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February 16, 2003
David Warsh, Proprietor

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Present at the Creation

It was a good week for Tax Policy Theater. Federal Reserve Chairman Alan Greenspan was on Capitol Hill, taking issue with the Administration’s stated reason for seeking tax cuts, implicitly questioned its commitment to good fiscal housekeeping. That is, he leaned against the wind.

Congress, meanwhile, was beating up in hearings on Enron, Sprint, the accounting partnership of KPMG and the law firm of Akin, Gump, Strauss, Hauer & Feld, among others, for the elaborate tax shelters they employed during the ’90s boom.

The economy remained in the doldrums.

And the White House struggled to reduce the confusion that began in December, after it fired its economic pointmen, Treasury Secretary Paul O’Neill and economic strategist Larry Lindsey.

The big problem with coverage of fiscal policy is its lack of continuity. Often it seems as if we thought that everything started with the last election.

To understand where we are today, it helps to recall that the group in power at the White House has been together for nearly thirty years, ever since they joined up in the Ford administration in 1974. Their shared history determines more than just their political philosophy. It conditions their underlying view of tax policy, too.

So begin with the resignation of Richard Nixon in August 1974.

The somber crew that signed on to serve under President Gerald R. Ford considered themselves to be a government of national reconciliation. Among them were Donald Rumsfeld (White House chief of staff), Dick Cheney (his successor), Alan Greenspan (chief economist), Paul O’Neill (deputy budget director) and George H. W. Bush (ambassador to China, then director of the Central Intelligence Agency).

It is a good bet that their collective sense of mission was shared by young George W. Bush, even though, fresh out of Harvard Business School at the time, he was knocking on doors in the countryside around Midland, Texas, seeking to buy mineral rights from landowners in hopes of starting an oil and gas company.

In 1976, the Ford crew all were bitterly disappointed to be turned out by a narrow margin in favor of Jimmy Carter, after two years in office

Twelve years later, they were back in power again, in the administration of President George H. W. Bush. This time they struck for fiscal responsibility and calm nerves, raising taxes on the eve of the Gulf War and resisting demands that they goose the economy after they had won. They got beat again, this time by Bill Clinton.

So it ought to surprise no one that in the administration of George W. Bush, behavior likely to be considered statesmanlike by the establishment press takes a backseat to stratagems designed to promote reelection in 2004. Almost all of the current menu of economic news — tax cuts, stimulus, lagging recovery, protection for domestic steel — can be understood mainly in terms of determination not to be turned out again from the White House.

The administration’s political strategist, Karl Rove, truly is a more important figure than any cabinet member — but only because the Bushes know that you cannot govern if you can’t get elected.

That said, the men and women running the government do have convictions. For a sense of what they might be with respect to tax policy, go back to a document published by the Treasury Department in January 1977, just as the Ford administration was leaving office.

The issues are laid out there with remarkable clarity in Blueprints for Basic Tax Reform. The author was a young man named David Bradford, Deputy Assistant Secretary for Tax Policy.

Bradford was following the instructions of his boss, Treasury Secretary William Simon, who in December, 1975, had opined that the time was ripe for fundamental tax reform, and ordered a year-long study.

The first hints of the American perestroika that would become known as Deregulation were in the air. The fixed commissions by which a small group of Wall Street firms controlled finance had been ended in May by order of the Securities and Exchange Commission — after nearly two centuries of dominion. The upstart Chicago exchanges, the Butter & Egg and the Board of Trade, had begun making markets in stock options and financial futures at the expense of New York. The consolidated tape, immediately reporting trades on all stock exchanges, even the exotic NASDAQ, had been introduced in June, replacing the time-honored “ticker.”

In his report, Bradford laid out two fundamentally different approaches to taxation. One was to tax income. The other was to tax consumption.

Laymen found it difficult to believe that there could be serious problems defining income, Bradford wrote. There were cash wages and salaries, easily identified and clearly income. There were interest payments and dividends. And in fact most of the dollars identified as income came under one or another of these headings.

But around the “edges” of the concept of income, Bradford wrote, there was “a substantial grey area,” of which the most obvious portion in those days of high inflation had to do with the measurement of capital gains. But there were other problems that arose in connection with the promise of payments in the future.

“Is the promise to pay a pension to be counted as income when made, although the amounts will be paid twenty years hence? Is a contract to earn $60,000 a year for the next five years to be discounted and counted as income in the year the contract is made? Is the appreciation in the market value of an outstanding bond resulting from a decline in the general market rate of interest to be counted as income now, even though that appreciation will disappear if interest rates rise in the future? Is the increase in the present value of a share in business attributable to favorable prospects of the business earning more in future years to be counted as income now or in future years when the earnings actually materialize?”

Strictly speaking, on the “accretion” definition of income — consumption plus additions to net worth — all these gains would count as income, Bradford wrote. No realistic person expected Americans to pay tax as the value of their stocks and bonds rose and fell on the markets. But plenty of other definitional problems arose with additional classes of income.

The most serious had to do with the double taxation of savings. Savings were accumulated only after taxes were paid. But then the yield on those savings was taxed again as income. The same argument applied to corporate dividends — they were taxed once at the source as business income, then again when distributed to shareholders. The effect in both cases was to discourage saving.

Naturally, these ill-effects often had been noted over the years, Bradford wrote in 1976. A variety of devices had evolved to counter them: the investment tax credit, accelerated depreciation allowances, special tax rates for capital gains, and the exclusion of mortgage interest and contributions to pension plans and their accruing gains, both employer-sponsored and individual, were among them.

To the extent that all these incentives shielded investment income from taxation, Bradford noted, they had the effect of shifting the tax base from income to consumption. Hence the second possibility. Why not forget about trying to define “income,” and tax consumption instead?

It might be hard to say when a gain was realized. It would be much easier to tell whether it was officially saved or available to be spent.

A consumption tax would differ from an income tax chiefly by excluding savings from the tax base, Bradford wrote in Blueprints. Net savings, as well as gifts, would be subtracted from gross receipts. Withdrawals from savings, and gifts received but not added to savings, would be added in to compute the tax base.

Form 1040 would remain much the same for most taxpayers, except that additions and subtractions to qualified savings accounts would play a much bigger role. And the special deduction for mortgage interest would disappear. The distribution of tax burdens among people of various “ability to pay” wouldn’t change very much at all, if the new tax code were written carefully enough.

The great advantage of consumption taxation would be simplicity. By excluding savings, all the difficult problems of income measurement would disappear — depreciation rules, double taxation and the like. Then there was the goad to saving that would arise from eliminating the disincentives of the present system. The consumption tax would encourage capital formation, Bradford wrote, “leading to higher growth rates, more capital per worker and higher before-tax wages.”

A pipe dream? Not necessarily. In an introduction to the Blueprints report, the eminent public financer economist Carl Shoup wrote, “Tax historians can reassure legislators and administrators that experience shows that we are capable of implementing sweeping changes that must at first seem formidable.”

A scant ten years later, history bore him out. Congress in 1986 unexpectedly precisely the kind of sweeping tax reform that Treasury Secretary Simon has envisaged in 1975. The 1986 Tax Simplification Act reduced the number of tax brackets to two, swept away fifty years worth of special interest loopholes and still managed to raise more or less the same amount of revenue as before — a triumph of base-broadening much rejoiced at the time..

But to tax professionals like Bradford who favored a shift to consumption taxation, the ’86 Act was a sharp disappointment. The Democratic-led Congress preferred to retain the same concept of income taxation as had been the basis for America’s broad-base tax for fifty years. And sure enough, as quickly as Bill Clinton was elected in 1992, Congress raised the top-most rates and began building back in the special favors.

So was that the end of Blueprints? Not at all.

In 1998, Bradford gave a talk to a meeting of tax experts in New York that he called “Waiting for a New Consensus of the Experts.” The old consensus was gone, he said. Not much coherent was likely to happen until a new one emerges. But perhaps just such a new consensus was visible on the horizon.

As the particulars of income taxation had become more complicated, he continued, the appeal of consumption taxation had only increased. A couple of decade of financial innovation had made it easier than ever for Wall Street rocket scientists to obtain the best tax results in connection with any particular economic activity — including outright profits at the expense of government. At the same time, tax rules often ruled out sound financial arrangements that otherwise made sense.

For that, and many other reasons, Bradford predicted, the tide of expert opinion soon enough would to shift decisively in favor of the consumption idea. The most fundamental questions still would have to be worked through — How much progressivity? Whether to abandon the well-loved subsidy to owner-occupied housing in the name of a “level playing field?” With what language might a politically acceptable new system be described?

Yet so great were the potential advantages of a substantially simpler tax system that he had no doubt that the day of consumption taxation eventually would arrive.

That was five years ago. Last month, under cover of providing a short-term “stimulus” to the economy, President Bush proposed to implement two major struts of consumption taxation — ending the double taxation of dividends and throwing open wide the door to tax-sheltered saving accounts.

Neither will pass easily through Congress this spring. But in a chapter of the President’s annual economic report to Congress, the case for consumption taxation was laid out with Blueprints-like clarity — very little different than when the case was first made during the Ford Administration. And thanks to Enron and Sprint, the case against tax shelters that are rooted in the manipulation of the definition of income is more obvious than ever.

David Bradford is long out of government. He served another hitch in the early 1990s as a member of the Council of Economic Advisers under the first President Bush. Now he divides his time between teaching tax policy at New York University Law School and Princeton University’s Woodrow Wilson School of Public Affairs.

The chances for significant restructuring in the next few years are still good, he says — not so much because of changes of heart among economists as because of growing recognition in the legal academy of the difficulties of pinning down the meaning of “income.” “It is hard to conjure up a political constituency for business tax rules as they currently exist,” he says. “Something needs to be done.”

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