Individual Tax Reform for Fairness and Simplicity: Let Economic Growth Fend for Itself

By McMahon, Martin J., Jr. | Washington and Lee Law Review, Spring 1993 | Go to article overview

Individual Tax Reform for Fairness and Simplicity: Let Economic Growth Fend for Itself


McMahon, Martin J., Jr., Washington and Lee Law Review


I. INTRODUCTION

The federal income tax system has undergone significant change since 1981. First, in a paean to supply-side economic theory the Economic Recovery Tax Act of 1981(1) slashed both maximum marginal tax rates and the tax base. Subsequent tax acts in 1982(2) and 1984(3) broadened the base in an effort to increase revenues without expressly increasing rates. Then the much heralded Tax Reform Act of 1986(4) broadened the tax base sufficiently to lower rates even further. Tax acts subsequent to 1986 again were designed to increase revenues by broadening the base while holding rates at the then current levels.(5) Despite the myriad changes in the tax laws during the 1980s and the almost universal cry for stability from tax practitioners, the need for further reform cannot be denied.

Although many of the base broadening provisions of the tax legislation of the 1980s were well grounded in tax policy analysis, some of the most significant provisions, such as the passive activity loss rules, are difficult to understand from a theoretical tax policy perspective. They must be justified, to the extent possible, as ad hoc solutions to problems in the tax system that were not addressed directly or as facets of tax expenditure analysis. In addition, many exclusions from the tax base that cannot be justified on tax policy grounds survived the tax reform of the 1980s. Finally, the 1986 Act etched into the statute the low effective tax rates for high income taxpayers that previously had been achieved through tax planning and tax shelters and did serious damage to the vertical equity of tax rates.

The 1992 election promises to sire still more tax reform. But preliminary indications are that the Clinton Administration's view of tax reform for the 1990s is narrow, and to some extent is tax "deform" rather than "reform."(6) Some of the "populist" oriented proposals from the Clinton Administration, such as raising the maximum marginal rates(7) and further limiting the deductibility of business entertainment,(8) actually have a sound theoretical basis in tax policy analysis, but other proposals, such as the proposed investment tax credit(9) and targeted capital gains preference" for new small business investment in no way represent tax reform. Introducing new tax expenditures will serve only to increase complexity and exacerbate perceived, if not real, unfairness in the tax system.

Both the reforms of the 1980s and the Clinton Administration's early proposals for tax reform for the 1990s generally fail to address a number of significant problems in the individual income tax system. Complexity and inequity continue to permeate the tax system. Although much of the complexity is attributable to efforts accurately to measure economic income,(11) more of it probably is attributable to limitations on tax expenditures,(12) stop-gap restrictions on exploitation of unjustifiable exclusions from the tax base,(13) and arbitrary limitations on deductions that serve as disguised rate increases.(14) Tax expenditures and the resulting ad hoc limitations on their benefits may be the major culprit in complexity.

Inequity in the tax system derives from two sources. First, despite a decade of "tax reform," the Internal Revenue Cade remains riddled with exclusions that result in horizontal inequity. Some, such as nonrecognition for like-kind exchanges, probably are best viewed as historical artifacts. Others, such as statutory tax-free fringe benefits, are not just remnants of the past, but continue to multiply. Second, the supply-side economics emphasis that strongly influenced tax policy in the 1980s has seen the effective tax rates on very high-income individuals--the top 10%--fall dramatically relative to the tax rates of the remaining 90% of individual taxpayers. This presents serious vertical equity issues that must be addressed.

Traditional tax policy analysis focuses on whether the system (1) raises adequate revenue, (2) in an equitable manner, (3) without undue complexity, and (4) without undue interference with the economic system. …

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