Tax reform plan could reduce tax bite for many

NEW YORK (CNNMoney.com) -- Tax reform. For years, economists, tax experts and lawmakers have pushed for it, to no avail.

But now there is a bipartisan tax reform proposal from two prominent senators that has earned praise in policy circles and may jump-start serious consideration of the idea over the next year -- a year marked by growing concern over U.S. debt.

Done right, experts say, tax reform should simplify the tax code, increase fairness and apply taxes at lower rates to a broader base of activities.

Among the goals: decrease tax avoidance and increase economic competitiveness.

The Bipartisan Tax Fairness and Simplification Act of 2010 -- put together by Sen. Ron Wyden, D-Ore., and Sen. Judd Gregg, R-N.H., -- arguably could do much of that to some degree.

And in the process, more taxpayers than not could see their federal tax burdens fall, according to a new analysis from the nonpartisan Tax Policy Center.

Among the changes, the Wyden-Gregg proposal would eliminate the Alternative Minimum Tax and reduce the number of individual income tax rates from six to three -- 15%, 25% and 35%.

It would more than double the standard deduction to $15,000 for single filers and $30,000 for joint filers.

The proposal would also change how capital gains and dividends are taxed. It calls for a capital gains exclusion: The first 35% of long-term gains and qualified dividends would be tax free and the remainder would be taxed as ordinary income.

That effectively would raise the long-term capital gains rate to 22.75%, up from 15% today (or 20% starting in 2011).

Tax-free savings would be expanded. The proposal would create a Lifetime Savings Account and it would consolidate all types of IRAs into a single Retirement Savings Account. Between the two accounts, a person could save up to $7,000 a year tax free (up to $14,000 for married couples) on top of their 401(k) savings.

It would repeal, restructure or consolidate a number of tax breaks for individuals. The plan, for instance, would kill flexible spending accounts for workers who wish to put away tax-free money to pay for health costs. That change alone would raise $567 billion over 10 years.

But to make sure the proposal remains "politically viable," Gregg said at a forum in March, it preserves the two most popular -- and expensive - tax breaks on the books: the mortgage interest deduction and the health care tax exclusion for workers whose employers subsidize their health insurance.

And the plan would permanently extend the recently expanded earned income tax credit, the dependent care credit and the child tax credit.

On the corporate income tax, the Wyden-Gregg proposal would replace today's six rates with one flat rate of 24%, well below the current top rate of 35%. Economists have long argued that a lower corporate rate would make the United States more competitive internationally, attracting more investment from companies abroad.

In exchange, the proposal repeals a number of corporate tax credits, deductions and exclusions.

The Wyden-Gregg proposal would increase by about $23 billion a year the amount of revenue brought in on the individual side, the Tax Policy Center estimates. At the same time, it would reduce corporate revenue collected by $22 billion.

So the net effect of the proposal is to produce roughly the same amount of revenue overall as today's system. That assumes current policies, such as the 2001 and 2003 tax cuts, stay in effect over the next decade.

But that doesn't mean everyone's tax bite would be the same as it is today. The Center estimates that on average the top 20% of households would see their tax bite go up under the proposal. Within that group, the Center estimates 61% of households would see a tax increase, while 39% would likely see their federal tax burden go down.

The bottom 80% of households, meanwhile, would see their tax bite on average fall.

The Center's analysis does not factor in how people might respond to the changes proposed. Researchers said if they did such a dynamic analysis they would expect the amount of revenue collected overall to decline somewhat.

The conservative Heritage Foundation arrived at a different conclusion after conducting its own dynamic analysis, using different methodologies and assumptions than the Center. Heritage estimates that the proposal could reduce the deficit by an average of $61 billion a year; spur foreign investment in the United States and create 2.3 million jobs a year.

The Wyden-Gregg plan -- already introduced as legislation -- is just a first step in the tax-reform discussion. Chances are near nil that Congress would seriously reconfigure the tax code in a mid-term election year.

But Gregg, who sits on the president's bipartisan fiscal responsibility commission, is likely to draw on the proposal as the commission considers how best to generate sufficient revenue in efforts to stabilize U.S. debt without hurting economic growth.

To the extent that fellow lawmakers on the commission support some of the Wyden-Gregg measures, the better the chance those measures will get a fuller hearing when the next Congress convenes.