Although Congress is sympathetic and the president determined, efforts to change the way the government collects its revenues (as distinct from attempts to simply raise or lower existing taxes) usually founder on the shoals of special interest opposition and institutional rigidity. “The cries for tax reform are cyclical,” notes Annette Nellen, professor of tax and accounting at the College of Business at San Jose State University in California. “It tends to come up every seven to 10 years.”

Reform schemes often come with distinctive tenets and fervent believers, all focused on the salvific goal of fundamentally changing the ways the government levies taxes. In the coming months, debates over the merits of perennial favorites such as the flat tax, the national sales tax and the value-added tax (VAT) will enliven the public discourse.

Each of these plans would affect the tax burdens borne by those in upper-income brackets. In most cases, affluent Americans would be the primary beneficiaries.

According to Chris Edwards, director of tax policy at the Cato Institute, a conservative think tank in Washington, D.C.: “A key purpose of tax reform is to reduce taxes on savings. And who does most of the saving? Rich people. Thus, to some extent, tax reform means substantial cuts for wealthy people.”

The coming debate over these options will be hard-fought, and if a reform is to pass, it will almost certainly require compromise. As former House Majority Leader Dick Armey, who advocates the flat tax, once said, “Tax reform is not for the timid.”

That may be so, but the president said when he named a bipartisan panel to study the alternatives to the current tax system, in January, that he was committed to putting tax reform on a fast track. “This is an essential task for our country,” Bush said. While the details of his tax reform package remained under wraps as Worth went to press, Bush outlined a few broad parameters. He wants the overhaul to be revenue-neutral, and he wants to retain deductions for mortgage interest and charitable donations. He also wants to make permanent the income and estate tax cuts he engineered in his first term. His appetite for more radical reform is unclear, but during his reelection campaign, he called a national sales tax proposal an “interesting” idea.

Many agree that the present tax system has become complex and unwieldy. Between 1995 and 2004, the total number of pages in the tax code, including regulations and IRS rules, increased by almost 50 percent, as has the average time needed to complete the forms. “The tax system is broken,” says Bruce Bartlett, senior fellow at the National Center for Policy Analysis, a conservative think tank in Dallas. “It is in dire need of simplification. There is growing tax evasion and glaring problems on the corporate side that are eroding the tax base,” he adds. “And it’s inefficient, because investment and other economic activities are being dictated by the tax code instead of the free market.”

While complying with the federal tax system has become more difficult, tax rates themselves have been trending down. In 2001, Bush signed into law the largest income tax cuts since 1981, and in 2003 he lowered the maximum tax rate on capital gains and dividends to 15 percent. “A lot of people considered Reagan’s 1986 overhaul the last major tax reform,” Edwards says. “But most of George W. Bush’s supporters consider his tax cuts as very real reforms.”

They are also temporary. The Bush income tax cuts expire at the end of 2010 and the dividend and capital gains cuts expire at the end of 2008. The president wants to make them permanent; supporters of such a move say the current situation fosters uncertainty that could damage the long-term growth of the economy, while sending mixed messages to the investment community. While many consider making the cuts permanent a drastic step, it would appear tame in comparison to the radical, systemic reforms currently bandied about.

One recurring idea made popular by Armey is to tax everyone at a flat income tax rate of 17 percent, while eliminating almost all deductions. Armey proposed such a system in the early 1990s, and buttressed his argument by theatrically waving about a 10-line, postcard-size tax return. He said it would dramatically simplify the filing process and reduce the cost of compliance by nearly $550 billion per year. In 1996, several politicians introduced their own flat-tax bills, and in 2000, magazine publisher Steve Forbes made the flat tax part of a pillar of his failed presidential bid.

The goal of the flat tax is to create a more efficient system that promotes savings and investment by eliminating levies on income from savings, capital gains and interest. Most flat-tax proposals would also allow businesses to deduct the cost of investments from their revenues immediately, instead of adhering to the complex depreciation schedule they currently use. This, its proponents claim, would free capital for reinvestment.

Flat-tax opponents dislike the fact that it eliminates popular deductions, such as those for mortgage interest and charitable donations. It would also eliminate corporate deductions for benefits such as health and life insurance and social security.

There is some support in Congress for variations of a flat tax—the proposed rates range from 17 to 20 percent—but most observers believe that it is not politically viable. “If the administration comes up with a flat tax, it will totally blow its credibility,” and paint it as beholden to its ultraconservative wing, says Kent Smetters, a former deputy secretary of the Treasury and now a professor at the Wharton School of Business. “That is something the Democrats would demagogue to death.” Opponents of the flat tax say it is less equitable than the current system because the middle class would pay more in taxes because of the elimination of the mortgage interest deduction.

While a flat tax might deliver some tax savings to affluent taxpayers, financial advisor Cynthia Conger of Arkansas Financial Group in Little Rock says that it may be less than expected. “I have a few dual-doctor couples who are in the 36 percent bracket,” Conger notes. “But after deductions, their average rates are 23 to 26 percent. That’s not very far from the flat rate of 17 percent.” By contrast, those earning $90,000 would see their real tax rates—after deductions—increase from 13 percent to 17 percent. “This would increase taxes on lower- and middle-income people extraordinarily and hit them very hard,” she says. Meanwhile, affluent individuals would pay 6 to 9 percentage points less on their taxes.

Mark Watson, a tax specialist with Asset Management Advisors, a multifamily office in Palm Beach, Fla., thinks a flat tax could have a more wide-reaching effect. “If it reduces taxes for high-net-worth individuals, then you will see less interest in using tax shelters and other offshore investments,” he says. “You won’t have to use these tools because you won’t need them.” Watson says that any reform that includes permanent removal of the estate tax could represent a death knell for tax shelters. “I expect tax reform could significantly depress that industry,” he says.

Replacing graduated income taxes with a national sales tax (NST) is another evergreen idea that enjoys support in certain Washington circles. Sen. Richard Lugar (R-Ind.) proposed an NST in the mid-1990s, and more recently, Congressman John Linder (R-Ga.) has crafted NST legislation he calls FairTax, which he, perhaps wishfully, claimed enjoyed more bipartisan support than any other tax proposal. A national sales tax would eliminate the taxes on ordinary income, estates and gifts, and do away with the IRS. Linder’s proposal would emulate state sales taxes, and require consumers to pay a 23 percent levy whenever they make retail purchases. (Wholesale purchases by corporations would be tax-free.)

As with the flat tax, NST proponents want to simplify the revenue system and promote savings and investment. They argue that this would save hundreds of billions of dollars now spent each year by businesses on the costs of tax-code compliance. They also argue that the NST would collect revenues from everyone who benefits from government services in the country, including illegal aliens who do not now pay income taxes.

Any proposal that would eliminate taxes on investment income could have a radical effect on the value of affluent individuals’ portfolios. “Most high-net-worth portfolios carry a lot of municipal bonds,” says C. Joseph Ramos, president of Private Consulting Group in Larkspur, Calif. “Under an NST, they could lose up to 20 percent of their value overnight.” Ramos notes that investors would quickly switch to higher-yielding corporate bonds, leaving the municipal issues to languish. He also believes that the elimination of the mortgage interest deduction could adversely affect investments such as real estate.

Watson says that the NST’s non-taxation of income and investments would seriously undermine the value of tax shelters and offshore investments. “A simpler tax code with lower rates would get rid of all the shenanigans going on right now,” he says. “It’s one of the goals of tax reform.”

The impact of an NST is the subject of some debate. The current income tax system is graduated, meaning that those who earn more pay higher rates. According to the Cato Institute’s Edwards, the average tax rate (taxes paid divided by adjusted gross income) for those earning more than $200,000 a year was 26 percent in 2002. By comparison, the average tax rate on households earning between $50,000 and $100,000 was 11 percent. Consumption taxes like the NST would close this gap by taxing everyone’s purchases at the same rate. “The wealthy would get a big tax cut,” Edwards says, because the plan would tax neither salaries nor investment income. Opponents of the plan argue that middle-income and poor taxpayers spend a greater percentage of their income on basic goods and services than do the affluent, and would therefore end up paying more on a relative basis. The poor and middle-class would also get less of a break, in terms of the percentage of their total purchasing power, from the elimination of income tax. Because of these issues, critics often portray the NST as regressive and unfair.

NST advocates counter that gains in overall efficiency would lead to a streamlined, expanding economy, and thus benefit everyone. Michael Boskin, former chairman of the Council of Economic Advisors, has projected that a national sales tax would promote a 10 percent increase in gross domestic product over a 10-year period.

“A national sales tax has a lot of momentum in Congress,” Edwards observes. “There were 54 cosponsors in the House for the FairTax. However, the Bush administration does not seem that radical. Bush has already said that he wants to keep deductions for mortgage interest and charitable giving.”

Beyond the political consequences of taxing the poor and middle class at a de facto higher rate, the task of administering the tax would be daunting. “It’s a stupid idea,” says Bartlett of the National Center for Policy Analysis. “It simply will not work administratively. It would also require a minimum tax rate of 30 percent [to be revenue neutral] on all retail sales, with state and local sales on top. New home sales, local government services—except education—and medical care would all be taxed.” Bartlett says that some economists believe that a rate almost twice as high would be necessary to sustain a national sales tax.

Those who have traveled and done business in Europe are familiar with the VAT, a twist on the national sales tax. Like the NST, the VAT would eliminate personal and corporate income taxes. Unlike the NST, the VAT would collect revenues at each stage of the consumption chain in a “value-added” sequence, in small-percentage increments from manufacturer to wholesaler, wholesaler to retailer and retailer to consumer. “If the retailer fails to collect the tax, all [the government loses] is that part of the rate,” explains Bartlett. “With a retail sales tax, all the revenue would be lost.” Because of this safeguard, he notes, “Every country that has seriously considered a national retail sales tax has concluded that a VAT makes more sense.”

Because a VAT is a modified form of a national sales tax, investment advisors think it would have much the same impact on a high-net-worth portfolio as an NST. Tax-free investments would move the mix away from municipal to higher-yielding corporate bonds, and lessen the appeal of tax shelters and offshore investments. Private Consulting Group’s Ramos also thinks both a VAT and NST would slow down the sales of annuities, because many owners buy them for their tax-deferred properties rather than simply for the death benefits.

While a VAT might offer upper-income individuals the same benefits of a national sales tax, it would cause nothing but pain for the entrepreneurial class. The job of collecting value-added taxes would fall squarely on the shoulders of business owners, turning them into mini-IRS divisions. VAT critics argue—with good reason—that this burden should not fall to the sector that generates the nation’s wealth.

Like the NST, a VAT is a regressive tax, taxing lower- and middle-income consumers for a larger portion of their income. A few voices in Congress have raised the idea of a VAT over the last 20 years, but they have been quickly drowned out by those who equate a VAT with high European taxes. “There’s never been much support in this country for a VAT, even though every other industrialized country has one,” San Jose State University’s Nellen says. “Politically it carries a lot of baggage.”

Bartlett, who has no love for new taxes, believes that it may be necessary to add a VAT to our current income tax regime to stem the rising government budget deficits caused by Bush tax cuts, growing defense expenditures and the impending retirement of the baby boomers. “I’m concerned that our long-term structural deficit problem may precipitate some financial crisis like the 1987 stock market crash,” he warns. “A loss of international confidence in the U.S. economy and the low dollar may cause a moment to come when everybody decides that we have to do something about the deficit.” Bartlett contends that a VAT could help pay down the deficit while also funding lower income tax rates.

The federal budget deficit, which for 2004 totaled roughly $400 billion, looms large in any debate on tax reform. According to the Congressional Budget Office, “if all of the tax provisions scheduled to expire were extended together, the revenue projection for 2006 would be about $16 billion lower. That revenue loss would grow to $45 billion in 2007 and $95 billion in 2010, before jumping to nearly $250 billion in 2011 and then reaching $422 billion in 2015. Over the entire 2006-2015 period, revenues would be reduced by about $2.1 trillion.”

Despite this fiscal reality, a flat tax, NST or VAT is “too radical and will run into a mountain of opposition,” Watson says. “Every sentence in the Internal Revenue Code has a constituent typically backed by a powerful lobbyist. Radical reform is nearly impossible.”

A more viable proposal would be to further tinker with the current system, Watson maintains. “I think we’ll see proposals to further shield interest, dividends and capital gains from taxation and eliminate the alternative minimum tax,” he predicts. He sees reform paralleling the 1986 Tax Reform Act—broadening the tax base by eliminating deductions and lowering tax rates. “This will be very favorable to most investments—particularly those that generate interest and/or dividends,” he adds.

The administration may also make moderate proposals such as permanently eliminating the estate tax or reducing taxes on gifts, which would have a substantial impact on upper income taxpayers by eliminating their current need for trusts, tax shelters and estate planning tools—and for the financial services professionals who provide such tools.

While Watson and a host of others may question the political viability of such radical proposals as a VAT or an NST, Bush has said that tax reform is an essential task and one that includes the permanent elimination of the estate tax—a radical proposal in itself. While his offhand remark about a national sales tax being an interesting idea may be a sop to his party’s conservative wing, it does signal his willingness to entertain new ideas.

The president’s bipartisan commission on tax reform will present its fresh—perhaps even radical—ideas in July.

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Michael Verdon is a freelance writer and frequent contributor to Worth. michael.verdon@verizon.net