Debate on Tax OverhaulIs Under Way (Really)

With little fanfare and even fewer expectations, at least in the short term, the Obama administration and Congress have opened a debate on a major overhaul of the U.S. tax code. Action will wait awhile -- probably until after the 2012 elections -- but the ground will be laid, or at least worked a bit, between now and then.

The goal is the ever elusive quest for a simpler tax system, and the catalyst is the report issued late last month by Obama’s economic recovery board, led by former Federal Reserve Chairman Paul Volcker. The task force had little room to maneuver, both in terms of its mandate and in terms of the requirement that it not go against Obama’s promise not to raise taxes on the middle class. Still, it managed to provide a wealth of proposals worthy of consideration.

Atop the list: Revamping family tax breaks. One option is to combine the personal exemption, standard deduction and the child credit into one credit. The earned income credit and the refundable extra child credit for low incomers would also be consolidated. The other choice would combine the earned income credit, the dependent exemption for kids and the child credit into a single credit. Because many of these tax breaks require complex calculations, Congress will likely opt for some form of simplification.

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And restructuring education tax incentives. There’s widespread agreement that the hodgepodge of the American opportunity credit, the lifetime learning credit and the tuition deduction is confusing. Melding them into one credit would help.

Defanging the alternative minimum tax, or possibly even repealing it. Lawmakers know the AMT is affecting far more taxpayers than it was intended to. Options include increasing exemptions and eliminating several tax preferences.

Easing the scope of the kiddie tax. Under current law, dependents with investment income over certain thresholds are taxed at their parents’ rates. The leading options are to raise the threshold so the tax affects fewer dependents and to use the rate schedule for trusts to figure tax on excess investment income.

Simplifying the huge menu of savings plans. Two of the board’s proposals have decent shots: Combining 401(k), 403(b) and 457 plans into one standard plan. And consolidating all health and education savings plans...flexible spending plans, health savings accounts, Archer MSAs, Coverdells, 529 plans...into a single plan.

Turning to business taxes: Reducing the maximum corporate tax rate. The board did not suggest a particular rate. But there is a consensus in Congress that the current 35% top rate makes it hard for U.S. companies to compete overseas.

Broadening the corporate tax base is the flip side of a rate cut. Tax reform won’t result in a net tax cut for business, so many deductions will be wiped out. Among the more plausible options offered by the board are eliminating the deduction for domestic production and limiting the deduction of interest on corporate debt.

Discussions on bigger-ticket items such as personal tax rates will come later. The board wasn’t asked to recommend major tax reform, such as the 1986 overhaul, which consolidated five tax rate brackets into two. That’s why the report is silent about revising the tax brackets. Remember, to sell tax reform to the public in 1986, Congress funded tax cuts for individuals with a $120-billion tax hike on business.