Monday, November 3, 2008

McCain and Obama on Tax Reform

McCain and Obama on Tax Reform

Hardly anyone disagrees with this statement: The nation's tax system is a mess. The U.S. tax code is riddled with far too many deductions, credits, exemptions, exclusions, phase-ins, and phase-outs. Nobel laureate Milton Friedman noted half a century ago that constant changes in the tax code discourage long-term planning by households and businesses. He was right, but that hasn't stopped Democrats and Republicans from tinkering with taxes ever since the income tax was imposed in 1913.

Perhaps it's the safest forecast in politics and economics that history will repeat itself when it comes to the tax code. It's going to get even more complex next year, since both John McCain and Barack Obama are proposing major tax initiatives.

For instance, among his proposals, McCain wants to make the 2001 and 2003 tax cuts permanent (with the exception of the estate tax repeal), phase in a two-thirds increase in the dependent exemption, and offer a voluntary alternative tax with two rates and a larger standard deduction and exemption.

Essential Difference

Obama is more aggressive in the number of his proposed tax plans. They range from creating income-related subsidies for health insurance to refundable "Making Work Pay" credits and "Universal Mortgage" credits. He'll increase the maximum capital-gains tax to 25%. He will keep some of the 2001 and 2003 tax laws, such as the child-credit expansions and the 10%, 15%, 25%, and 28% income rates.

That breakdown of the two tax plans comes from the Tax Policy Center, a joint venture between the Urban Institute and the Brookings Institution. Its recent analysis captures the essential difference between the two tax approaches:

• Senator McCain's tax cuts would primarily benefit those with very high incomes, almost all of whom would receive large tax cuts that would, on average, raise their aftertax incomes by more than twice the average for all households. Many fewer households at the bottom of the income distribution would get tax cuts, and those whose taxes fall would, on average, see their aftertax income rise much less.

• In marked contrast, Senator Obama offers much larger tax breaks to low- and middle-income taxpayers and would increase taxes on high-income taxpayers. The largest tax cuts, as a share of income, would go to those at the bottom of the distribution, while taxpayers with the highest income would see their taxes rise.

McCain Wins on the Simplicity Front

For many voters, that's all the information they need to know about the candidates and taxes. But there are other ways to judge. For instance, by one critical measure—how they would deal with the omnivorous Alternative Minimum Tax—both plans are failures. The AMT was designed in the late 1960s to make sure that the very wealthiest Americans paid at least some tax. Yet because it was poorly constructed, some 3 million taxpayers now pay the AMT, and by 2010 that figure could swell to 30 million, according to William Gale, economist at the Brookings Institution.

Congress and the White House have punted for years on the AMT, largely because neither political party is sure how to replace the lost revenue. It's estimated that repealing the AMT would cost at least $800 billion over the next decade. Instead, Washington has preferred to rely on a series of "patches" to keep the dreaded tax from reaching deep down into the middle class. Both McCain and Obama plan on continuing that ignoble Washington tradition.

By the metric of simplicity, McCain edges out Obama. For one thing, he's proposing fewer tax initiatives. For another, he has embraced repealing various corporate loopholes, such as eliminating the preferential treatment of oil companies, in return for a lowering of the corporate tax rate from 35% to 25%. Nevertheless, neither candidate is embracing dramatic simplification by broadening the tax base and eliminating a wide range of deductions and credits.

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