The Freedom To Save Act: Getting The Tax Reform Job Done

1
The Freedom To Save ActGetting The Tax Reform
Job Done

• Ernest S. Christian
• Executive Director
• of the
• Center For Strategic Tax Reform
• Before The
• Presidents Advisory Panel on Federal Tax Reform
• May 11, 2005
• Washington, DC

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Relief From Double Taxation

• I urge first-year expensing for businesses and
  Universal Savings and Investment Accounts (USIA)
  for individuals
• This relief from double taxation --
• -Achieves 80 to 90 percent of the economic
  goals of
• Big Bang tax reform
• -Forever changes the tax codes anti-capital
  character
• -Can readily be made revenue neutral
• -Stands an excellent chance of being enacted
• Step Two is to enact the Simplified USA Tax
  (SUSAT)
• -Historic simplification of the tax code (as per
  H.R. 269 in the 108th Congress)
• -Non-radical international tax reform that allows
  Americans to compete and win in global
  markets

3
The Core Component of Tax Reform

• Elimination of double taxes on savings and
  investments is the core economic component of all
  tax reform proposals
• -Some proposals do it in unfamiliar ways
• -Others are experimental -- and have uncertain
  side effects
• The tried and true way is to stay within the
  familiar framework of the current code
• -First-year expensing has predictable results
  based on experience
• - USIAs are patterned after the familiar Roth IRA

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Keeping Our Eye On The Ball

• Why go searching for some new magic elixir that
  may have unknown results?
• -With expensing and USIAs, there is only an
  upside and we know what it is
• Every tax reformers inclination is to propose
  something dramatic -- something that will capture
  the publics imagination
• But real tax reform is not about dramatic
  proposals, it is about dramatic
  accomplishments
• The combination of first-year expensing and USIAs
  gets the job done

5
Expensing Versus Depreciation -- A Timing Issue

• Because depreciation postpones deductions, it
  requires businesses to prepay tax
• -Thus, government tax receipts are increased up
  front but are lesser by the same amount in the
  future
• -Prepaying tax increases the cost of capital
  equipment for a business
• First-year expensing is the opposite It allows
  the deductions to be taken now instead of later
• -With expensing, government tax receipts are
  reduced up front but are greater by the same
  amount in the future compared to depreciation
• -Expensing reduces the cost of capital equipment
  compared to depreciation
• The revenue cost of switching to expensing
  starts out large, as continuing depreciation
  deductions on pre-effective-date assets stack up
  on top of expensing deductions for new assets
• -But, after three years, the impact of the
  carryover depreciation deductions starts to
  diminish, and the revenue cost quickly declines

6
Switching to Expensing Example of Revenue Cost
Pattern -In this example, the cumulative
revenue cost over ten years is 752
billion -But the PV (in Year 1) of that
10-year cost is 603 billion
Source Fiscal Associates
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Universal Savings and Investment Accounts

• A USIA account is like a Roth IRA -- except that
  it is unlimited and not restricted to retirement
  savings
• -Deposits in USIAs are made out of current-year
  earnings
• -Americans can save in a USIA for whatever
  purpose they want
• -They can withdraw their money whenever they
  wish
• USIAs will function much like a combination
  brokerage and checking account
• -Because USIAs are funded with after-tax
  savings, withdrawals are not taxed -- and
  interest, dividends and capital gains on
  investments inside the account are taxed at a
  zero rate
• The pattern of revenue losses from USIAs is just
  the opposite from that of first-year expensing
• -Because USIAs allow no up-front deduction, the
  revenue loss is small in the beginning and
  builds up over time as greater amounts of
  dividends, interest and gains are received in
  those accounts without further taxation

8
Paying for the Revenue Cost with a Voluntary Toll
Charge

• The revenue cost of first-year expensing and
  USIAs can be paid for --
• -Step One Expand USIA accounts to apply to
  existing savings as well as to new savings out
  of current earnings
• -Step Two Charge the owners of existing
  portfolios who want to put their savings in a
  USIA account a toll charge for the privilege of
  doing so
• Many tax reform proposals automatically exclude
  from additional tax all future interest,
  dividends and gains on existing portfolios
• -And tend to pay for the revenue cost with
  radical changes elsewhere in the tax code
• The future yields on all after-tax savings (old
  and new) should be free of additional tax -- but
  the transition should be paid for in a
  traditional way by those who most directly
  benefit
• Everyone who has retirement savings in 401(k) or
  other tax-deferred accounts should be given the
  option of paying a realistic toll charge for
  converting those accounts to Roth IRAs

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B.100.e Balance Sheet Data From Federal
ReserveBillions of dollars amounts outstanding
end of period, not seasonally adjusted
Potential Approximate Amount Transferable to USIA
(or Roth IRA)
Source Flow of Funds Accounts for the United
States, March 2005, Board of Governors of the
Federal Reserve System, Washington D.C. 20551.
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Theory and Amount of Toll Charge

• Economists tell us that a share of stock is worth
  the discounted present value of the future stream
  of dividends and gains that the market predicts
  it will produce
• -Thus, the capital invested in the stock and
  the future stream are two versions of the
  same thing and both should not be taxed
• Under current law, the owner of the stock is
  required to pay a 15 percent tax on those future
  dividends and gains -- and because the value of
  the stock is equal to the present value of the
  future stream, current law in effect imposes a 15
  percent tax on the value of stock
• -If, however, the share of stock is in a USIA,
  the owner will not pay tax on the stream of
  dividends and gains in the future -- and,
  therefore, the 15 percent tax on the value of
  the stock is removed
• In exchange for removing that 15 percent tax on
  the value of the stock, a onetime, voluntary toll
  charge of 10 percent of the value of the stock is
  suggested

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A Simplified Example of the Toll Charge

• Present Law Jones owns a stock that will produce
  a pre-tax stream of dividends and gains that has
  a present value of 117.65
• -However, because dividends and gains are taxed
  at 15 percent, the present value of the
  after-tax stream is only 100 and the stock is
  worth only 100
• USIA Format Jones paid 100 for the stock. Now,
  he pays a 10 percent (10) toll charge for a
  total of 110. The present value of the future
  stream of dividends and gains is 117.65 -- and
  because the tax rate is zero, Jones gets to keep
  the entire amount. Having paid 110 (including
  the toll charge) for a stream of dividends and
  gains worth 117.65, Jones is 7.65 better off
• As a result, Jones would be strongly motivated to
  put the stock in a USIA account and pay the toll
  charge

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Reasonably Predictable Results

• Experience with Other Toll Charges
• -Indications are that the repatriation
  rate of accumulated foreign- source income
  subject to a 5.2 percent toll charge pursuant to
  American Jobs Creation Act (AJCA) of 2004 is
  going to be about 50 percent of the amount
  eligible and perhaps closer to 100 percent of
  liquid assets where the repatriation is
  beneficial to the taxpayer
• -Conversions of regular IRAs to Roth IRAs
  have been going on since 1997 even though the
  option is severely restricted and the toll charge
  is very high
• -With a 10 percent toll charge, it is likely
  that the transfer rate into USIAs (and
  conversions to Roth IRAs) would be at least 50
  percent -- and the transfer rate could be
  higher
• Revenue Results of 10 Percent Toll Charge With
  Two Assumed Transfer and Conversion
  Rates
• 50 Percent . . . . . . . . . . . . .
  1.07 Trillion
• 75 Percent . . . . . . . . . . . . .
  1.61 Trillion

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Approximate Net Present Value Budget Impact of
Proposals ( Billions)
10 Toll Charge
12 Toll Charge
Assumes 6 federal government borrowing and
discount rate
Source Fiscal Associates
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Conclusion Simple and Effective Tax Reform

• I am not undertaking to give precise revenue
  estimates -- nor do I say that my way of
  calculating the toll charge is the only way
• Rather, I am suggesting a basic analysis from
  which I believe that certain important
  conclusions flow
• -The use of a toll charge is a workable idea
  with which we have experience
• -An official revenue estimate can be made
  drawing upon the expertise of the Treasury
  Department and the financial community
• -The toll charge could pay for part, all or
  more than the revenue cost of first-year
  expensing and USIAs
• Therefore, I conclude that this simple and
  effective approach to tax reform should be
  included in this Panels recommendations

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AppendixExplanation of Table Entitled
Approximate Net Present Value Budget Impact of
Proposals

• On the line showing the result of a 10-percent
  toll charge applied on the assumption of a
  50-percent transfer rate
• -603 billion is the present value of the
  nominal 752 billion 10-year revenue cost of
  expensing
• -328 billion is 50 percent of the present
  value (655 billion) of the 840 billion
  nominal 10-year revenue cost of excluding all
  dividends and capital gains from tax under
  present law
• -1,070 billion is both the nominal and present
  value of one-half of a 10-percent toll charge
  applied to a base of 21,416 billion
• The Table is intended to encapsulate the way that
  the combination of expensing, USIAs and the toll
  charge would typically be presented in the budget
  documents which take into account (as they must)
  both interest costs and interest savings
• -For example, in the budget presentation, the
  cost of expensing plus the interest cost to the
  government on that lost revenue would be
  presented in annual increments over the budget
  period
• -Similarly, as an offset thereof, the upfront
  revenue gain from the toll charge plus the
  annual interest cost savings to the government
  would be presented over that same budget period
• -The net present value presentation in the
  Table collapses these costs and savings over a
  number of years to an equivalent current
  valuation using an interest rate equal to the
  government borrowing rate