9 – 9 – 9, ridiculous or on the right path?



Tax reform is like birthdays. They come around every year with the promises of money and gifts.
The current flavor of the week is 9-9-9; a plain pizza with no toppings.

Herman Cain, the former CEO of Godfather’s Pizza, proposed this catch phrase as his idea for tax reform, and it vaulted him to the top of the polls of Republican presidential candidates.

His proposal is to toss out the entire tax code, repeal the 16th Amendment and replace it with a simple new system that reduces the personal income tax rate to 9 percent, reduces the corporate tax rate to 9 percent, and imposes a new 9 percent sales tax on all “new” goods.

Like all new and bold ideas, it has pros and cons. But, like our nation’s problems, they are not simple.
Reforming the tax code is different than eliminating the 16th Amendment. Beginning with the Civil War, Congress adopted several income tax laws which touched only the rich and usually expired after the need – usually a war – passed.

When Congress passed a peacetime income tax in 1894, the Supreme Court declared it unconstitutional because it was not a “direct” tax requiring each state to pay its share based on its population. For example, suppose the federal government needed $100 million and California had 10 percent of the population. It would then owe $10 million, and if California had 1 million people, each person would owe $10 which clearly could not work. The 16th Amendment, passed in 1913, fixed that, and thus began the taxation of income and what are now millions of words of law and regulations.
All tax systems have three common elements: a taxpayer, a tax rate, and a tax base. For example, individuals and corporations are income taxpayers while partnerships and non-profits are not and pay no tax.

Tax rates are easy. Just move them up or down.

The big trouble lies in defining the tax base, that is, what the taxpayer pays tax on. Mr. Cain defines individual income as “gross income minus charitable deductions” though gross income doesn’t include capital gains. His idea is to exchange sacred cows such as the mortgage interest deduction and the exemptions for children for a lower rate.

Mr. Cain’s definition of business income is gross income minus purchases from U.S.-located businesses, capital investment, and net exports. So, if Ford builds a car and uses parts that it manufactures overseas, those parts aren’t deductible, but if it exports the car, that is deductible as is the cost of the new plant that will last 40 years.

Sales taxes are regressive, so lower income taxpayers will pay more tax and higher income taxpayers will pay less. Mr. Cain argues that it may not penalize lower income people since this tax only applies to “new” goods. They can avoid the tax by buying “used” goods. Move over Walmart. Here comes Goodwill. Every new car and new house will cost 9 percent more, so those industries may be mired in the doldrums for another decade. Accountants will surely have plenty of work keeping track of all this.

But, since Mr. Cain proposes eliminating the IRS, the calculations would be completely voluntary anyway.

To be fair, Mr. Cain’s underlying theory has serous merit because he is trying to wring tax incentives out of tax policy so that taxpayers make economic decisions without weighing tax consequences.
The U.S. tax code has become a vehicle for encouraging certain economic activities and discouraging others. Because the tax base is net income rather than gross income, taxpayers are rewarded with lower taxes by reducing net income. At the same time, taxpayers have little incentive to decrease gross income.

The most popular income reduction “loophole” is the home mortgage deduction. Theoretically, it encourages people to buy houses, but a larger percentage of people own homes Canada and Germany which have no mortgage interest tax incentive (and no lobbyists to protect it).

Corporate incentives are enormous. Last year, GE earned billions and paid no tax. In 2010, U.S. corporations generated about $30 trillion in revenues and paid $227 billion in tax, or less than 1 percent of total revenues. In other words, a 1 percent gross receipts tax would raise more revenue than the byzantine game of computing net income. A gross receipts tax would also dramatically reduce complexity and the cost of compliance. States, for example, spend substantially less collecting sales tax than they do collecting income tax.

Sales taxes, the source of most state government revenues, rarely impact consumer behavior. As much as consumers enjoy tax-free weekends and buying online to save sales tax, few go to the store and think, “I’m not going to buy that because the sales tax is too high.”

Mr. Cain knows that our tax code looks like pizza all the way. So, flawed as his idea is, and it is by no means simple, he knows how consumers behave and may be on the right track.

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