- The Washington Times - Tuesday, January 18, 2005

Regardless of what President Bush’s tax reform commission proposes, the principal debate about it inevitably will be how much more or less each income class will pay compared with current law. While a valid consideration, the overwhelming emphasis on distributional effects tends to push other important tax issues off the table.

To begin with, there are two different concepts of distributional equity: horizontal and vertical. But only the latter ever really comes up in congressional debate. Horizontal equity involves treating equals equally. In simple terms, if you and I have roughly the same income, we should both pay about the same taxes. Vertical equity has to do with ensuring those with a greater ability to pay — i.e., the rich — pay a higher share of their income in taxes than do the poor.

Other important taxation principles are simplicity and efficiency. Ideally, we should have a tax system the average person can understand and comply with, which does not involve excessive complexity or demand professional assistance. Obviously, our current tax system falls far short of this ideal. Growing numbers of moderate-income taxpayers require the aid of accountants and expensive tax software just to file returns. And even tax professionals increasingly are baffled by confusing and contradictory provisions of the law.

Tax efficiency involves taking money out of the economy in a way that discourages output as little as possible. Every tax discourages some production over and above the tax itself. Economists call this the deadweight cost of taxation. Some taxes are known to discourage more than a dollar of economic activity for every dollar raised. Others cost just a few cents per dollar. A common estimate is the federal tax system as a whole has a deadweight cost of about 20 cents per tax dollar.

Economists know fairly well how to achieve reasonable equity, efficiency and simplicity in taxation. But it is extraordinarily difficult to achieve all these goals simultaneously, because they inherently conflict with each other. For example, any effort to increase efficiency will tend to be at the expense of vertical equity, because it will necessarily involve reducing taxes on capital, the income of which mostly goes to the wealthy.

Distributional problems are compounded by using snapshots of tax changes for individual years that assume everything stays the same except taxes. Distributional tables also use certain conventions about what constitutes “income” that are at odds with the way taxpayers themselves understand the term.

In general, distributional methodology makes taxpayers look richer than they are by imputing to them income they never see, such as health and pension benefits, thus making tax cuts seem more tilted toward the wealthy than they actually are.

Capital gains policies are a key way benefits to the rich are made to seem greater. Distribution tables always assume the same capital gains would be realized no matter how they are taxed. But obviously, people will realize more gains if the rate is reduced, thereby paying more taxes.

According to a new Treasury Department study, between 1996 and 2000, capital-gains revenues more than doubled even though the maximum tax rate fell from 29.19 to 21.19 percent. Yet though the rich paid most of these higher taxes, distribution tables showed them getting a huge tax cut.

Finally, distribution tables exclude higher incomes that may result from growth-oriented tax changes and implicitly assume people remain in the same income class year after year.

But we know in the real world peoples’ incomes tend to rise with age because of real economic growth and because workers gain knowledge, experience and savings that yield promotions, higher wages and investment returns. And many with low incomes are well-to-do elderly spending assets in retirement.

A new study by the Congressional Budget Office illuminates the high U.S. income mobility by looking at the same individuals over a long period, what economists call a panel or longitudinal study. This avoids the problems inherent in traditional snapshot analyses and lets us see how tax changes alter behavior.

The CBO found incomes are much more evenly distributed when the same people are examined over time than when examined only in isolated years. One finding is that those in the second quintile (20 percent) of households had an income 26 percent higher when viewed over a 14-year period than when measured annually. In general, the study shows the poor are richer, the rich are poorer and tax cuts for the wealthy affect many more people than commonly believed.

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.

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