This election season has re-energized the debate about the tax code and how to make it more effective. In general, most proponents of “tax reform” call for simplification through a combination of fewer (and presumably lower) marginal tax rates and an elimination or sharp reduction in tax preference items. To understand the evolution of the current debate, consider the two prominent, bipartisan proposals introduced in late 2010, the Bowles-Simpson plan and the Domenici-Rivlin plan.

Bowles-Simpson plan

President Obama created the commission in February 2010 to address the nation’s fiscal situation by “identifying policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run.” The commission, co-chaired by former Chief of Staff to President Clinton Erskine Bowles and former Senator Alan Simpson (R-WY), recommended over $4 trillion in long-term deficit reduction, composed of approximately $3 trillion in spending cuts and $1 trillion in increased tax revenues.

In addition to individual tax-related provisions, the Bowles-Simpson plan calls for similar changes to the corporate tax system. The current top tax rate of 35% would be reduced to 28%, but many tax preference items would be reduced or eliminated. To strengthen Social Security, the proposal recommends an increase in the Social Security wage base to cover 90% of wages (approximately 85% of wages are currently taxed), a gradual increase the retirement age, and a change in the formula for calculating cost of living adjustments (COLA).

Domenici-Rivlin plan

This plan was developed by a bipartisan task force chaired by former Senate Budget Committee Chairman Pete Domenici (R-NM) and former White House Budget Director and Federal Reserve Vice Chair Alice Rivlin. The plan also seeks to reduce federal debt, reform tax systems, and stabilize Medicare and Social Security, with recommendations including fewer marginal tax brackets, lower rates, and reduced tax preference items.

Like Bowles-Simpson, the plan also calls for a reduced corporate tax rate (27%) while scaling back writeoffs. Domenici-Rivlin proposes the same framework to strengthen Social Security (increased wage base, adjustments made for increased longevity, and change the COLA formula). Perhaps the biggest difference between the two plans is that Domenici-Rivlin proposes a 6.5% debt reduction sales tax. This tax would be structured similar to value added tax (VAT) systems many other countries employ.

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Fundamental tax reform will likely be very challenging to implement, given the complexity of the current tax code, the influence of special interests, and an environment of gridlock in Washington. However, the directional aspects of these proposals can provide clues to how taxpayers may be affected in the near future. Understanding and planning for potential risks or opportunities can dramatically improve outcomes. Engage clients and prospects right now on near-term opportunities by referring to our “Ten income and estate planning strategies for 2012” education piece.