Blowing up the tax code

By Jeanne Sahadi, senior writer


NEW YORK (CNNMoney.com) -- So much to love. So much to hate.

That's what everyone will find in the tax reform proposals laid out this week by the co-chairmen of President Obama's fiscal commission.

And that may also be the best indication that Erskine Bowles and Alan Simpson got something right.

The truth is, there's no escaping the need to make serious tradeoffs on taxes if the goal is to create a tax code that supports economic growth, provides enough revenue to fund everything Americans want their government to do, and achieves real deficit reduction when paired with spending cuts. (10 biggest cuts the co-chairmen recommend)

Of course, politicians aren't yet willing to acknowledge those tradeoffs. Most Republicans still cleave publicly to the idea that taxes are the devil's spawn and must be beaten back. And most Democrats think that only the wealthiest should ever have to pay more in taxes.

That doesn't mean there isn't something for them to like in the Bowles-Simpson proposal.

For one thing, the co-chairmen propose simplifying the tax code, while lowering rates. They would also eliminate the Alternative Minimum Tax (a.k.a. the crazy-making-calculate-your-taxes-twice-to-see-if-you-owe-more tax).

In exchange, their proposal calls for a reduction -- or the complete elimination -- of the hundreds of tax deductions, credits and exemptions in the code.

Tax breaks reduce the amount of revenue the government takes in by more than $1 trillion a year, much of which comes from just a few of the biggest and most popular ones like the mortgage interest deduction.

Many experts regard tax breaks as a stealth form of spending. That's because the lost revenue doesn't appear anywhere on the federal budget. And once a break is passed into law, it's rare that anybody reviews its effectiveness.

"They're unsustainable. They have no oversight. And they really cost this country a bundle," Simpson told CNN.

Still, as the co-chairmen know all too well, removing them will elicit all sorts of "shrieking," as the ever-tart-tongued Simpson has put it many times. Tax breaks are enjoyed by many powerful special interests -- to say nothing of many Americans.

Fewer breaks = lower rates

Bowles and Simpson offer two options that slash tax breaks. And by doing so, they can lower income tax rates.

In their "zero plan" option, breaks are eliminated altogether. Under that scenario, individual income tax rates -- which they reduce from six brackets to three -- can fall substantially.

For instance, the lowest two rates (10% and 15%) could fall to 8%. The middle two rates (25% and 28%) could drop to 14%. And the top two rates (33% and 35%) could drop to 23%.

The corporate rate, meanwhile, could drop to 26% from 35%, to make it more attractive for companies to invest in the United States.

On the other hand, of course, lawmakers could choose to retain tax breaks. But the fewer they prune, the less rates can be lowered.

The second option from Simpson and Bowles, building on a bipartisan proposal in Congress, would reduce the mortgage interest deduction. The tax break would apply only to the first $500,000 of a loan on one's primary residence, about half of what counts today.

The second option would also repeal the state and local tax deduction and various other itemized deductions.

Individual tax rates under that plan would be 15%, 25% and 35%.

Another big proposed change under both reform plans would affect investment income. Capital gains and dividends, which are currently taxed at 15%, would be taxed as ordinary income -- that is, at higher rates.

More revenue on tap

The Simpson-Bowles tax reform options would raise an estimated $80 billion in additional revenue in 2015 and $160 billion by 2020. Their plan overall would cap federal revenue at 21% of GDP.

Who exactly will be paying in all that extra revenue? A specific break-out by income groups is still in the works.

It is likely that more people would end up with higher -- rather than lower -- tax bills, a commission staffer said. But he also noted that the revised tax code would probably be more progressive.

No one will like paying more, of course. But the staffer said the comparison shouldn't be to what someone is paying today but rather to what that person is likely to pay in the future if no changes to the tax code or to the federal balance sheet are made.

Translation: Taxes are going up one way or the other. The question is will those higher taxes be levied in a system that is widely considered to be outdated, overly complex and highly inefficient, or in a system that is simpler and smarter? To top of page

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