Tax reform could mow down deductions, special cap gains treatment

An emerging effort to lower tax rates and broaden the tax base could mow down special treatment of retirement and life insurance plans, as well capital gains and dividends.

Congress is a long way from enacting any broad reform that would change the tax code significantly. In fact, experts don’t foresee such an outcome before the 2012 elections.

But the conversation was amplified this week when House Ways and Means Committee Chairman Dave Camp, R-Mich., proposed a 25% top rate for individuals and corporations — down from the current 35%.

Such a precipitous drop would require eliminating virtually every tax deduction and exclusion now offered, according to Clint Stretch, managing principal of tax policy at Deloitte Tax.

The congressional Joint Committee on Taxation estimates that between fiscal years 2009 and 2013, shielding contributions to 401(k) plans would cost the government $184.3 billion; excluding employer-sponsored health care benefits would total $568.3 billion, and providing tax-deferred build-up of cash value in life insurance and annuity contracts would amount to $158.8 billion.

“Those are big numbers that have to be on the table if you’re going to 25% in a revenue-neutral way,” Mr. Stretch said.

Capital gains and dividends also will have to take a tax hit under such a plan, he said. Currently, both are taxed at 15%, but that likely would rise to the top individual level under a tax overhaul as envisioned by Mr. Camp.

Most investment income goes to the top two tax brackets, according to Mr. Stretch. Reducing capital gains and dividends proportionally along with the top rate would cause a wide variance in the distribution of taxes.

“You would lose too much revenue from high-income individuals and not be able to make up the loss,” Mr. Stretch said.

Mr. Camp’s proposal aligns philosophically with a plan offered in December by President Barack Obama’s deficit commission. In a bipartisan vote, 11 of the 18 members backed a proposal that would lower individual rates across the board while eliminating all tax expenditures.

Adding more momentum to the idea that tax reform has to be addressed in efforts to balance the federal books, a group of 64 senators sent a letter to Mr. Obama today urging him “to engage in a broader discussion about a comprehensive deficit reduction package … [including] discretionary spending cuts, entitlement changes and tax reform.”

The rate target that Mr. Camp floated will stoke the dialogue about tax reform. But the legislative road is long and difficult.

“It’s going to take awhile to work through the political process,” said Andrew Friedman, principal at The Washington Update. “Absent a national fiscal crisis, I just don’t see [tax reform] happening before the election.”

The political machinations will include a fierce defense of tax expenditures by the insurance industry. Their efforts are already under way, as they argue that tax deferrals for inside buildup are a key element of retirement saving for middle-income Americans.

“There is a bipartisan view that the tax system needs to be simplified,” Mr. Friedman said. “The only way to do that is to eliminate some of these tax expenditures. One person’s crazy tax expenditure is another person’s good economic policy.”

It’s also difficult to convince someone to give up a tax preference for something like an insurance policy with the promise of a lower overall tax rate.

“It’s the concrete versus the theoretical,” Mr. Stretch said.

A much bigger and more difficult question to settle than the one surrounding tax expenditures is for Democrats and Republicans to agree on just how big the government should be.

Mr. Camp’s proposal doesn’t address deficit reduction, which hangs over every policy item on the agenda in Washington. His idea would lower tax revenues to about 18% of the national economy, while government spending amounts to about 24%.

One way to achieve balance is to tackle entitlement spending — another politically difficult undertaking.

“Until you know how much in Medicare benefits you’re willing to give retirees, you don’t know how much in taxes you’re going to have to collect,” Mr. Stretch said. “We’re going to have to stop giving as many benefits, and we’re going to have to raise the price – and nobody will like either of those things.”