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Tax Reform Ė Donít Get Your Hopes Up

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
February 22, 2005

IN THIS ISSUE:

1.  Not True Reform – Just More Tinkering

2.  How To Really Broaden The Tax Base

3.  “Revenue-Neutral” Means No Big Changes

4.  Let’s Scrap The Current System & The IRS

5.  Funding Tax Reform – Not A Pretty Picture

Introduction

During his re-election campaign, President Bush piqued interest among voters, especially conservatives, when he said that replacing the current income tax code with a national sales tax was “an interesting idea.” Then just after the election, he signaled that tax reform would be a centerpiece of his domestic agenda, and made a pledge to name a bipartisan panel to draft a fundamental tax reform proposal.  That sent conservatives scurrying into either the flat tax or national sales tax camps to muster political momentum.

Shortly thereafter, White House spokeswoman Clare Buchan said, “The president believes the tax code should be simpler, fairer, and more conducive to economic growth and he looks forward to appointing an advisory panel to review options for reforming the tax code.”

The nine-member, bipartisan “Advisory Panel on Federal Tax Reform” was named in January to study options to “simplify” the nation’s tax system.   Heading the panel are former Senators Connie Mack (R-FL) and John Breaux (D-LA). Both served on the Senate Finance Committee, the panel that acts as the Senate’s gatekeeper on all tax legislation.  The tax reform panel even has its own website http://www.taxreformpanel.gov/ if you care to check it out.

President Bush is said to have told them to “be bold” in their thinking about tax reform.  While all this sounds good, the Bush administration has already begun dialing back expectations that they will move to scrap the current graduated income tax for another system.  At this point, it does not appear likely that a flat tax, a national sales tax or a value-added tax are even on the table.  This is disappointing.

What now appears most likely is that the tax panel will look to simplify the current income tax system and cut or eliminate taxes on saving and investment.  While any simplification of the draconian tax code is welcomed, and while lowering taxes on savings and investment is a good idea, Bush’s tax reform proposals are likely to be disappointing to most conservatives who want to see the current system scrapped.

This week, we’ll look at some of the ideas and proposals being talked about by those who are close to the panel’s proceedings.

Broadening The Tax Base

In his State of the Union address in January, President Bush said he would reform the tax code so that it is “pro-growth, easy to understand and fair to all.”  Sounds good.  The current tax code is so complicated that an alarming number of taxpayers are under-reporting their income or are not filing tax returns at all.  Experts estimate that uncollected taxes will hit $400 billion for 2005, up from an estimated $311 billion for 2004 and $127 billion for 1998.

President Bush has said that one of his main objectives is to broaden the tax base by simplifying the system to get the under-reporters and the non-filers to pay their fair share.  In order to do this, you have to devise a tax system that captures the tax revenues from the vast underground economy, criminals and illegal aliens who do not report income.  I would argue that simplifying the current ponderous tax code will NOT be enough to entice those who are under-reporting or not paying taxes at all to pay their fair share.

Proponents of a lower flat tax on all income, with little or no deductions, believe such a system would go a long way toward capturing tax revenues from the underground and non-filers.  But you have to wonder if these people would step up to the table just because the system is vastly simpler.

If we really want to reform the system to significantly broaden the tax base, then we should be looking at a national sales tax (also called a consumption tax) or a value-added tax, which automatically affects everyone at the cash register.

But according to everything I have read in the last few weeks, neither the sales tax nor the value-added tax is on the table for the panel.  Ditto for the flat tax.  While President Bush may personally favor some of these plans, White House insiders have intimated that he does not believe he could get such a radical change through Congress.  No doubt it would be a major political battle, but that does not mean he shouldn’t try.

So, they will tinker with the current IRS code, make some changes (hopefully including some good ones), and those of us who pay taxes will continue to do so, while those who don’t pay or under-report will also continue to do so.  The hundreds of billions of dollars in uncollected taxes will continue to be uncollected, thereby making tax rates higher on the rest of us!

Reforms Must be “Revenue-Neutral”

President Bush has said that a centerpiece in his tax reform plan would be making his tax cuts permanent, while also reducing or eliminating taxes on savings and investment.  But he has also instructed the bipartisan tax panel that any new reforms must be revenue-neutral, meaning that whatever plan they come up with should not significantly increase or decrease overall tax revenues.

Here again, the president has reduced the options available for change.  In a revenue-neutral plan, tax cuts and other benefits have to be paid for somewhere, and there is currently no shortage of bureaucrats in Washington who believe taxes should be raised on those making $200,000 a year or more.  It could happen.

Why can’t President Bush be bold on this one?  Why not go for the whole enchilada and press for a radically new system such as a national sales tax or a value-added tax that truly does substantially broaden the base of taxpayers?  Sure, the Democrats would fight it, but Bush could take the issue to the people, as he’s doing with Social Security reform, with even more success.

Americans Dislike The Current System

The current voluminous tax code and the IRS are almost universally disliked by the public.  The current tax code consists of several million words on over 17,000 pages.  It includes many perplexing rules and is riddled with “special interest” provisions.  Former deputy Treasury Secretary Samuel Bodman estimated that Americans collectively spend  “six billion hours a year” in deciphering the rules and filling out their tax returns.  Considering there are apprx. 131 million individual tax returns, that equates to 45 hours each.  Bodman estimates the cost of doing this at $120 billion per year.  An estimated 75 million individual taxpayers (57%) pay accounting firms to do their returns for them each year.

Imagine the outpouring of public support President Bush would enjoy if he were to embrace a national sales tax or a value-added tax, or even a flat tax that either eliminated the need to file tax returns or dramatically simplified them.  I think it could happen if Bush would push for it!   But apparently, these ideas – which can work, by the way - are off the table.

Reforms That Apparently Are On The Table

Several articles I have read are in general agreement about what the tax panel is considering.  The Bush administration is pushing for major amendments that would shield interest, dividends and capitals gains from taxation, expand tax breaks for business investment and take other steps intended to simplify the system and encourage economic growth.

The administration is also pushing hard for large tax-deferred savings accounts that could shelter thousands of dollars of deposits each year from taxation on interest and investment gains, according to White House economic advisers who have been involved with the planning.

And any tax reform, according to Treasury Department officials, would likely eliminate the “alternative minimum tax,” a parallel income tax designed to ensure that the rich pay income taxes, but one that increasingly ensnares the middle class.

There is also talk that President Bush wants to see marginal tax rates lowered and the number of rate brackets reduced.  I wouldn’t bet on lower rates since the president is still battling just to get his previous tax cuts made permanent.  The president also said in December that he wants to see the estate tax repealed.  Bush has also said he wants to maintain the deductibility of mortgage interest and charitable donations.

How Will The President Pay For It All?

As noted above, any reform is supposed to be revenue-neutral.  To pay for the reforms and tax cuts, the administration is looking at eliminating both the deduction for state and local taxes, and the business tax deduction for employer-sponsored health insurance.  That would raise nearly $926 billion over five years, according to White House and congressional documents.

Eliminating the state and local tax deduction, for example, would allow the administration to scuttle the alternative minimum tax and raise an extra $400 billion over 10 years according to Leonard Burman, a tax policy expert at the Urban Institute. That would be twice what the White House needs to fund the planned tax-free savings accounts, expanded retirement savings accounts and tax-free health savings accounts.

These two revenue-generating proposals alone guarantee there will be a huge fight over Bush’s tax reforms!  Taxpayers who have been able to deduct state and local income taxes for years are going to scream bloody murder if these deductions are eliminated. 

Businesses that provide health insurance to their employees will have major heartburn if they can no longer deduct these expenses.  Some may have to eliminate health insurance, and their employees will cry “foul.”   This will depend, however, on what happens with Health Savings Accounts and whether they provide an acceptable alternative to employer-provided health insurance.

Of course, most Democrats will oppose all of the tax cuts that are likely to be suggested.  Certainly, they will fight the elimination of double taxation on corporate dividends, claiming that it only helps big business and wealthy individuals.

Bush’s tax reform proposal, whatever it ultimately entails, will be a royal dogfight for sure!

Timeline For Tax Reform

The tax reform panel has until July 31 to submit to the Treasury Secretary its recommendations.  The Treasury Secretary then has until the end of this year to develop a final proposal to submit to the president.  The president would then lobby Congress to enact his plan sometime in 2006.

There are some, however, who believe there is a chance that the House of Representatives could beat the president to the punch on tax reform, and we want to keep an eye on this.  Congressman John Linder (R-GA), who favors a national sales tax, said last week that the House Ways and Means Committee may begin hearings as early as March on tax reform. 

Linder, who has been discussing his sales tax plan with congressional leaders, says he expects the full House to have a menu of tax reform options to act upon by August.  He believes the House will move on tax reform before it moves on Social Security reform, because tax reform could alleviate some of the Social Security funding problems.

It may be that Congressman Linder is the best hope we have for truly reforming the tax code with a system that casts the net over the vast underground economy and non-filers. 

Conclusion: Let The Fight Begin

The Democrats are already preparing to fight against any tax reform plan Bush comes up with.  They claim that the supposedly bipartisan panel is stacked, and to the extent that former Senator John Breaux helped Bush get his first tax cuts through, they are correct.  So they are predisposed to oppose whatever plan Bush presents them.  They will certainly oppose any of the tax cuts and/or incentives to business and wealthy individuals. 

Taxpayers who pay state and/or local taxes will oppose the elimination of these deductions.  Ditto for businesses that provide health insurance for their employees (unless Health Savings Accounts are a viable alternative).

The bottom line is that Bush will not be able to get everything he asks for.  And he’s not asking for that much, as compared to scrapping the current system and replacing it with a sales tax or a value-added tax.

Needless to say, I am once again disappointed in President Bush.

As should be obvious by now, I favor some kind of consumption tax.  The value-added tax system has proven to work in other countries, including parts of Europe.  Closer to home, it works well in Bermuda.

I would even support a national sales tax, even though upper income folks like me would pay more because we consume more.  Yet if the sales tax also removed the taxes on my investment and savings income, plus estate taxes, it would be more than worth it.

Most importantly, a consumption tax would capture money from people who currently dodge the system.  Most people don’t realize it, but close to 50% of the people in America pay NO income taxes, while the top 20% of wage earners pay 80% of all income taxes.  The top 50% of wage earners pay 96% of all income taxes.

Opponents of a consumption tax, whether a sales tax or a value-added tax, argue that it would be regressive in that it would hit the poor harder than the rich.  It is true that there are millions of lower income people who pay no income taxes today, and a consumption tax would affect everyone.  But that argument eventually gets back to the issue of a welfare state and whether or not all Americans should contribute to the benefits of living in this great nation.  Emotions run high on both sides of this issue.

I could write volumes on whether a consumption tax is too regressive versus the current system where the top 20% of wage earners pay 80% of all income taxes.  Yet the real issue that almost no one in Washington wants to address is the fact that the government is too big, grossly inefficient and politicians on both sides of the aisle spend way too much.  If the government was smaller, more efficient and truly accountable, then income taxes could be much lower and much less complex.

You would think that even the liberals could support a new tax system based on consumption that would capture the underground economy, the under-reporters and the non-filers.  Yet they won’t even have to consider that decision if the President of the United States doesn’t have the political nerve to advance such a system!

[Editor’s Note:  This weekly E-Letter is sent to over 1.5 million subscribers.  Whenever I write about polarizing issues, such as tax reform or politics, we get tons of responses from those who agree and disagree.  Actually, the negative responses often run higher than the positive, because many readers who agree with me don’t feel compelled to respond (although I appreciate it when you do). 
One of the most common responses we get is, “You’re an Investment Advisor; why do you write about politics and related issues?”  The answer is, this E-Letter is free of charge, so I write about whatever issues are of most interest to me each week.  And like it or not, politics, geopolitics and other non-financial matters do in fact affect the investment markets from time to time.
As a conservative on most issues, I know that not everyone will agree with me, nor would I want them all to do so.  But whether you agree with me or not, I hope to make you think.  I appreciate your feedback (agree or disagree), and we do our best to answer all responses that request a reply, so long as they are civil and understandable.]

Very best regards,

Gary D. Halbert

 

SPECIAL ARTICLES 

 

Why millions say, softly, God bless America.
http://www.forbes.com/forbes/2005/0228/025_print.html

Belgian socialists stoop to new low (caution, this one is a little rank).
http://weeklystandard.com/Content/Public/Articles/000/000/005/276vsdtv.asp

When camels fly – editorial by Thomas Friedman
http://www.nytimes.com/2005/02/20/opinion/20friedman.html


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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