Anti-Tax Crusaders Work for Big Shift
White House Wary Of Broad Changes

By Jonathan Weisman
Washington Post Staff Writer
Saturday, June 14, 2003; Page A01

After the third tax cut in three years, some Bush administration policymakers are pushing for more fundamental changes that would largely shelter investments from taxation, dramatically changing the way Americans are taxed and how the government is financed.

But they are running into surprising opposition from White House officials who fear that such prescriptions could have dangerous economic and political consequences as the budget deficit grows.

At the heart of the matter is an ambition of conservative tax theorists in and outside of the Bush administration to pursue tax cuts not only to relieve the burden on taxpayers, but also to create a system that they believe will make the economy stronger.

Their ambitions outstrip what even some conservative tax-cutting Republicans think is feasible or wise.

Until now, both camps have pursued tax-cutting in close alliance because they agreed that lowering taxes was the right policy. But now they are divided about where to go next and why.

"My look at tax reform tells me, I don't see it," outgoing White House budget director Mitchell E. Daniels Jr. said last week, referring to certain proposals by the Treasury Department for more tax-cutting. "The political problems are too intractable. . . . Until [President Bush] sees a system that has social justice and economic smarts, I don't think he'll spend any time on it."

Pamela F. Olson, assistant Treasury secretary for tax policy, said she does not see a division in the administration. She played down the significance of the next steps toward tax reform advocated by the Treasury Department. "All we're doing is simplifying things, opening things up," Olson said.

But the conservative theorists say they have achieved far more in three years than they had expected.

Since Bush took office, this decade's federal tax bill has been cut by more than $1.7 trillion. That amount would more than double if tax-cut provisions now set to expire are extended. Federal tax revenue, as a percentage of the overall economy, will fall this year to about 16.5 percent, its lowest level since the Eisenhower administration.

The record federal budget surplus of $236 billion in the last year of the Clinton administration has turned into a record deficit that is expected to surpass $400 billion this year, in part because of those tax policies.

Specific changes to the tax code mean the government now depends more on taxing wages than investment income such as dividends, capital gains and interest. Because investment income and inheritances tend to flow to the very rich, the effective federal tax rate on households earning more than $416,000 will have fallen from 32.7 percent when Bush took office to 26.9 percent by 2010, while their share of federal taxation will have dropped from 24.3 percent to 22.8 percent.

The architects of the last three tax cuts at the Treasury and the Council of Economic Advisers say their combined effect will be to push the United States toward the holy grail of conservative tax theory: a system that they believe would promote economic efficiency and growth by focusing taxation on consumption while rewarding investment. These administration officials argue that taxing returns on investment amounts to unfair and punitive "double taxation," because the income that was invested was taxed when it was earned.

Critics have long held that such a system would unfairly shift the tax burden from the affluent to the working class. Besides, said William Gale, an economist at the Brookings Institution, by granting businesses tax breaks on their income then reducing taxes on dividends and capital gains, administration policymakers are not ensuring that corporate income and investment gains are taxed only once, they are ensuring that much of it is not taxed at all.

R. Glenn Hubbard, former chairman of the White House Council of Economic Advisers, said that for the president, reforming the tax code to eliminate taxation of investments was never the primary motive. But to others in the administration, it was always a goal.

"The discussions the president instigated will be a good precursor to tax reform," Hubbard said, "and that wasn't lost on anybody."

Last year, Ernest S. Christian, a Treasury official in the Reagan administration and founder of the Committee for Strategic Tax Reform, devised a plan for stealth tax reform in "five easy pieces."

Placed against the tax cuts of the past three years, Christian's agenda is beginning to look like a road map: lower marginal income tax rates, including capital gains tax rates; eliminate taxes on dividends; accelerate the speed with which businesses can write investment expenses off their tax bills; expand the Roth individual retirement account to all personal saving; and exclude export and other foreign trade income of American companies from taxation.

The first piece, lower rates, has now been accomplished in dramatic fashion. The top income tax rate of 39.6 percent in 2001 has now fallen to 35 percent, while the tax rate on most capital gains has fallen from 20 to 15 percent. A substantial leap toward completion of the second piece was taken when taxes on corporate dividends were cut last month from a top rate of 38.6 percent to 15 percent for most dividends, and 5 percent for others. A year ago, the concept of the "double taxation of corporate earnings," as opponents refer to dividend taxation, did not exist in the political lexicon. Now it is front and center.

As for the third piece, tax cuts in 2002 and 2003 drove up depreciation rates to the point where companies can now write off at least half the cost of their investments in the first year.

And with his 2003 budget, Bush appeared to have followed Christian's fourth recommendation precisely by proposing "lifetime savings accounts" that would allow everyone, regardless of age or income, to shield $7,500 a year from investment taxation. The accounts would be accessible at any time for any reason. A family of five could put away $37,500 annually, a figure that very few Americans could even contemplate saving.

"If you beat your breast, jump up and down, and come in with some revolutionary idea to change the tax code overnight, you're just going to scare the devil out of everyone; we don't do revolutionary things," Christian said recently. "Now, the last stage, three years or so from now, is that we say we've done the substance [of tax reform] already, but the code is still complicated. Let's really simplify it a lot and finish the job."

The debate in the administration is centered on the savings accounts.

Olson and Andrew B. Lyon, the Treasury Department's head of tax analysis, highlighted the lifetime savings account proposals in speeches to two major financial trade groups earlier this month.

Daniels, in an interview, dismissed the proposal as more of "a discussion piece" than a legislative initiative.

It first appeared in the president's 2004 budget, described as a modest step toward simplifying the tax code by establishing a single, tax-favored savings account to replace existing medical, education and retirement savings accounts.

The broader ramifications of the proposal emerged only after the budget was released, Daniels said, and it took the White House by surprise.

"I freely admit that I didn't and I don't think most people realize how fundamental a difference those proposals, if fully acted on, would be," Daniels said.

He attributed the inclusion of the proposal in the budget to a "policy hitch," saying "pure tax policy tended to be sort of left at Treasury" and was not coordinated with the White House. A senior Treasury official, who spoke on condition of not being identified, strenuously disagreed and said the proposal was "fully vetted and considered."

The proponents of broad reform include academics for whom such theory is hardly radical, such as Hubbard, who has returned to Columbia University, and his successor, N. Gregory Mankiw, who is on leave from Harvard University. They also include tax lawyers such as Olson and her predecessor at Treasury, Mark Weinberger, both of whom were advisers to a 1996 congressionally appointed commission that recommended that investment income be exempt from taxation and that all wages be taxed at the same rate.

Treasury's determination is giving conservative, anti-tax activists something to cheer for, and that may be the White House's intention, administration sources said.

"In each of these fronts, we've found we've pushed and there's an open door," said Grover G. Norquist, an influential activist at the conservative Americans for Tax Reform. "We'll keep moving forward as fast as we can. No one I have talked to has any expectation that we will have anything less than a tax cut every year of the eight years of the Bush administration."

One Republican economist with close administration ties said White House officials have begun soliciting advice on tax proposals that could be sold as both reform and deficit reduction. The growing deficit and its potential effect on Bush's campaign for reelection is now drawing their attention.

"If we ever reform taxes, in my judgment, you have to put all the chips on the table," said Daniels, specifically mentioning increasing capital gains taxes as an engine for balancing the budget.

© 2003 The Washington Post Company