For the first time since 1986, the stars may be aligning for a grand bipartisan compromise on fundamental tax reform. Regardless of who wins in November, the next president and Congress will have to deal with the collision of two cataclysmic tax events: the 2011 expiration of the Bush tax cuts and the growing irritation of the Alternative Minimum Tax (AMT).

The seeds for compromise lay in the fact that both sides have something to gain by addressing these problems at once. Naturally, Republicans want to avert the largest tax hike in history by maintaining the lower tax rates on income, capital gains, dividends, and married families with children. Meanwhile, Democrats will be brought to the table by the fact that the AMT is largely a Blue State problem, mostly affecting those living in high tax and high-income states such as New York, New Jersey, Massachusetts, and California.

But the path between here and a simpler tax system has as many landmines as an IRS audit.

The first landmine is the distribution of the tax burden itself. Despite the rhetoric from the left about the “Bush tax cuts for the rich,” the reality is that the 2001 and 2003 tax cuts knocked millions of lower income people from the tax rolls. When Bill Clinton left office, some 29 million tax filers had no income tax liability after they took advantage of their credits and deductions. Today, the number of “non-payers” has grown to more than 43 million, or one out of every three Americans who files a tax return.

And since so many lawmakers see the IRS as a giant ATM dispensing “refundable” credits, such as the Earned Income Tax Credit, it will be very difficult to convince them to support fundamental tax reform.

With the nation’s tax burden now so concentrated at the top – the top 20% of taxpayers pay about 86% of all the income taxes – any tax reform plan is caught in a rhetorical catch-22; tax reform equals “tax cuts for the rich.” Enter landmine number two: AMT and the interests of Democrats. Although the vast majority of households affected by the AMT earn between $100,000 and $500,000, Democrats have masterfully positioned it as a middle-class issue. Of course, who is “middleclass” among New York Times readers is far different than who is middle-class at a NASCAR race. Be that as it may, wrapping fundamental tax reform around AMT reform could inoculate the debate from the predictable class warfare diversions.

Considering all of these landmines, how do we craft a politically realistic tax reform plan? 

Step 1: Eliminate Exemptions and Deductions

As the below table shows, more than 80% of the benefits of these tax deductions flow to households earning more than $80,000 and more than half of the benefits flow to those making over $118,000, the “New York Times middleclass.”

Eliminating these deductions would solve several problems. It would free up dollars for marginal rate cuts to keep effective rates down, and it would add greater simplicity and equity to the tax code.

While affluent taxpayers may be the initial beneficiaries of these tax preferences, the real economic subsidies flow to well-heeled interest groups such as the housing industry, state and local governments, and public employee unions. In particular, the state and local tax deduction allows local politicians and school districts to shift as much as one-third of the cost of any tax hike along to Uncle Sam – and thus other taxpayers. 

Step 2: Make it a Tax Cut and Tax Simplification

Next, one must recognize that tax cuts will always generate more support than a revenue neutral tax shift. A 2007 Tax Foundation /Harris Interactive Poll found that about half of all American adults said that they would give up their credits and deductions for an across-the-board cut in their income tax rates. The repeal of deductions, as outlined above, would fund significant marginal rate cuts. However, the task of mobilizing the other half of Americans who said they were not sure or who rejected the idea will require the sweetener of a lower tax bill as well as the promise of a simpler 1040 form. 

Step 3: Continue to Shield Low-Income Earners

We must accept that politicians are not likely to put the non-payers back on the tax rolls by shrinking the value of the personal exemption, standard deduction, or the child credit. With the political consensus that some low-income people should be protected from income taxes, then the practical solution is to collapse the various credits and deductions into a super-deduction that accomplishes what current policies already do inefficiently: eliminate the income tax bill for a family of four earning up to about $42,000. Continuing to protect low-income taxpayers in this way will help to earn goodwill from the left without actually creating any new programs. 

Step 4: Make Everyone a Stakeholder

An ideal plan would take this process a step further (as did the 1986 act) by slashing all tax rates equally, giving every taxpayer a stake in the reform. Better yet, the plan could condense the number of brackets to no more than two, as existed in 1988.

Such a tax code would be simpler, fairer, and closer to the kind of efficiency economists have long called for. It would reduce the compliance costs for families and small businesses alike. It would almost certainly strengthen the American economy and help move the tax code back to its proper purpose of revenue raising and away from its current distorted position of social policymaking. 

Step 5: Fend Off the Special Interests

None of this is to say that fundamental tax reform would come easily or cheaply. With absolute certainty, every interest group and lobby will line the halls of Congress demanding that their interest have protections carved into the new legislation. Advocacy groups of every stripe will take to the airwaves bemoaning the plight of their specific interest. They will scream that this new tax bill will evict people from their homes, leave children hungry on the street, and force seniors into destitution.

Of course, like most cries from special interests, none of this would be true. What would be true is that the United States would enjoy one of the best and most effective tax systems the world over. The new tax code would still show compassion for the poor and still take a hefty chunk from the rich, while becoming considerably more fair and equitable. 

Time is on Our Side

With the Bush tax cuts and AMT time bombs continuing to tick, time is truly on the side of real and significant tax reform.

The only question that remains is whether the politicians will find the motivation and will to get the job done right, or simply punt the ball down the field yet again, hoping someone else will pick up the pieces when things once-and-for-all explode.                   RF 

Scott Hodge is President of the Tax Foundation.