Rabbits Out of Hats?

Might George Bush succeed in pulling off some sort of significant tax reform in his second term? Conceivably even restore balance to the Social Security system before leaving office?

Several different avenues may be open, thanks to the peculiar geometry of the Congress.

But whichever path the president takes will involve a fundamental assertion of individual rights and responsibilities in the modern mixed economy. Successful financial reform is like that — simple, or not at all.

Here’s where we will find out what George W. Bush really believes.

The president campaigned on a vague promise to attempt to overhaul the tax system in a second term.  But he has been deliberately unclear all along about exactly what that might mean. Even at his post-election press conference, he said only that “Simplification would be the goal.  The main thing is that it would be viewed as fairÉ that it wouldn’t be complicated.”

Two main approaches are being bruited about within the administration.  One is some form of “flat tax,” perhaps a national sales tax, designed to target consumption. The other would be a return to the two-brackets-and-no-loopholes approach of the 1986 income tax reform that was the signal achievement of Ronald Reagan’s second term in office.

For thirty years, there has been a growing enthusiasm among tax experts and within the Republican Party for replacing the current system of income taxation with some form of consumption taxation.  Never underestimate the power of expert thinking to drive changes in tax law!

The original goad to this impulse to reform was inflation, which made difficult attempts to fairly tax capital gains. Now that inflation has abated, thanks to advances in central banking techniques, increased financial flexibility has become the issue. It has become possible for sophisticated taxpayers to book their income — to “realize” it –whenever it is most tax-advantageous to do so.

Several tax regimes based on consumption have been devised as alternative to systems of income taxation.  They include the national sales tax known as a “value-added tax” and various “flat tax” schemes designed to exempt savings and investment.  In all cases, a certain amount of progressivity could be maintained through the uses of exemptions and exclusions.

Vice President Dick Cheney is thought to be the leader of the faction that favors an all-out push for a new approach. For the most part, however, the new tax systems remain the province of experts — lawyers, accountants and economists. Many details would have to be worked through before a genuinely new tax philosophy could be presented to a divided nation. With what language might a politically acceptable new system be described?

The 1986 tax simplification act, on the other hand, is already relatively well-understood by taxpayers. It achieved many of the same goals, however briefly, by the unlikely expedient of eliminating all tax breaks but a few basic ones — notably the mortgage interest deduction for home owners and the deduction for charitable gifts — both tax incentives that Bush has pledged to retain in any event.

Many of the most important features were voided by the tax increases engineered by the Clinton administration in the first few months of 1993, in the name of deficit reduction.

Few convictions, I suspect, will turn out to be more deeply ingrained in most Americans at the end of the 20th century than the proposition that taxation should be progressive in some degree — that is, that the well-to-do should bear a heavier burden than the poor. On what evidence? I’ll explain in a moment. The two simple brackets of the ’86 act were designed with that principle in mind — 15 percent and 28 percent, with a healthy exclusion from paying any tax at all for those earning least.

The president is said to plan to appoint a bipartisan commission by the end of the year to study the alternatives, with instructions to report early next year.  But who can doubt that his mind already is basically made up on which to prefer? The interesting thing is the extent to which the politics of the alternatives differ.

Option A, scrapping the tax code altogether in favor of a philosophically different system, involves a bold attempt to move into uncharted territory — a wholesale break with the political past reminiscent of former House Speaker Newt Gingrich’s visions of an “Opportunity Society.”

Option B, returning to the compact of the Ô86 act, would mean ratifying the far more limited goals of Reaganism, which involved embracing the original goals of Franklin Roosevelt’s New Deal while seeking to place limits on them.

A similar opportunity may exist with respect to Social Security. The cost of providing a secure if limited retirement at age 65 to every participating citizen has soared in recent year as life spans have lengthened dramatically and the generation of the baby boom has approached retirement.

Some combination of tax increases and benefit cuts would be required to keep the system in long-term actuarial balance.  Meanwhile, President Bush has advocated establishing a very expensive parallel system of encouraging individuals to make private investments in markets.

Several possible compromises are being bruited about. The most interesting of them was described by Phillip Longman in Fortune magazine last month as “percolating within the Social Security Administration.” (Longman, a demographer, is a senior fellow at the New America Foundation.)   It involves gradually raising the age for retirement with full benefits to 72, and permitting individuals to channel one sixth of the taxes that they and their employers now pay into new Early Retirement Accounts.

By moving the retirement age back by 5 years (recent changes have moved the full benefits retirement date back to 67 for those born after 1959), the remaining five-sixths receipts of the payroll tax apparently would be sufficient to fund the plan in a steady state even with the baby boom retirements.  Disability Insurance benefits would not have to be cut, as they are under most privatization plans. (The numbers here naturally need to be subjected to extensive scrutiny.)

Intrigued?  You can read the article for yourself. Expect to hear plenty more about the idea in coming months. It has many surprising benefits — not the least of which would be persuading Americans to plan on working longer.

“It preserves full benefits for those who need them, the Ôold old,’” writes Longman.  “It leaves individuals exposed to some financial risk, but they bear that risk while they are still relatively young and able to recover.

“If your Early Retirement Account doesn’t perform well enough for you to be able to retire in your early or middle sixties, then you can just work until you are 68 to qualify for Social Security’s early retirement benefit or until 72 to receive the standard benefit.”

(You can just work a little longer, that is, as long as your job is still there.)

Here, too, the choice between the competing visions is interesting:  preserving Social Security as a government insurance program against elderly poverty and advanced old age, or seeking to jettison it altogether in favor of a “Personal Security System” which would offer adventures in market risk to rich and poor alike, in the name of creating better men and better women and, of course, promoting economic growth.

It is here that the peculiar geometry of the U.S. Congress comes into play. It is no accident, for instance, that Gingrich is bringing a new book to market in January, “A 21st Century Contract with America.” He told the New York Sun last week that it is a blueprint for “phase four” of the conservative revolution, the first three phases having consisted of the elections of Ronald Reagan, Gingrich’s Republican majority in the House of Representatives in 1994 and George W. Bush.

The former Georgia congressman is out of office now, president of a health policy think tank.  But he remains highly influential in conservative circles, a mediating figure between Republicans who are willing to accept New Deal reforms and those such as House majority whip Tom Delay (R-Texas) who seek to repudiate them.

Meanwhile, the front-runner for the 2008 Democratic Party presidential nomination is a senator who therefore may wield unusual influence in that divided body — Hillary Rodham Clinton of New York.

What are the chances of compromise among these competing interests and the White House? People forget, too, that George Bush possesses a top-notch team of economic advisers of his own.  National Economic Council director Stephen Friedman, formerly of Goldman Sachs; Council of Economic Advisers chairman N. Gregory Mankiw, of Harvard University; Treasury Undersecretary for International Affairs John Taylor, of Stanford University:  all have been working away quietly on these issues behind the scenes.

Above all, the president possesses one towering advantage coming into the Show Time of his second term.  Hardly anyone knows what he really thinks. For what it is worth, my guess is that he will come down on the side of the two-bracket Reagan reform — strong evidence, if he does, of a widespread preference for fairness in the form of progressivity.