7,500 a year in after-tax dollars into an account and then make subsequent withdrawals for any purpose — emergencies, down payments on homes, tuition, or medical expenses — without paying either penalties or taxes. The other option would allow another $7,500 to go into an expanded Roth IRA-type account for retirement (that's a significant increase from the current maximum contribution to such accounts, $3,000, and even from the $5,000 cap already scheduled to be in place by 2008).

The tax treatment of these new accounts, like the Roth, is "back ended." That is, unlike traditional IRAs that offer a tax deduction for deposits going in while taxing withdrawals coming out, these would offer no immediate tax exclusion (and thus have little immediate impact on the federal budget), but would allow for tax-free withdrawals. In economic terms, these two models for tax-free savings accounts are essentially indistinguishable. (For political reasons, I still think a front-ended approach is best, but you take what you can get.)

The point is to avoid double taxation of the same stream of income, which happens if you tax the principal of the investment — the dollars going into the account — and later the interest, dividends, or capital gains derived from the income. Why does this constitute double taxation? Because any tax on deposits automatically reduces the earnings on those deposits by the same percentage. For example, if I wanted to put $1,000 in an IRA and the taxman took 25 percent of it, I'd have only $750 left to invest. That means that the government has already reduced the projected return on my investment — even if I don't receive it and spend it until 20 years later — by 25 percent. The fact that we layer additional levels of taxation on this income, directly as well as indirectly through corporate income taxes and the like, is one reason why Americans still don't invest as much as they would and probably should if a neutral tax code simply let them plan for their own long-term needs without a bias one way or the other.

In fact, this idea of allowing Americans to take personal responsibility for the big-ticket items of life — such as buying a house, rearing children, sending them to college, and preparing for the possibility of chronic disease or disability — is one of the major attractions of the savings-account strategy, about which I wrote in some detail in a book entitled Investor Politics. To the extent possible, advocates of free markets and limited governments should be pushing for the substitution of tax-free savings vehicles for government entitlement programs that have resulted in excessive expense, poor service, lack of competing providers, and a sundering of the natural, reciprocal relationships between parents and children, friends and neighbors, churches and congregations.

Obviously, the most significant programs deserving of this Investor Politics treatment are Social Security and Medicare, massive entitlements that, due to inevitable demographic factors, threaten either the long-term fiscal balance of the federal government or the interests of future taxpayers, or both. Building on previous versions of tax-free savings, the new Bush accounts would, as the American Enterprise Institute's Kevin Hassett said in the Journal article, help "set the stage for Social Security reform" as Americans become more comfortable with personal investing and with controlling their own financial futures. Interestingly, on the same day that the White House offered its new vision for tax reform, Republicans in Congress were restating their support for a related idea: including health savings accounts in any legislation on Medicare reform and prescription drugs. Indeed, no bill should pass without this worthy provision (and without significant private-sector involvement in Medicare, by the way).

But there are other important implications in the White House's new tax-cut push. One has to do with the longtime goal of fundamental tax reform. During the 1990s, one of the most interesting debates within conservative and free-market circles was about which model for tax reform was best: the flat-tax model championed by the likes of Dick Armey and Steve Forbes or the national sales tax championed by the Cato Institute, among others. By now, it should be obvious that the correct answer to this question was neither. As a practical matter, we are never going to reach a day when politicians in Washington can orchestrate some grand, elaborate piece of legislation that rewrites the entire federal tax code. Such deals devolve. They invite pinprick assaults by special interests. They require compromises and accommodations to the demands of individual lawmakers that would subvert the broader goal. In short, they aren't going to occur in any form that would be worth enacting into law.

Successful tax reform must be gradual, consisting of small but steady steps toward a code that taxes consumed income once and only once at a single, low rate. For all its imperfections, the Bush tax policy of the past three years has been nudging the federal tax code forward along this path by bringing down rates, reducing the bias against capital formation through dividend and capital-gains relief, and offering families additional ways to shield their investment income from double taxation.

The new tax-cut agenda for 2004 represents another step in the right direction. It also offers President Bush another opportunity to cultivate the new political constituency of the investor class, which continued to grow even during the recent recession. For them, job growth is not nearly as compelling an economic prospect as the idea of taking control over their own lives away from government bureaucrats through pro-savings tax reduction.

Critics will carp about deficits, the poor, Keynesian claptrap about the "paradox of thrift," and other distractions. Mr. President, stay the course. It will pay dividends, literally and figuratively.

— John Hood is president of the John Locke Foundation in Raleigh, N.C., and author of Investor Politics (2001).