Individual Tax Reform For Fairness AndSimplicity: Let Economic Growth FendFor Itself

I. INTRODUCTIONThe federal income 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 rates and the base. Subsequent 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 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 laws during the 1980s and the almost universal cry for stability from practitioners, the need for further reform cannot be denied.Although many of the base broadening provisions of the legislation of the 1980s were well grounded in policy analysis, some of the most significant provisions, such as the passive activity loss rules, are difficult to understand from a theoretical policy perspective. They must be justified, to the extent possible, as ad hoc solutions to problems in the system that were not addressed directly or as facets of expenditure analysis. In addition, many exclusions from the base that cannot be justified on policy grounds survived the reform of the 1980s. Finally, the 1986 Act etched into the statute the low effective rates for high income taxpayers that previously had been achieved through planning and shelters and did serious damage to the vertical equity of rates.The 1992 election promises to sire still more reform. But preliminary indications are that the Clinton Administration's view of reform for the 1990s is narrow, and to some extent is 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 policy analysis, but other proposals, such as the proposed investment credit(9) and targeted capital gains preference for new small business investment in no way represent reform. Introducing new expenditures will serve only to increase complexity and exacerbate perceived, if not real, unfairness in the system.Both the reforms of the 1980s and the Clinton Administration's early proposals for reform for the 1990s generally fail to address a number of significant problems in the individual income system. Complexity and inequity continue to permeate the 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 expenditures,(12) stop-gap restrictions on exploitation of unjustifiable exclusions from the 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 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 policy in the 1980s has seen the effective rates on very high-income individuals--the top 10%--fall dramatically relative to the rates of the remaining 90% of individual taxpayers. This presents serious vertical equity issues that must be addressed.Traditional 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. …