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President Bush has established an advisory panel to study federal tax reform options. Thepanel is headed by former senators Connie Mackof Florida and John Breaux of Louisiana.Congressional leaders, including House SpeakerDennis Hastert and Majority Leader Tom Delay,have also pledged their support for reform.Enacting a major tax reform bill will be a chal-lenge, but the president has been remarkably successful with his tax agenda so far. Income taxrates have been reduced, dividend and capitalgains taxes have been cut, and the tax rules onretirement savings vehicles have been liberalized.However, the tax system remains terribly com-plex and inefficient. The number of pages of feder-al tax rules has increased 48 percent in the pastdecade. The complex alternative minimum tax willhit about 35 million households by the end of thedecade if not repealed. The high-rate U.S. corpo-rate income tax is under growing pressure as glob-al investment capital has become more mobile.This study looks at possible changes toaddress those problems. It identifies three goalsfor tax reform: simplification, efficiency, andlimited government. The latter goal focuses ontax code features such as visibility and equaltreatment that cultivate an understanding of thehigh cost of government.This study examines reform options includinga flat tax, a national retail sales tax, and a savings-exempt tax in reference to those goals. It also pro-poses a new option: a “dual-rate income tax.” Thisrevenue-neutral option would convert the individ-ual income tax to a two-rate system that elimi-nates most deductions and credits and allowsnearly all families to pay tax at a low 15 percentrate. A 27 percent rate would kick in for earningsabove $90,000 (single) and $180,000 (married).To promote growth, the maximum individualrate on dividends, interest, and capital gainswould be 15 percent. The corporate tax rate wouldbe dropped to 15 percent and interest made non-deductible. These changes would equalize and cutthe combined top income and payroll tax rates onwages, dividends, interest, and small businessincome to just under 30 percent, compared withbetween 35 and 45 percent under current law.The dual-rate tax plan would retain the stan-dard deduction, an expanded personal exemp-tion, and the earned income tax credit. The planwould create a simpler and more efficient taxcode within the structure of today’s system andmay be just the type of tax plan that the presi-dent’s advisory panel is looking for.
Options for Tax Reform
by Chris Edwards
_____________________________________________________________________________________________________
Chris Edwards is director of tax policy studies at the Cato Institute.
Executive Summary 
No. 536February 24, 2005
Routing 
 
Introduction
The Bush administration and the Repub-lican Congress have been remarkably success-ful at passing tax cut legislation. In the pastfour years, they have enacted four substantialtax bills.
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Table 1 summarizes the progressthose bills have made toward the three taxreform goals examined in this study: simplifi-cation, efficiency, and limited government.There has been progress toward making thetax code more efficient with cuts to individualtax rates, reduced taxes on dividends and cap-ital gains, and liberalization of savings instru-ments such as individual retirement accounts(IRAs). However, there has been no progresstoward making the tax code simpler or mak-ing the burden more equal and visible to helplimit the government’s growth. Another problem with recent tax cuts isthat they have not been matched by federalspending cuts. Federal outlays jumped 31percent between fiscal 2001 and 2005 as theadministration and Congress went on a spending spree.
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High spending has createdlarge and persistent deficits. The deficits may impede the ability of Congress to move aheadwith further tax reforms because reforms areeasier to enact when accompanied by taxcuts. Congress needs to make spending cuts a high priority in order to create room in thebudget for tax reform. In another report, Ihave proposed more than 100 budget cuts tobring the deficit down to zero over five years.
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That said, the president has indicated thathe wants to pursue tax reform on a revenue-neutral basis—neither increasing nor reduc-ing overall federal revenues. The Tax Reform Act of 1986 illustrated that it is possible tomake major changes to the tax code on a rev-enue-neutral basis, although numerous of the revenue raisers in that bill were economi-cally damaging.
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Note that the use of “dynamic scoring” of tax changes could helpgrease the skids of reform. Dynamic scoringwould take into account the real-world eco-nomic benefits of adopting a more efficienttax system. Congress could enact a pro-effi-ciency tax reform that might reduce federalrevenue on a static basis but would be rev-enue-neutral on a dynamic basis as the posi-tive effects of reform boosted the economy.The following sections discuss the threemain goals of tax reform, as illustrated in
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The Bushadministrationand theRepublicanCongress havebeen remarkably successful atpassing tax cutlegislation.
Table 1Recent Progress toward Tax Reform Goals
Tax Reform GoalProgress?Notes1. SimplificationNoThe number of pages of federal tax rules is up 48 percentin the past decade. Congress continues to add specialinterest tax breaks to the code. Simplification has beenstudied by the Treasury and the Joint Committee onTaxation, but no action has been taken.2. EfficiencyYesIndividual tax rates have been cut. Top dividend and capitalgains rates have been reduced to 15 percent. Savingsvehicles such as IRAs have been liberalized. Businesscapital expensing was enacted temporarily. However, allreforms will expire unless Congress acts to make thempermanent.3. Limited governmentNoThe corporate income tax and half of the 15.3 percentpayroll tax create large hidden burdens on individuals. Thetax code is as intrusive as ever and treats Americans veryunequally.
 
Figure 1. I then discuss some preliminary reforms to clear the decks for broaderchanges. Last, the paper examines four alter-nate tax proposals: a flat tax, a sales tax, a sav-ings-exempt tax, and a “dual-rate incometax.” The latter proposal would create a sim-pler and more efficient income tax—a goodmodel for the type of reform that the admin-istration and its tax advisory panel may beconsidering.
Simplification
 According to CCH, a tax law publisher,federal tax rules spanned 60,044 pages in2004—48 percent more pages than a decadeago.
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Taxpayers have to contend with a risingnumber of tax forms, longer tax instructions,and returns that are more cluttered with spe-cial credits and deductions.The complexity of today’s tax system cre-ates five main problems. First, it imposeshigh administrative and compliance costs. Americans spend 6.5 billion hours annually filling out tax forms, keeping records, andlearning tax rules.
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Many of the best andbrightest are drawn into the nation’s “taxindustry,” which helps individuals and busi-nesses reduce their taxes and comply with thecomplicated law. The cost of complying withfederal income taxes is roughly $200 billionannually.
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Second, tax complexity impedes efficientdecisionmaking by individuals and business-es. For example, the growing number of taxrules on pensions, savings vehicles, andinvestment earnings confuses family finan-
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Many of the bestand brightest aredrawn into thenation’s “taxindustry.”
Figure 1Goals of Tax ReformLimited Government
Greater tax visibility so that people canmeasure the cost of government
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Fewer and slower-growing tax bases to bet-ter control the overall tax burden
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Equal treatment of citizens and an end tosocial engineering in the tax code
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Maximization of privacy and civil liberties
Simplification
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Reduced time and expense for admin-istration, planning, and enforcement
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Better economic decisionmaking
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Fewer taxpayer and governmenterrors
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Less tax avoidance and evasion
Efficiency
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Lower marginal tax rates
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Reduced taxation of saving and invest-ment
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Equal treatment of industries, assets,and investments
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Greater growth and higher incomes
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