11/26/2012 07:53 pm ET | Updated Jan 26, 2013

The Tax Deal: How to Win by Yielding

With the election over, the political attention has turned to the fiscal "cliff" built into last year's budget deal. The Democrats have fixated on, and Republicans have resisted, allowing the top income tax rate to increase from 36 percent to the 39.6 percent it was at prior to the Bush era tax cuts. Speaker Boehner has signaled that tax increases but not tax rates are on the table. There is a relatively simple proposal that the president make that could raise more money than the nominal rate increase he wants, be progressive in its impact, and produce a more equitable and widely understood tax system.

People sense a fundamental unfairness in the tax code. On paper, the tax code is progressive with a top rate of 36 percent. The code, however, is so riddled with exemptions, exclusions, deductions, and bargain special rates for certain types of income that the real tax rate is highly erratic, favoring certain types of income over others. In the just-completed election, Mitt Romney was the poster child for this inequity, accumulating several hundred million dollars of wealth while paying only about 14 percent of his income in taxes. How? He was able to get his particular form of income classified as in one of these favored categories, "carried interest."

Complexity. The tax code itself is thousands of pages long. It creates all sorts of classes of income. By a perverse logic, income derived from hard personal labor, wages and salaries, is taxed at the highest rate. Several other forms of income are more sacred. Capital gains, for example, get a lower tax rate. The special status of "carried interest" was almost completely unknown outside of Wall Street, until Mitt Romney's tax return was made public. Hardly anyone yet understands what that is, except we now know that, whatever it is, it allowed him to accumulate millions while paying 15 percent tax rate on that income. Still others, such as tax free bonds are declared off limits to taxation entirely. And almost all of these benefit primarily the wealthiest taxpayers.

Then there are the myriad of deductions from income. Some of these, such as charitable deductions or the home mortgage deductions, are popular. The specter of taking these away is the first choice to refute anyone proposing tax reform: propose to eliminate "loopholes" and the defense will be to cite these two popular exemptions. And the wealthier you are, the more these deductions are worth, since they apply to income taxed at higher rates.

The more income is subject to special rates and the greater the number of deductions that are permitted the higher tax rates are required to yield the same income. Every deduction given to one group ultimately means higher rates for everyone.

No Accident. Of course, the many, many arcane provisions of the tax code are not there by accident. They were intentionally inserted by an army of lobbyists flush with campaign cash. The chance of cleaning up the tax code by attempting to find out all these carefully placed loopholes is virtually zero. That is why "tax reform" focused on "closing loopholes" is doomed to failure. These loopholes are buried in myriad of places in a tax code so complex no one can understand it. Even though many of these provisions would be instantly rejected if put to a popular vote, they are protected by the fact that they are voted in the privacy of obscure tax-writing subcommittees whose actions will never be understood or even seen by the public.

Complexity is the fundamental enemy of fairness. Any fair reform has to be simple and easy to understand.

A Simple Proposal

There is simple change in the tax code that could bypass all of these arcane details and make the code transparent and fair.

If we acknowledge that we could never ferret out all these deductions and preferences individually, simply place a low fixed dollar limit on them. The limit would include not only all deductions but would eliminate preferential rates for income earned in previously protected ways. All income whether earned through labor, capital gains, dividends, or bonds would be taxed at the same rate. The essence of fairness: income is income. Period. The lower the limit on these deductions and exemptions, the lower the tax rates could be. Indeed if the limit on preferences and deductions were set low enough, it might well be possible to allow anyone to take a certain amount of capital gains or dividends at a zero tax rate and still increase revenues, if it were within the same low fixed dollar limit.

The equity in this approach would come from the fact that the limit would be a hard fixed dollar amount, not a percentage of income. The amount could be set so that most middle class taxpayers could still receive the deductions for home interest that have been sacrosanct. (This is the realist part of the proposal: most past reform proposals have blown up when these have been threatened). But the hard dollar cap would make the wealthy pay nearly the stated tax rate, since for the wealthy a fixed dollar limit would be less significant with increased income. And a low cap on deductions and preferences for capital gains, carried interest and all of the other "preferred" forms of income should raise far more revenue than the 3.6 percent increase the president proposes.

A reasonable debate could be had about what this cap would be. The lower it is, the lower the tax rates could be while raising the same revenue. (I'd actually prefer zero, but that would incur objections noted above about home mortgage and charitable contributions). $25,000 might be a reasonable balancing of these considerations. But the logic of the proposal would work at higher levels, although too high a cap and the proposal approaches the current system and diminishes its equity benefits.

This equity would preclude spectacles like Romney's 14 pecent rate or Warren Buffet paying a lower tax rate than his secretary. And because the hard dollar cap would be widely understood, tampering with it would be politically costly. Even among wealthy taxpayers, it would be more equitable than the current system since only some of the wealthy pay preferential rates, while others whose income derives from salaries pay close to the stated rates.

The most enduring benefit would be to force transparency into the system. Everyone would understand that preferences and deductions would be limited to this fixed amount. That which is widely understood is difficult to alter.

What good is negotiating for a 39.6 percent stated rate on the highest incomes when many wealthy people are actually paying 15 percent? This proposal would get the rate actually paid by the wealthiest citizens to something just shy of the stated rate of 36 percent. Give Speaker Boehner a symbolic win on the issue of the tax rate. Let him go to his caucus and declare victory. In return, the president would get more revenue, true rather than inconsistent progressivity, and transparency.

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