The key to tax simplification is to make fewer distinctions across economic activities and taxpayers’ personal characteristics. Doing so would not only reduce compliance costs, given current administrative structures, but also allow for simpler administration. For example, if everyone paid the same tax rate on dividends, the tax could be collected at the firm level, without having to trace the dividend payments to individuals. The general structure of a simple tax system would be a broad tax base with rates that are the same across different income sources or types of expenditure. Progressivity could be embodied in the rate structure (with rates rising with income, as they are now), the initial exemption amount, and the choice of the tax base, rather than in the design of specific provisions. Universal exemptions, deductions, or credits are much simpler than targeted ones.
- Several reforms could make the current tax system simpler as well as fairer and more conducive to economic growth. One reform would be to resolve the uncertainty created by the sunset, phase-in, and phase-out provisions of the 2001 and 2003 tax acts. Having numerous tax provisions dangle for an indefinite period does not simplify the tax code. (It would also make sense to decide whether to keep permanently or to abolish the entire set of temporary tax provisions that existed even before 2001.)
- Another option would be to reform the individual alternative minimum tax (AMT). To spare the middle-income taxpayers who were never its target, the AMT should be indexed for inflation, deductions should be allowed for dependents and for state and local taxes, and all personal credits should be available against the AMT. Any new proposal that cuts regular income tax liabilities should be required to make conforming adjustments to the AMT so that more taxpayers are not subjected to it.
- A third option would be to coordinate credit phase-outs. A number of tax credits phase-out across different income ranges, so that claiming each credit requires a separate worksheet and tax calculation. The phase-outs also create hidden taxes over the phase-out range and diminish the effectiveness of the credits in encouraging the very activities they are designed to spur.
- In a number of areas, numerous provisions-each with slightly different rules-apply to the same general activity. Coordinating or consolidating these provisions would simplify taxes, often with little or no forgone revenue. Examples include the various provisions relating to families with children (the earned income tax credit, the dependent exemption, and the child credit), tax subsidies for education (the Hope and Lifetime Learning credits and the deduction for tuition and fees), and saving incentives (traditional Individual Retirement Accounts (IRAs), Roth IRAs, educational IRAs, and Keogh plans), and the plethora of different tax rates for capital gains.
- One could also reduce the top tax rates and tax capital gains as ordinary income. This was the cornerstone of the deal struck in 1986 that allowed substantial simplification of the individual income tax. It would massively reduce incentives to create tax shelters and the need to engage in complex tax planning.