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What will your tax returns look like four years from now? The answer depends in no small measure on who the voters send to the White House in November. Over the last few weeks, American voters have heard a lot of talk about taxes on the campaign trail and have seen a lot of action in Congress on tax bills. The month of October saw two major tax acts passed by Congress. The first bill extends otherwise-soon-to-expire tax relief to middle-class taxpayers for five more years. The second measure, a 650-page corporate tax bill, adds enormous � perhaps even fatal � complexity to the tax code in an attempt to deliver new incentives for American manufacturers. These bills essentially address long-term problems in the tax code with short-term solutions. It may be that such long-term problems will only be definitely resolved by a comprehensive re-examination and rewrite of the tax code. The last time proposals to fundamentally change how the federal government raises tax revenues arose was in 1984, when President Ronald Reagan called on Congress to produce a fairer and simpler Internal Revenue Code. The Reagan Treasury Department spent the next year-and-a-half evaluating different ideas, including a value-added tax, and ultimately put forth a reform proposal in May 1985. This served as the basis for the Tax Reform Act of 1986, which kept the income tax in place but broadened the tax base and reduced marginal rates. (From 1984 through 1987, I served in the Treasury Department and was involved in formulating those tax reform proposals and in seeking their enactment by Congress.) In 1986, Reagan was a popular president who won his second term in a landslide and had no need to worry about another election. These two factors enabled the administration to propose to Congress a restructuring of the tax code with many winners and losers. Among the primary losers in the Tax Reform Act, as ultimately passed, were banks, financial institutions, and corporations with international operations. It is hard to imagine that any president would propose a major restructuring of the tax code in his first term knowing that such businesses may again be forced to bear the cost of revising the tax code. Nonetheless, our next president, even without the Reagan popularity, may be faced with a number of factors that create the “perfect storm” that makes fundamental tax reform a possibility for a second-term George W. Bush or a first-term John Kerry presidency. POTENTIAL DRIVERS OF REFORM The first alternative minimum tax was enacted more than 30 years ago as a backstop to ensure that very high-income individuals � who found ways to avoid all income taxes by taking certain deductions, exclusions, exemptions, and credits (known as tax preference items and tax adjustment items) � paid a minimum amount of federal income taxes. If a taxpayer’s alternative minimum tax liability exceeds her regular income tax liability, she pays the alternative minimum tax. Taxpayers compute their alternative minimum tax liability based on their alternative minimum taxable income, which adds back tax preference items and tax adjustment items. Accordingly, the alternative minimum tax is similar to a “flat tax,” which is imposed on gross income without regard to deductions. There is an alternative minimum taxable income exclusion amount designed to exempt middle-class taxpayers from the tax, but the exemption amount is not inflation-adjusted, and middle-class taxpayers are increasingly affected by the alternative minimum tax. Short-term legislative fixes � including a one-year increase in the exemption amount that was included in the relief for middle-income taxpayers � have kept the problem at bay. But if no longer-term solution is enacted, the alternative minimum tax will actually raise more tax revenue than the regular income tax from individuals starting in 2008, thereby effectively replacing the income tax with a flat tax for many Americans. The projected cost of making sure that the alternative minimum tax hits only wealthy taxpayers is very high. The Congressional Budget Office estimates that indexing the alternative minimum tax exclusion amount for inflation would cost the Treasury $370 billion. It would cost the Treasury as much as $600 billion if Congress repealed the alternative minimum tax altogether. Nonetheless, it would be politically unwise for any first-term president to allow the alternative minimum tax to become the flat tax that applies to most middle-class taxpayers. Another potential disaster that may push tax reform onto the next president’s agenda is the fact that the pensions of hundreds of thousands of employees in many industry sectors, including airline and steel, may be at risk. When a company cannot pay its pension obligations to its retirees, the Pension Benefit Guarantee Corporation assumes some, but usually not all, of the obligations. Today, with so many companies at or near the point of default on pension payments, the projected costs could not only bankrupt the agency but force policy-makers to re-examine the way employers and employees shoulder the burden of funding retirement plans. Federal retirement security programs are also at some risk. The two major entitlement programs, Social Security and Medicare, will be forced to provide benefits for the retiring baby boom generation starting at the end of this decade. A new Medicare prescription drug plan will soon add hundreds of billions of dollars in future federal spending. All of this points to a coming tidal wave of red ink. Only three real options are possible: (1) cutting benefits, (2) borrowing to cover the costs, or (3) raising taxes. This latter option may mean not just increasing payroll taxes but also looking for new sources of revenues. WHAT THE CANDIDATES SAY The White House has not endorsed a specific comprehensive reform plan, but President Bush has said that we do need to reform the tax code. As a first step, President Bush says he will create, by executive order, a bipartisan panel to advise the Treasury secretary on options to fundamentally reform the tax code to make it simpler, fairer, and pro-growth. The White House says that the panel will be asked to present revenue-neutral options “at least one of which should be a reform of the current individual income tax system.” A recent White House press release also notes, in a pre-emptive bow to political reality, that tax reform “should recognize the importance of homeownership [i.e., mortgage interest deductions] and charity [i.e., charitable contribution deductions] in our American society.” Republican House leaders are also talking about the issue of tax reform. Speaker Dennis Hastert (R-Ill.) promises in his new book that a Republican Congress will tackle the tax code, assuming that Bush is re-elected. Hastert has expressed a preference for a national sales tax but has not committed to a specific plan. House Majority Leader Tom DeLay (R-Texas) also wants to eliminate the Internal Revenue Service by replacing the federal income tax with a national sales tax. Republican Senate support for the idea of tax reform was recently demonstrated in a somewhat counterintuitive manner during committee negotiations on the recently passed corporate tax bill. During the House and Senate conference committee meetings on the final bill, Sen. Don Nickles (R-Okla.) successfully offered an amendment to delete from the bill a bipartisan commission to study and report on comprehensive reform proposals. Nickles said such a commission, which would have been required to issue a report by the end of 2006, would duplicate the president’s tax reform panel and only delay action on the issue. On the Democratic side, Sen. John Kerry (D-Mass.) has not said much of anything about the possibility of comprehensive tax reform. This silence probably reflects the fact that a first-term president would have a very hard time putting tax reform on the administration’s agenda. His running mate, Sen. John Edwards (D-N.C.), however, has taken issue with the Bush administration’s call for tax reform. At a campaign stop in Ohio last month, Edwards discussed a recently uncovered 2002 Treasury Department memorandum that examined the pros and cons of replacing the tax code with various regimes. Edwards charged that the Treasury memo is the precursor to enacting a flat tax or consumption tax. “It will eliminate entirely the tax deduction for home mortgage interest,” Edwards said. A spokesperson for the Kerry campaign has also stated that the president’s support for tax reform is a backdoor attempt to raise taxes on the middle class. There are, however, some senior Democrats in Congress who are willing to talk about tax reform. House Minority Whip Steny Hoyer (D-Md.) has put forward a set of fairly bold ideas. Rep. Hoyer has urged action to address the coming alternative minimum tax problem and made the case for “return-less filing.” He has also proposed simplification for small businesses and major reforms in the international tax arena. A QUESTION OF WHEN, NOT IF? Rewriting the tax code is a massive undertaking and must, in the end, generate at least the same revenues as the current system. Thus, to the extent some taxpayers end up as winners under a new system, there must be losers who pay more taxes. Indeed, even talking about changing the tax code invites strong reactions. The job is so big and so full of potential political pitfalls that almost everyone agrees a president can only undertake it during a second term of office. For President Bush to propose a tax reform plan, he must win in November and keep a sympathetic Republican majority in both chambers of Congress. For Sen. Kerry to consider studying possible tax reform proposals in his first term, he must win an electoral mandate and at least one Democrat-controlled chamber of Congress. Keeping a Republican majority in the House is likely, but the Senate majority may depend upon the length of the next president’s coattails. In summary, many factors are currently converging to invite a hard look at how the American people finance their government and social programs. Fundamental tax reform could be a primary policy goal for a Bush second term and may be a necessary policy goal for a Kerry second term. The question is whether either a Democratic or Republican administration and Congress will have the political will and wisdom to make hard choices or whether our elected officials will continue to do whatever is politically expedient in the short term. Linda E. Carlisle is a partner in the D.C. office of White & Case. She served in the Treasury Department as special assistant to the assistant secretary for tax policy from 1985 to 1987, when the last comprehensive reform to the tax code was undertaken. Tax legislative assistant Patrick Holten assisted in the preparation of this article.

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