Bush's Tax Reform

Everybody is reporting that President Bush's new budget includes a big boost for investors, but the larger news is that taken together his proposals are a great leap forward for tax reform.

A few weeks ago Mr. Bush proposed ending the double taxation of dividends for shareholders. Last week he topped that with a sweeping plan to benefit saving-plans. Both move the U.S. closer to a better tax system that rewards savings over consumption.

The saving-plan idea -- and it is huge -- is to replace the current complicated network of tax-preferred saving accounts with three simple plans: two for individual savers and one for employer-sponsored retirement accounts. The most delicious one, for us, is called the Lifetime Savings Account where contributions can run up to $7,500 a year and is indexed for inflation. Although contributions are taxed, all earnings accumulate tax-free and withdrawals can be made at any time with no tax penalty.

The result will also be huge. People will be allowed to save more dollars, regardless of income. No investment income will be taxed. And the penalty-free withdrawals will mean that those with low and moderate incomes can contribute without worrying about what will happen if they suddenly need the money they have committed -- a big barrier to their participation in current plans.

The second personal account is similar but for retirement savings, so tax-free withdrawals are limited to those who are age 58 and older. The Retirement Savings Account would replace the three types of IRAs now on offer and the $7,500 contribution limit would be indexed for inflation. The third plan, an employer-sponsored account, would consolidate half-a-dozen such plans, like the 401(k) and 403(b), into one plan with enormously simplified rules.

On the grounds of utter simplicity alone, the new accounts will encourage more people to save and to save more. Ditto for business, especially for small firms, where acres of red tape and high compliance costs now discourage employers from offering any retirement program. By itself this streamlining and clarity is important enough to justify some cheerleading. But there is more.

The combined effect of ending dividend taxation and expanding savings accounts constitutes a major leap toward removing the tax on income and thereby leveling the field with consumption. Because the current system taxes income -- including income from investment and saving -- it generates incentives to consume rather than invest and save. But by shielding more investment and saving income from taxation, the Bush proposals tilt the tax code away from this bias.

Of course the merest hint that taxes might be lowered -- and that people might keep more of their own money -- has infuriated income redistributionists and the budget "deficit" frightsters. They are complaining that the Bush proposal will result in more tax revenue now (true, since contributions are not deductible) but less revenue later (true, since withdrawals are not taxed). The critics forget that the years during which people are consuming less, and investing and saving more, will be years of higher growth. As everybody and their dog knows, a larger, stronger economy is the best, most efficient way to reduce deficits.

A second line of carping is that these saving-plan proposals will benefit the rich. Well, duh. The "richer" one is, the more one is exposed to higher marginal rates of taxation and more in need of a way to shelter income from taxation. But the critics ought to consider just where this money goes after it escapes taxation. It doesn't buy yachts or gold coins (not that there's anything wrong with that). It goes into saving and investment where it spurs productivity and economic growth.

It is clear from these proposals that the Bush Administration is taking the investor class seriously. As it should since investors constitute half of all households; more than 40 million people have IRAs. But the bigger point here is that by paying attention to investors, Mr. Bush is paying attention to the economy.

Updated February 5, 2003