Politics & Policy

Keeping Score On Tax Reform

It's coming. Here's what you need to know.

The likelihood of a tax-reform bill coming out of Congress is now pretty high. President Bush campaigned hard on it and has formed a commission to help pursue it. Tax legislation has also passed in each of Bush’s first 4 years in office, with the president now enjoying a more solidified Republican majority in the Senate (55 seats, up from 51) to help push reform legislation through.

Some argue today that there should be a tax cut each year so that interest in (and lobbying for) tax cuts grows and becomes entrenched. Tax reform, however, is a little more involved than an annual tax-cut package. The following Q&A might be helpful as the tax-reform ship sets out on its long, though potentially smooth, sail.

What’s the process? One possible scenario is that in 2005, the Treasury, White House, Office of Management and Budget, Senate Finance and House Ways & Means committees, and president’s tax commission develop tax-reform proposals. From there, the process might be somewhat similar to how the 2003 tax cut came about: A tax proposal will become part of the fiscal year 2007 budget presented by the OMB in February 2006 and will be incorporated into the congressional budget in April-June 2006.

The bigger Republican majorities will make this stage of the process a little easier than it was in 2003. Should hearings begin in the House Ways & Means and Senate Finance committees in the first half of 2006, legislation might then pass in the second half of 2006 under the budget reconciliation process that allows Senate passage with a simple majority (rather than a filibuster-proof 60 votes).

What’s the tax commission? The administration has announced a tax commission headed by former senators Connie Mack (R., Fla.) and John Breaux (D., La.). According to Mack, the commission’s mandate is to “address issues of fairness, simplicity and encourag[e] more economic growth.” The president said he wants the commission’s product to be revenue neutral and to leave intact favorable tax treatment for mortgages and charitable contributions. The commission’s product is advisory, but the chairmen are both serious Washington insiders. The commission’s product will carry weight.

What might be in the legislation? An extension of the lower tax rates provided in 2003, an expansion and aggregation of tax-preferred savings vehicles such as IRAs, Roth IRAs, 401(k)s, and 529 education accounts, and some relief from the ever-broadening alternative minimum tax should all be part of tax reform.

The lower tax rates probably won’t be made permanent (even though that would be more pro-growth) — just extended for 2 to 4 years. Similarly, the reduced taxation of estates might be pushed beyond the end of 2010. Tax-preferred savings vehicles might be grouped and, in the aggregate, the caps and limitations allowed to expand faster than under current law.

Given intense public opposition, implications for state governments, and questionable economic benefits, a retail sales tax, a value-added tax, a new consumption tax, or a movement toward a flatter tax are not likely.

Will this be a tax cut or a tax increase? Both. The president has said he wants tax reform to be “revenue neutral.” This means taxes will be cut in some areas and increased in others. In 1986, taxation was shifted somewhat from individuals to corporations, helping that tax reform sell. It’s not clear yet what the “revenue raisers” would be in 2006 to make up for the assumed revenue losses from the extension of lower rates, AMT relief, and the expansion of savings incentives. In the tax-writing process, there will be a list of possible revenue raisers, a wish-list of tax reductions, and a daily re-tallying of 10-year totals.

How does tax scoring work? Congress’s Joint Committee on Taxation works with the tax-writing committees. It prepares an estimate of the revenue impact of each provision. The assumption in the scoring process is that tax changes won’t affect overall economic growth. This is called a “static” model.

But the congressional tax-writing system primarily tracks the cost of tax changes to the federal government, and ignores the benefits to the private sector and the economy as a whole. This presents a particular difficulty for a major tax reform, in that a primary goal of such a reform is to increase economic growth. A major tax reform based on simplification would bring private-sector benefits in terms of economic efficiency, faster economic growth, asset price appreciation, increased employment, and, probably, a broader federal revenue base.

Could the whole scoring process be changed? Previous attempts to change the scoring process (in the mid-1990s and in 2002) failed. However, it might be possible for Congress to agree on a special scoring procedure for this particular reform bill. For example, Congress might assume that tax simplification and reform should add 0.25 percent to GDP growth in each of the next 5 years. The resulting legislation would be revenue neutral when the added revenues from a faster-growing economy are included.

Why is scoring so important? The current scoring system blocks effective tax reform by assuming tax changes won’t improve the economy and then inserting this (faulty) assumption into House and Senate voting procedures. An innovation in the scoring area would be a particularly favorable economic and market development because it would open the way to more meaningful current and future tax reforms.

By itself, a scoring innovation would constitute a major pro-growth structural reform, putting it in company with Social Security and tort reform and (although less likely) a new congressional procedure to restrain spending growth.

– David Malpass is the chief economist for Bear, Stearns.

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