Financial Times
(c) 2002 Financial Times Limited . All Rights Reserved
Thursday, June 13, 2002

GLOBAL INVESTING - Saving our way to flat-tax shangri-la.

By AMITY SHLAES.

Fundamental tax reform is actually closer than it seems, with the drive being to switch from Henry Simons' old income tax culture to a consumption tax culture.

This is visible in the rise in recent decades of savings vehicles such as Individual Retirement Accounts. IRAs may be quirky fellows, and they certainly affect populations unevenly. If you are left-handed on Tuesday, you qualify; if you are right-handed on Wednesday, somehow you don't. But it is possible to regard these tax protection devices as a sort of benign virus spreading the culture of the consumption tax.

Everyone these days acknowledges that the current hybrid system is an abomination - Treasury secretary Paul O'Neill's word - and that somehow the rich wind up paying less than the not-rich and almost-rich.

But how to get a simpler, more consistent system?

Along comes Fair Not Flat, a book that offers a vision of a tax utopia where we are all meant to donate together. The book's author, Edward McCaffery, believes we should drop all those IRA limitations and make all of our savings life one grand-tax free IRA. (Mr McCaffery and I are tax buddies, as he acknowledges in the book.)

This, in effect, is what Steve Forbes' flat tax does. But rather than impose a flat rate on income, Mr McCaffery advocates a progressive schedule. The first $20,000 of income is tax free. The next $20,000-$80,000 faces a 10 per cent rate. And so on, up to income over $1m, which is taxed at 50 per cent. That is more than ten points higher than the top rate right now, although in the McCaffery schedule the rate kicks in at a much higher point.

But the important point is you only pay those rates if you don't save. You are allowed to subtract from gross income an unlimited amount of savings. In the McCaffery plan, millionaires can save themselves from the tax man, not through their lawyers but by living like John Doe and saving and investing a lot.

This notion has its charms. Under the McCaffery regime, taxpayers can buy, sell and trade assets as they deem fit, enjoying the same benefits that the current IRA-eligible do. Capital is not taxed multiple times, as it is under the current system. There is no step-up-in-basis nightmare to contend with, and there is no cap-gains bother either.

The McCaffery plan also eliminates the estate tax. Mr McCaffery is that rare bird, a progressive who hates the estate tax. He opposes it mainly on efficiency grounds, noting that the revenue it raises is just about negated by the costs of collecting it.

He also calls the corporate income tax "a wage tax in drag", an accurate analysis since, looking at the big picture, it is workers and not ephemeral firms who shoulder that tax's load.

In many ways, Mr McCaffery's programme is a way to arrive at a national sales tax. This could be, in theory, very beneficial for the savings rate, not to mention the interest rate.

What about borrowing? To be consistent with its consumption theme, the McCaffery system treats borrowing as income. Since borrowing is just negative savings, that makes sense. (When you buy goods on your Amex, you pay tax then and there.)

Fortunately, Mr McCaffery continues the current favourable treatment of home borrowing, on the theory that this is a form of saving. With this step he saves his programme from generating something like a Japanese culture, where savings is all and people live in tiny houses.

My problem with this system is the progressivity. Mr McCaffery defends his plan by arguing that it isn't all that progressive, especially because people can opt to escape levies by saving. That is not sufficient. Work is, for most Americans, still one of the main ways they derive satisfaction. It is also the way they decide how much to push up gross domestic product. High marginal rates are a deterrent - they prevent people from taking that one extra step and doing just a little more.

As it happens, Mr McCaffery wrote another book, Taxing Women, on the problems progressivity imposes on married couples. The second earner is usually a woman and usually earns less than her spouse. But her income is just enough to push the family into a higher bracket. Effectively, even though she earns less, she is taxed at a higher rate than her husband.

In other words, flat still remains the fairest way to go. Note to Steve Forbes: time to run again. Tax law, after all, is not only about taking from the people we are - it is also about allowing us to become what we want to become.

At very least, Mr McCaffery takes an important first step in the systematic non-taxation of capital. An especially valuable aspect of this book is that it dispenses with all the usual class rage. The fact is that when we free up savings, we do all of ourselves a favour.

US Edition 2.