First Step to a Flat Tax

By Kevin A. Hassett and
Charles W. Calomiris

In 1996, Bob Dole based his campaign on an across-the-board 15 percent tax-rate cut amounting to $500 billion over five years. It didn’t work. Most Americans were unmoved by the idea, and Mr. Dole was soundly defeated by a Democratic rival who even then was carrying around ethical baggage.

Four years later, the centerpiece of George W. Bush’s candidacy is what he calls a "bold plan" for the twenty-first century: another almost $500 billion tax cut. His structure for marginal tax rates is so similar to the 1996 flop that Mr. Bush’s plan might as well be call ed "Dole redux."

Why will the general-election voters who repudiated Mr. Dole’s offering in 1996 embrace Mr. Bush’s nearly identical plan? They won’t. One reason John McCain’s tax plan was received so enthusiastically in New Hampshire is that voters have a better sense of the economic lessons of the 1990s than do Mr. Bush and his advisers. Americans want a compelling long-term vision for tax reform, not tax tinkering. The Bush plan does not offer such a vision, but the McCain plan does.

Mr. McCain’s plan offers prudent and purposeful first steps toward tax reform. His general goals include moving toward a privatized Social Security system that will stave off a coming fiscal disaster, building wealth for the roughly 50 percent of American families who don’t have any, and creating a fairer, flatter tax code that will reward savings. Mr. McCain’s ultimate goal is a consumption-based flat tax, which, polls consistently show, most of the nation favors.

Here are the specifics of Mr. McCain’s plan:

• Keep government away from savings and investment. Mountains of theoretical economic studies have shown that taxing savings is always a bad idea, and even more so in boom times. Low savings and the high current-account deficit are widely regarded as the main threat to the current investment-led boom. Mr. McCain has made increased savings a hallmark of his new tax plan, beginning with his proposal to introduce tax-deductible family-security account contributions for middle-income taxpayers.

• Minimize marginal rates. Both the McCain and Bush plans recognize overall tax-rate reduction as a long-term goal. True, Mr. Bush’s reductions do more in the short term to reduce marginal tax rates at the top than does Mr. McCain’s extension of the 15 percent tax bracket. Mr. McCain’s long-term objective is to move to a flat-rate structure by cutting marginal rates from the bottom up.

This would encourage work, investment, and enterprise, allowing government to extend tax brackets upward as the supply-side benefits of the plan take hold, rather than by initially cutting the highest rates paid by the wealthy. The bottom-up approach is a credible reform mechanism that promises to lock recalcitrant Democrats into a process that will move quickly to a flat tax, provided supply-side benefits are as high as Republicans believe they will be.

• Limit uncertainty about tax policy. Social Security liabilities are much greater than assets, and benefit cuts or payroll tax increases will be necessary if on-budget revenues are not devoted to reform. Mr. McCain’s plan sets aside money to ensure that government could help finance a move toward private Social Security, while Mr. Bush has only paid lip service to such a reform. This is the main reason why Mr. McCain’s tax cut is smaller than Mr. Bush’s. Uncertainty about future changes in tax rates is itself a drag on economic activity. The possibility of marginal rate reversals, and the uncertainty over who will bear the cost of Social Security, is a government-made risk that is within our power to eliminate. Mr. McCain has made that risk reduction a clear priority.

• Keep tax policy from threatening monetary policy. Concern over the potential undermining of the Federal Reserve’s hard-won gains in reducing inflation was clearly reflected last summer in Alan Greenspan’s opposition to tax cuts that were smaller than what Mr. Bush proposes. Mr. Bush’s response is that he and the Fed chairman have a "difference of opinion." Mr. McCain and Mr. Greenspan do not.

• Eliminate special-interest distortions in tax policy. Special-interest tax breaks are unfair and also inefficient because they force up the marginal tax rates that others must pay. Mr. Bush seems unable to find any corporate welfare he doesn’t like. Mr. McCain has promised to take his case for eliminating these policies directly to the American people.

• Leave the Internet alone. The Internet has clearly been a powerful force, driving the economy in the late 1990s. Uncertainty about future Internet taxation threatens current investment in new technologies. Mr. McCain supports a permanent ban on taxation of the Internet. Mr. Bush refuses to make such a pledge.

Mr. McCain’s tax-reform proposal offers a pragmatic approach to achieving a flat, consumption-based tax without increasing uncertainty about tax policy or monetary policy. It also addresses the most pressing problems our economy is facing: the need to spur savings and protect Social Security.

The solemn duty of Republicans in the primaries is to select the candidate who has the best substantive proposals and the best chance of carrying them out by winning the general election. Mr. McCain’s plan does not rehash old ideas with the hope that, this time, Republicans will explain them better. His plan, unlike any other, addresses the economic challenges of the future and respects the wisdom of America’s voters.

A Deficit of Principle

By Lawrence B. Lindsey

Former senator Russell Long had an aphorism that summed up the typical politician’s attitude toward taxes: "Don’t tax you, don’t tax me, tax that fellow behind the tree." It didn’t really matter how much the fellow behind the tree was already paying in taxes. The key was that he wasn’t part of the conversation. Even better if the "fellow" isn’t a voter—a corporation, for example.

Sen. John McCain claims there are billions of dollars of corporate loopholes to be closed, enough money to give a large tax cut to many upper-middle-class Americans without touching the rest of the budget. How does the senator’s rhetoric match up with reality?

Mr. McCain lists 53 supposed loopholes with 69 separate provisions. But four items on his list were repealed by Congress in November. (Sen. McCain missed the vote.) Three other loopholes had been closed in the Taxpayer Relief Act of 1997, which Mr. McCain supported. Mr. McCain is urging Congress to do things it has already done. This is leadership?

The senator is also guilty of double-counting. Among the "loophole closers" he proposes to pay for his tax cut are four that he proposed using last fall to pay for his education reforms.

Nine other provisions, accounting for at least a quarter of the McCain tax increase, raise taxes on American corporations doing business abroad. While there is certainly a need for both thoroughgoing reform to simplify this area of the tax code and tougher enforcement of existing laws on multinationals, the McCain plan would take us in the wrong direction. His proposals would put U.S. companies overseas at a competitive disadvantage vis-à-vis their foreign competitors, which would reduce U.S. exports and eliminate American jobs.

Mr. McCain’s proposals for hitting U.S. businesses overseas also double-count revenues from overlapping provisions and thereby exaggerate the potential gain to the Treasury. In the longer term, revenues would fall more as U.S. corporations’ foreign operations became less profitable and some disappeared altogether.

The largest single proposal in the McCain plan, worth about 20 percent of the purported revenue gained, would end the full deductibility of advertising as a business expense. We all get tired of watching commercials, but is the cost of running them—or the cost to a car dealer or a supermarket to list its specials in the Sunday paper—really a "corporate loophole"? To me it seems like an ordinary business expense.

Further down the list of "corporate loopholes" is nearly $10 billion of revenues Mr. McCain proposes to raise through two changes that would directly hit contributors to charities and nonprofit organizations. He proposes to end the ability of individuals to deduct the current value when they give art, land, or common stock. Instead, taxpayers would be able to deduct only what they initially paid for the property. Economic research on this topic suggests that charitable giving would fall sharply, with museums and universities particularly hard hit.

Though billed as closing a "corporate loophole," this tax increase doesn’t fall on corporations at all, but on individuals. In fact, this McCain tax hike on individual contributions to charity is a bigger revenue raiser than his proposed tax increases for the banking, oil, gas, insurance, and utility industries combined. This from a man who says he’s crusading against the influence of "special-interest money"?

Mr. McCain has offered a variety of proposals to tax workers’ benefits. Last July he cosponsored the Middle Class Tax Relief Act of 1999. To offset the bill’s proposed tax cuts for upper-middle-class taxpayers, Mr. McCain proposed imposing an excise tax on all employer-provided fringe benefits except pensions. Health insurance is the largest of these perks, and taxing it proved incompatible with the need to expand coverage to the uninsured. On January 11, 2000, Mr. McCain amended the list of fringe-benefit loopholes to exclude health insurance and child care. Then, on January 19, his campaign issued a new press release that said educational and adoption-assistance benefits would also be tax-free.

If elected, Mr. McCain may also find himself having to flip-flop on a matter of fundamental principle. To meet the 2001ÿ05 revenue figures in his tax-cut plan, Mr. McCain would have to make his tax hikes effective next January 1—nineteen days before the new president takes office. That means Mr. McCain’s tax increases would have to be retroactive, as Bill Clinton’s were in 1993. In that year Mr. McCain led the charge against retroactive tax increases, arguing on the Senate floor that they were unconstitutional and, for good measure, proposing a constitutional amendment to prevent such tax hikes in the future.

A candidate is, of course, free to change his mind and to have any, or as many, tax proposals as he wants. But Mr. McCain’s plan seems to be based on no principle other than Long’s adage about taxing the fellow behind the tree. That lack of substance is what makes the difference between campaign rhetoric and a tax-reform agenda that might actually be enacted.

Kevin A. Hassett is a resident scholar at the American Enterprise Institute. Charles W. Calomiris is a professor of finance and economics at Columbia Business School and a visiting scholar at AEI. Lawrence B. Lindsey, a former governor of the Federal Reserve, is a resident scholar at AEI.