In Tax Law, an Overdue Overhaul a Step, With Miles to Go

Floyd Norris|The New York Times

What is the most outrageous section of American tax law?

“People get a deduction for punitive damages paid in a lawsuit,” was the response from Senator Judd Gregg of New Hampshire, the top Republican on the Budget Committee. “I always thought that was pretty absurd. It is significantly less punitive if you get a deduction.”

Senator Ron Wyden, an Oregon Democrat and member of the Finance Committee, pointed to a nontax item, a subsidy to oil companies for research in deep-sea drilling. “Some of the biggest, most profitable companies in the world are getting government subsidies,” he said.

Senator Judd Gregg
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The two senators introduced a bill this week, which they modestly called the Bipartisan Tax Fairness and Simplification Act of 2010. It may be significant less for its details than for its mere existence. Until passage of a modest jobs bill this week, cooperation across the aisle had not been a feature of the current Senate, as Senator Evan Bayh, Democrat of Indiana, complained in announcing he had had enough and wanted out.

Moreover, a study of the Gregg-Wyden tax bill provides a road map to issues that Congress will have to grapple with if it tries to do something more than a quick patch of tax laws.

There is urgency to passing a tax bill for two reasons. One is that the government is starving for money, running deficits that would have been unimaginable a few years ago. That reason, sad to say, seems to have little resonance on Capitol Hill.

The other is a legacy of some of the least responsible tax legislation ever passed by a Congress, the 2001 and 2003 tax acts. To make 10-year cost estimates look better, and to use a Senate rule making the measures easier to pass, those tax bills had sunset provisions: at the stroke of midnight on Dec. 31, 2010, many current sections of tax law will self-destruct.

Without legislative action, tax rates will rise across the board in 2011. The estate tax, abolished this year, will come back with a vengeance.

It has been almost a quarter-century since Washington produced the Tax Reform Act of 1986, with a Republican president (Ronald Reagan) and a Democratic senator (Bill Bradley) taking the lead. That bill got rid of all kinds of loopholes and special-interest provisions, and then used the extra revenue to lower rates.

The next year, Congress began to clutter up the tax code.

Senator Wyden and Senator Gregg have in mind a repeat of the Reagan-Bradley experience. They propose cutting the corporate tax rate to 24 percent, from 35 percent, and the top individual rate to 35 percent. To pay for that, all kinds of special sections go away.

Those who can take advantage of lots of special provisions would lose even if rates came down. Others would benefit.

For those of us who don’t have tax lobbyists, the list of things they want to do away with is somewhere between fascinating and outrageous. There is the “inventory property sales source rule exemption,” the “deferral of active financing income” and the “special tax rate for nuclear decommissioning reserve fund.” They want to “disallow a portion of the LIFO (last-in, first-out) inventory method for large integrated oil companies.” And they want punitive damages to be treated the same as fines after convictions — as nondeductible expenses for companies that are forced to pay them.

They also want to do things that will hit home for some readers of this column, like taxing fringe benefits and no longer excluding income earned abroad by American citizens. They want to end the deferral of tax on income from United States savings bonds, and to get rid of the deduction for moving expenses.

The bill reflects preferences of the two senators. Mr. Gregg is worried about capital formation and about reducing tax reasons for capital to flow to areas that might be less productive. Mr. Wyden wants to preserve progressivity and to assure that the tax breaks that remain are available to all.

One result is a change that keeps preferential tax rates for capital gains, but adjusts the computations so that people in the two lower tax brackets they propose — 15 and 25 percent — actually pay lower rates than do those in the upper bracket. Another is a change in the break for municipal bond interest that assures a middle-income taxpayer would get the same benefit, in dollars, as would a taxpayer in a higher bracket.

One interesting proposal is to reduce the tax incentive for companies to borrow money by reducing the deduction for interest payments. That reduction would be based on the inflation rate, and is too complicated to explain here, but the important point to Mr. Gregg is that it could encourage companies to raise equity rather than debt.

To be sure, there are the same kinds of tax preferences that they criticize. Small businesses — those with revenue under $1 million a year — are to be allowed to deduct from their income the costs of any equipment and inventory they purchase.

And sometimes they simply punt. They point to billions in “direct payments and indirect subsidies to businesses each year,” and call them “corporate welfare.”

But rather than specify which ones should be eliminated, they would direct the Congressional Budget Office to identify the least productive subsidies so that Congress could consider reducing them.

It would be really refreshing if other legislators and the Obama administration joined in seeking to find compromises that would simplify the tax law and rip out various subsidies and preferences that have been inserted over the years.

Perhaps there could be a new tradition of cleaning up the code every 25 years.

But the reality is likely to be far different. Republicans will accuse Democrats of wanting to tax and spend. Democrats will accuse Republicans of favoring the rich. We will get, in Mr. Wyden’s words, “another partisan debate about fiddling with a broken tax system.”

At the last minute, some temporary measure no one likes will be passed, accomplishing nothing in the way of real change.

If you have found the health care debate edifying, particularly the parts about death panels and illegal immigrants, you’ll really love the tax squabble.

The existence of this bill is a signal that some legislators want something much better. Let’s hope they get it.

Floyd Norris comments on finance and economics in his blog at nytimes.com/norris.