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Winners, Losers And Big Problems With Either Tax Overhaul Plan

By Jonathan Weisman, CQ Staff Writer

Dozens of young congressional staff members packed themselves into a basement conference room recently to hear Alvin Rabushka tear his opposition to shreds. In his Looney Tune tie, Rabushka, a senior fellow at Stanford University's Hoover Institution, did not seem to take himself too seriously.

But to advocates of a flat income tax rate, Rabushka's words had great meaning. He is an icon, after all: the blunt-speaking prophet of a movement he helped found more than 20 years ago.

"To the maximum extent possible, [the flat tax] removes the tax code from the economy," he told the casually attired staff members, virtually all of whom were Republicans. "In three to five years, everybody will end up a winner."

All is wonderful with the flat tax, Rabushka said, unlike its main competitor in tax reform circles: the levy on goods and services at the point of consumption, known as a national sales tax.

"It's been a disaster wherever it's been tried," he said dismissively, maintaining that it "always evolves into a value-added tax" (a tax levied on each sale at each stage of the manufacturing process) that is more invisible than a flat tax to retail consumers. "It always spurs a one-time leap in inflation. And it may not be enforceable."

Nonsense, countered Dale Jorgenson, an economist at Harvard University and the guru of the national sales tax camp. All but eight states already collect sales taxes, he said. What's a little more? And besides, the flat tax, as outlined by House Majority Leader Dick Armey, R-Texas, would not be a legitimate tool for economic growth.

"The benefits of an Armey-variety tax package would be small," Jorgenson said, "and the effect on national savings could be a wash."

Opposing GOP Camps

The opposing camps in the Republicans' war on the current tax code may save their public bile for the Democrats, but they really seem to hate each other. Both camps have their intellectual gurus. Both have their high-profile advocates in Congress.

The Republican rank-and-file has been eager to seize on the nebulous cause of scrapping the existing tax code. But there is nothing close to a consensus on what should take its place. The sharp divisions between the flat-tax crowd and national sales tax groups may prove to be the largest obstacle in the way of a new tax system.

"I haven't decided where I stand," said Rep. Saxby Chambliss, R-Ga.

Both the national sales tax and the flat tax have similar aims: simplify the current tax system, shift the tax burden off savings and investment and onto consumption, and spur economic growth. Their means to get there are radically different, however.

National Sales Tax

The national sales tax legislation (HR2001), as laid out by Reps. Dan Schaefer, R-Colo., and W.J. "Billy" Tauzin, R-La., must be considered the underdog, although it has the strong backing of House Ways and Means Committee Chairman Bill Archer, R-Texas. This retail sales tax proposal would eliminate the income tax, and, by extension, the Internal Revenue Service (IRS). The states, most of which already collect sales taxes, would be the new federal tax collectors.

In place of a tax on income, a 15 percent tax on gross receipts from the retail sale of any taxable good or service would be installed for domestic and foreign purchases. No tax would be imposed on goods and services purchased for re-sale, to produce other goods or services, to be exported, or for education and training. Interest would not be taxed. Because the proposed tax does not include sales taxes on goods used to make other goods, it cannot be called a value-added tax, which is common in Europe.

To ensure that the tax did not fall too heavily on the working poor, all wage earners would receive in each paycheck a refund equal to 15 percent of the poverty level. Theoretically, that would ensure thatwage earners could earn up to the poverty level tax free.

The plan also includes a measure requiring a two-thirds vote in both chambers of Congress to raise the sales tax rate or to create additional exemptions.

Flat Tax

The flat tax bills sponsored by Armey (HR1040) and Sen. Richard C. Shelby, R-Ala., (S1040) may have broader appeal simply because they are easier to understand. Under the proposals, a single income tax rate of 20 percent would replace the existing marginal tax rates of 15 percent, 28 percent, 31 percent, 36 percent and 39.6 percent. After Dec. 31, 1998, the rate would drop to 17 percent.

All deductions, credits and other so-called loopholes, such as the deduction for interest paid on home mortgages, would be removed and replaced by a large personal allowance designed to shield low-income taxpayers. For instance, a family of four could exempt its first $33,800 from taxes. The IRS would not be abolished, but its size and reach would shrink dramatically.

Not So Simple

Both of the main GOP plans have serious detractors, and neither may be as simple to administer as advocates proclaim.

The Schaefer-Tauzin national sales tax may claim to abolish the IRS, but it creates a complicated refund scheme, and some federal entity will have to step in to figure out who gets what and to ensure that checks are sent out, said Diana Furchtgott-Roth, an economic researcher at the American Enterprise Institute. Joel Slemrod, an economist at the University of Michigan, proclaimed the national sales tax "NAUSEA-I Not Administrable at Usual Standards of Equity and Intrusiveness."

Its advocates may say a 15 percent rate is high enough, but James Poterba, an economist at Massachusetts Institute of Technology, has calculated that it would take a rate of 17.2 percent to raise the $1.5 trillion levied by the current system.

Include state sales taxes, and the total tax on goods and services would top 25 percent in some places. At that level, critics say, there would be a huge incentive to take sales underground. Businesses could offer favors to customers under the table: pay an extra 7 percent on the cost and we will waive the 15 percent federal sales tax. Small retailers would be particularly tempted.

Big-ticket items could also escape the tax through some fairly simple manipulation. Because interest would not be taxed, car dealers could offer an automobile at a bargain basement price with the understanding that a buyer will take a loan from the dealership at very high interest rates.

The largest concern may be political. The sales tax is designed to encourage savings and deter profligate spending. But that could hit senior citizens hard. Under a national sales tax system, earned income that went straight into savings would go untaxed, but seniors with large bank accounts already paid taxes on their earnings before they put the money in the bank. Would it be fair for them to pay income tax on that money, save diligently, and then, when they are finally ready to spend it, get whacked with a 15 percent national sales tax?

Besides, the rich can forgo luxury items to avoid the added 15 percent, but lower-income Americans spend more of their money on necessities. A national sales tax would hit them the hardest. Some states have dealt with fairness questions by exempting such necessities as food and medicine from the sales tax.

Simplicity vs. Progressivity

The flat tax cannot escape similar charges of being unfair. As former Rep. Bill Gradison, R-Ohio (1975-93), put it, tax policy has always been a trade-off between simplicity and progressivity. The flat tax would be a sharp swing toward the former.

Advocates of the flat tax maintain that it can be structured to lower taxes on everyone. But by exempting all investment and savings income from taxes, a flat tax by definition lowers taxes on the wealthiest, who own most of those investments. Lowering their taxes sharply and still lowering everyone else's strains credulity, unless Congress is willing to decrease total t ax receipts and shrink the size of government. Republicans, since they came to power in 1995, have proved unable to do that.

When pushed, flat-tax analysts concede the point. Within three or four years of passage, Rabushka maintains, a flat tax would spur so much economic growth and such a dramatic increase in tax receipts that the rate could be lowered. Then everyone would be better off. But until then, the middle class would pay higher taxes. "The politics of fairness is instant politics," Rabushka said. "The politics of growth is almost statesmanlike." He then confessed, "I'm not all that sympathetic with this question, 'What is fair?' "

Transition Problems

If flat-tax advocates take shots at the feasibility of the national sales tax, sales tax believers question the premise behind the flat tax: that it would broaden the tax base and be a boon to the economy.

The flat tax has its own transition problems, something Rabushka readily concedes. Homeowners purchased their houses with the expectation that they could deduct the interest they pay on their mortgages from their taxes. Likewise, businesses have made decisions on new plant and equipment purchases by factoring in the tax advantages of depreciation allowances. Those advantages may have to be grandfathered into a new system without loopholes.

"I don't propose that anybody lose their unused depreciation," Rabushka said.

But there is a price for such magnanimity: a significant dilution in the economic benefits of the new tax system. The point of the flat tax is to broaden the tax base by ensuring that everyone pays something. Thus in theory, overall rates would go down. Every exemption, whether it be for the working poor or grandfathered assets, chips away at that broader base. "In the end, tax reformers confront a trade-off," concluded a July 1997 study by the Congressional Budget Office. "If they want to ease the additional tax burden on existing assets and on the older Americans who own the largest portion of those assets, they must be willing to accept substantial reductions in the long-run economic benefits to younger people and future generations."

Couple transition relief with the flat tax's large standard exemptions, and, Jorgenson said, significant amounts of money would be taken out of the new tax realm. His message: If lawmakers will not make the difficult decisions on winners and losers, why bother?

© 1998 Congressional Quarterly Inc. All rights reserved.

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Saturday Jan. 24, 1998

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Winners, Losers And Big Problems With Either Tax Overhaul Plan

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