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Dangers and foibles of tax reform

May 04, 2009 11:02 IST
Of late the misappropriation of terms such as innovation and reform in the context of finance or taxation has become commonplace.

Thus when the top tax practitioner in the UK passed me a book offering another tax reform plan for the US, I took it with some apprehension. Surprisingly, Yale professor Michael Graetz 100 Million Unnecessary Returns (Yale, 2008) is worth reading, with no algebraic skulduggery making it a rapid reader.

A fortnight back, I reviewed in this page the main elements of his Competitive Tax Plan (CTP), pointing towards its sensible proposals, albeit with an important caveat that it is limited to federal or central government tax reform, essentially eschewing sub-national concerns.

The books other merits are what I touch upon today its anecdotal historicity, with ramifications and anomalies of earlier US reforms and plans. And this is contextual and relevant for India.

For example, to keep track of tax incentives that become law, the US federal budget is required to contain a list of tax expenditures, defined as all tax credits, deductions, or exclusions that deviate from a normal income tax.

The revenue loss is $700 billion per annum. In India too, a beginning was made in the Union Budget with a section on tax expenditures from 2005-06, though its rudimentary approach should now be sharpened.

Reagan's 1986 tax reform reduced incentives just as Yashwant Sinha's budgets during Indias 10th Plan. But base erosion has crept in: in the US, 66 items out of a total 146 (45 per cent) have been added since then. In India, variegated regional incentives as well as the SEZ Act have sharply narrowed a reformed tax base.

Mr Graetz reminds us that, even though 1986 witnessed income tax reduction to 28 per cent, Reagan is not remembered for it. Indeed, the politicians associated with it never attained national prominence, suggesting that leadership in tax reform is not likely to reap political benefit. Soon after Mr Sinhas tax reforms, he was moved to South Block.

Graetzs accounts reveal that sensible ideas are shelved while populist ones have longer lives. For example, a panel rejected the replacement of the federal income tax with a populist flat rate tax or national sales tax.

Instead, it sensibly supported income tax restructuring to: (1) reduce the top marginal rate; (2) replace personal exemptions and standard deduction with a tax credit; (3) rationalise tax credits for earned income and for children; (4) expand and simplify savings incentives; (5) extend deduction for mortgage interest to all taxpayers, but reduce its size; (6) eliminate the alternate minimum tax (AMT); (7) eliminate federal deductions for state and local taxes paid, and for charities; and (8) cap fringe benefit deduction for employer-provided health insurance. Yet the proposal failed. It is well known that similar reforms are discussed regularly at Indias Budget time but they remain discussion points.

Removing AMT would cost $1 trillion, implying that tax rates could not be reduced too much. Interest groups objected, including charities, the life insurance sector and pension professionals who would be adversely affected.

Interestingly, Jeb Bush, Florida governor, wrote to his brother, the President, strongly objecting to the proposal. Indias empowered committee of state finance ministers would also react to a Central proposal that would negatively impact the states revenue!

In contrast, populist ideas have long lives. In the mid-1990s, in a Scrap the Code road show, two Republican Congressmen pushed for the replacement of income tax, corporate tax and estate tax with a national sales tax or flat rate tax on consumption.

Graetz opines that the Flat Taxs survival reflects ill feeling towards the IRS under the belief that a Flat Tax could be administered by state tax administrations.

Senate hearings took place at about this time over alleged IRS foiblescomputer malfunction, liens, levies, audits, compounding interest and penalties with the witnesses including employees, a priest, six anonymous IRS agents, and one seen IRS agent who indicated that the IRS wants to stick it to people who cant fight back.

The IRS did not fight back. Congress passed legislation revising IRS governance and operations and enhancing taxpayers legal protection. The Indian tax administrations have not been scrutinised along comparable lines even though their computerisation has come under Parliaments magnifying glass.

The move to scrap the income tax was revived in 1997. A Tax Code Termination Act was introduced in Congress that would have ended the income tax at end-2001 without any revenue replacement solution.

It passed the House though not the Senate. In the mid-2000s, Harris Polls revealed that almost 80 per cent of the public wanted overhauling of the federal tax system. Another Fair Tax proposal was introduced in May 2006, again to replace the income tax with a national sales tax.

Authors Boortz and Linder claimed that wages would go to workers tax-free and prices would not rise. Famed economist Jorgenson was cited for this double effect, though he took responsibility only for the no-price-increase claim.
Separately, Kotlikoff had said that wages would not fall, assuming that prices would rise. Thus Graetz claims that populists selectively combine half-truths from different sources to arrive at a false, though convenient, result. Nevertheless, the Americans for Fair Tax movement continues. This is reminiscent of the arguments in favour of SEZs that did the rounds of Raisina Hill corridors and committee rooms before the SEZ Acts introduction.

Graetz claims that his Competitive Tax Plan (CTP) would avoid such problems since it would eliminate income tax for most Americans, lower income and corporate tax rates, and produce revenue from a federal consumption tax on goods and services. It proposes:

A federal VAT: rate 10-14 per cent; preferably single rate; exempt turnover below $100,000 per year (leaving out 65 per cent of the 25 million existing businesses); few exemptions to be allowed.

Income tax: exempt incomes below an indexed $100,000 per family ($50,000 per individual). This will leave out 150 million taxpayers. Tax rate of 20-25 per cent. Allow limited deductions for charity, large medical expenses, (possibly) home mortgage interest, and state and local taxes. Allow employers to deduct retirement savings schemes and health insurance contributions until a national health insurance system emerges. Standard deduction, personal allowances, other tax credits to be eliminated.

  • Alternative Minimum Tax (AMT): abolish it.
  • ┬áCapital gains tax: raise it to income tax level of 20-25 per cent or retain at 15 per cent.
  • Dividend tax: retain at 15 per cent.
  • Corporate tax: reduce rate to 15 per cent, or a maximum of 20 per cent. Exempt small businesses with less than $100,000 turnover. Equalise book-tax accounts differences. Any difference in depreciation, R&D, foreign income and taxes should be made explicit.
  • Estate and Gift taxes: retain, while raising exemptions and protecting farmers and small businesses.


Social Security tax: maintain structure until a new financing mechanism for national social insurance retirement, Medicaid, Medicare is in place.

I have already illuminated the reader as to why the CTP is essentially a sensible proposal, provided it also is able to propose concrete steps towards sub-national tax reform.

Opinions expressed are the authors and not of any government, institutions or individuals unless indicated.

Parthasarathi Shome
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