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Tax Breaks

Straight Talk on Taxes

Give everyone a lower tax rate on investment income than on earnings, but make it progressive.

Facing the vexing challenge of how to close our huge federal budget deficit, pragmatists in both parties agree on what their firebrand colleagues refuse to acknowledge: It will require deep spending cuts and more revenue. Both are necessary; neither is sufficient by itself.

SEE ALSO: How Well Do You Know the Deficit?

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The trick will be finding the right mix of reduced spending and higher revenues to gradually close the gap over several years while maintaining decent economic growth. Relying too much on either the spending or revenue side -- or moving too fast on both -- would risk derailing the fragile economy.

Don't expect much progress on the deficit in this election year, as each party fights to boost its head count in Congress. In a perfect world of reasonable legislators, the next Congress would resolve to spend two years deciding on spending cuts and crafting a total replacement of our byzantine tax code with something vastly simpler.

Each of the numerous alternatives has its pros, cons and passionate partisans. It could be a national sales tax, which taxes consumption rather than income, leading to a huge and valuable boost in personal savings and capital formation.

Or it could be a flat tax on income, with no deductions or credits for anything, regardless of how beneficial to society those tax breaks may be. There would be no more social engineering through the tax code.

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While they're at it, members of Congress could come up with new ways to fund Medicare and Social Security -- for example, by replacing or supplementing the flat-rate payroll taxes, which exceed most American taxpayers' income taxes. Legislators apparently didn't know how hated these regressive FICA taxes were until they lopped two points off the Social Security levy last year to stimulate middle-class spending. Now they find themselves stuck with the lower rate, undermining the retirement system's finances.

Slim odds. Of course, we're not living in a perfect world of reasonable legislators, so the odds of scrapping the IRS code (totaling 3.8 million words) are slim. More likely, Congress will continue to tinker.

Here are some tax simplifiers and revenue boosters that I believe are worthy of consideration, drawn from members of both parties:

Wages and salaries. Leave the marginal rates as they are (or trim them a little), but reduce deductions and credits as income rises -- including sacred cows such as deductions for mortgage interest and charitable giving.

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Business taxes. Reduce the top 35% corporate tax rate to 15% or 20% (typical of other advanced nations), but phase out all industry-specific tax breaks (for energy, housing, technology, agriculture, commercial real estate -- everything).

Capital gains and dividends. Give everyone a lower tax rate on investment income than on earnings, but make it progressive. For example, the present flat 15% could be replaced by a scale ranging from 10% for middle-income taxpayers to 20% for those with more than $500,000 of dividends and capital gains.

Social Security. Apply the full Social Security tax (usually a combined 12.4% for employer and employee, but currently 10.4% thanks to the payroll tax holiday) to all earned income, as the 2.9% Medicare tax is now, not just the first $110,100. High-salaried executives, lawyers, athletes, physicians and entertainers (and their employers) would pay a lot more into the retirement system than they do today.

None of these ideas is without flaws, and any we adopt should be phased in over several years to give affected businesses and individuals plenty of time to adjust.

And don't forget: While the budget deficit is being narrowed from the revenue side of the ledger, spending cuts should be contributing as much or more to balancing the books.

Columnist Knight Kiplinger is editor in chief of this magazine and of The Kiplinger Letter and Kiplinger.com.

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