Future Shock
However the President overhauls the tax code, someone will have to pay more. Will it be you?
By Amy Feldman

(MONEY Magazine) – President Bush has two big ideas about your tax bill.

First, he wants to repeal the estate tax and make the tax cuts of 2001 and 2003 permanent. Given the G.O.P.'s strength in the Senate, that increasingly looks like a done deal. What comes next is more audacious: an overhaul, perhaps a total gut job, of the whole confusing, jerry-rigged tax structure that keeps you muttering under your breath, or worse, every April.

Bush's goals are clear, if lacking in details (and, many Democrats would argue, fairness and fiscal sanity). He wants tax laws to be simpler, to reward saving and investment, and to be "revenue neutral," meaning the same amount of money would flow into federal coffers. Turning those concepts into law encompasses a zillion possibilities, and the White House is just now setting up a bipartisan tax advisory panel. A Bush proposal is unlikely to take shape before spring, with a congressional vote sometime before the 2006 elections.

Whatever the final outcome, it's hard to imagine there won't be change. You'd be hard-pressed to find any real defenders of the current system in Congress. No wonder. The tax code runs to thousands of pages, and Americans spend 6 billion hours a year filling out paperwork. Worse, the alternative minimum tax (a second tax system designed to make sure that the ultrarich didn't deduct their way to zero tax liability) is in danger of becoming the de facto income tax for a third of all taxpayers.

But reform will be controversial. The federal budget deficit is $400 billion; extending the tax cuts and minimizing the AMT's impact could cost $1.9 trillion over the next 10 years. That's going to make it tougher for the President to stick to his goal of revenue neutrality. Even if he does, "by simple arithmetic there are going to be lots of people whose tax burdens are going to go up," notes Joel Slemrod, director of the office of tax policy research at the University of Michigan. Here's how the tug-of-war over who pays what shapes up under the most likely reform scenarios.

• The flat tax. This is the simplest of reforms, at least in theory: Take everyone's income and tax it all at one rate, say 20%, without all those deductions. The idea has been around for years. Steve Forbes made it his rallying cry in his 1996 and 2000 bids for the Republican presidential nomination. Sen. Arlen Specter (R-Pa.) has introduced a flat-tax bill every year since 1995, and during this year's campaign he posed for cameras with a postcard-size flat-tax form. Could now be the flat tax's time? House Speaker Dennis Hastert (R-Ill.), in a book published last summer, urged consideration of both the flat tax and a national sales tax as ways to fix the existing mess. "This is the only time in generations that you might have a chance to be able to do it," he told Fox News Sunday after the election.

There are, however, two big problems with a flat tax. First, unless you make adjustments to the tax so that it's not so flat anymore, the wealthy win and the less wealthy lose, because the rate will naturally fall somewhere between today's lowest and highest rates. Second, Americans love their deductions. In fact, Bush's promise to keep the popular mortgage-interest and charitable deductions makes a true flat tax impossible. But the sweeping 1986 tax reform pushed through under Ronald Reagan may offer a precedent: It squeezed 15 tax brackets into two (which have since been expanded to six).

• The sales tax. Instead of taxing income, this solution would tax consumption. Bush himself called it "an interesting idea" over the summer. One way to structure such a system is a European-style value-added tax, or VAT, in which goods are marked up at each level of production. Tax academics like this, but politicians recoil from the system's complexities. A national sales tax, akin to the state sales tax most Americans now pay, does have support in Congress: A bill sponsored by Rep. John Linder (R-Ga.) and backed by House Majority Leader Tom DeLay (R-Texas) proposes a 23% tax rate on all purchases of goods and services.

The sales tax offers a big incentive to save, since only what you spend is taxed. But it fails the President's simplicity test big-time. For starters, the Linder bill understates the tax rate, at least as far as most people understand how a sales tax works. The markup on a purchase is actually 30%. And experts say that if groceries were exempted (as they are from state sales taxes), the real rate would have to go higher. The bill also includes a complex rebate scheme for lower-income Americans that could make a sales tax as unwieldy as today's income tax system.

• The stealth consumption tax. Take today's mess, add tax breaks for investment and saving, and new tax-free savings vehicles, simplify, and shake well. Such a stealth consumption tax is the odds-on favorite for passage. It gives you a reason to salt away more money by excluding more and more savings from taxation, but it doesn't require a nasty political showdown over the junking of the progressive income tax system the way a true flat tax (or sales tax) would.

• The deduction battle. The big question in any overhaul is how to pay for it. With a sales tax, that becomes a debate over what products or services, if any, aren't taxed, and how lower-income people are aided.

With the income tax—flat, flatter or otherwise—the debate has been heard before. Deductions for mortgage interest and charitable contributions are safe, but not much else is. Elimination of the deduction for state and local income taxes almost came to pass under the Reagan reform, and it's sure to be up for discussion again. That's bad news for residents of high-tax states like New York and California (read: blue states). On the other hand, if you're a blue-stater, you may be paying the AMT now (which disallows state and local income tax deductions). And if the current tax system were to continue, you'd almost certainly be facing it soon enough.

How business will fare under a Bush plan isn't clear. Reagan helped pay for his tax reform by reducing or ending deductions for some business expenses and investment losses. Expect similar proposals from Bush's tax commission—and a fierce lobbying effort from those whose oxen would be gored.

No matter the shape of reform, the question remains: Can the President square his big ideas with the need to fund government? "Rates may have to eventually go up," says PricewaterhouseCoopers partner Bernard Kent, who is advising clients not to defer compensation or capital gains. Pay taxes now while rates are low, Kent figures. "At some point," he says, "budget deficits become an issue."

What You Can Count on for '05

You can contribute a maximum of $14,000 to your 401(k) or similar retirement account, up $1,000 from 2004. Maximum "catch up" contributions for those age 50 or over also increase by $1,000, to $4,000.

Donors of used cars can forget about deducting their full blue-book value. They can deduct what the charity netted for the sale of the car.

You can now deduct either your state sales tax or your state income tax on your federal return, a boon to people living in states with low or no income tax.

Teachers can once again deduct $250 for the purchase of classroom supplies. That deduction had been scheduled to expire.

You'll pay Social Security taxes on the first $90,000 in earnings in 2005, up from $87,900 in '04.

The basic standard deduction for a married couple is expected to increase $300, to $10,000.

The Individual Retirement Account (IRA) contribution limit climbs to $4,000 in 2005, up $1,000. The catch-up contribution is unchanged at $500.

The AMT Monster

In 1969, Congress came up with the alternative minimum tax as a way to prevent the superrich from using deductions and tax loopholes to avoid paying anything. Now the AMT threatens to hit most upper-income filers.

HERE IT COMES Without a fix, by 2010 the AMT will snare 30 million taxpayers (or roughly one in three) to the tune of $105 billion. How'd that happen? For starters, the AMT isn't indexed for inflation, while the regular tax code is. But the Bush tax cuts are culpable too. The lower marginal income tax rates go, the more families with high deductions are likely to be swept into the alternate tax universe.

WHO GETS SNARED Hardest hit by the AMT are those who earn between $200,001 and $500,000. Today, half of that group pays the AMT; by 2010, 94% will. But as the AMT snags more taxpayers, it will move down the economic ladder. By 2010, 80% of those earning $100,001 to $200,000 will be paying it, as will 52% of those who make $75,001 to $100,000. Most at risk are families who live in high-tax states like New York and California and have children.


TAX CUT? WHAT TAX CUT? One of the biggest ironies of the AMT is that it helped pay for the 2001 and 2003 tax cuts. That's because lower marginal rates shuffle more people into the system. The impact: Without a congressional fix, by 2010, taxpayers earning $200,001 to $500,000 will, as a group, have lost 70% of their tax cut.

Percentage of 2001 and 2003 tax cuts to be taken back by the AMT in 2010

Source: Urban-Brookings Tax Policy Center.