THE POINT OF NO RETURN

By DAN GOODGAME

Newt Gingrich was taking questions at a town meeting in his suburban-Atlanta district last January, when a fortyish woman rose and identified herself as a tax lawyer. Before anyone could hiss, she allowed, "I'll go out and learn how to make cabinets for a living if you will eliminate the current tax law. It's disgraceful the way my clients use it to avoid taxation, and I hate it. And I hate the irs. The whole system is corrupt." The crowd of more than 600 erupted in applause and shouts of approval. So Gingrich asked some questions of his own. "How many of you would pay $100 more if you could just have a simple tax, fill it out yourself and never use an accountant?" All but two hands went up. (Both, it turned out, were accountants.) Someone yelled, "Try $250!" A third of the audience raised hands for that one. Gingrich tried the same straw poll at other town meetings and got a similar response. "It was amazing," he told Time. "It was the most emotion I've seen" on any issue.

And that was before taxpayers had to face what some veteran accountants are calling the Tax Season from Hell -- a three-month ordeal climaxing with this week's rush to meet the April 17 deadline for filing tax returns. The Internal Revenue Service, under pressure to root out more fraud -- and more revenue -- has sharply stepped up the number of returns it rejects and audits. While encouraging taxpayers to file electronically-mainly to save irs manpower and paper work-this year the tax collectors returned, often for minor clerical errors, fully 20% of the 9.9 million electronic returns submitted through late March. The irs is running 11% behind last year in processing refunds, which exerts a $4.6 billion drag on the economy and is depressing retail sales nationwide. These delays often amount to eight to 12 weeks, an excruciating lag for low-income taxpayers counting on their refund to fix the car or pay the rent. Some such workers, accustomed to quick refunds, have taken out their frustrations on storefront tax preparers like Jesse Ivy of Chicago, who twice has called police to quell near riots. Says Kevin Crosby, who received death threats from a client: "Until now, I never thought of tax filing as being a high-risk business."

The I.R.S. is doubling the number of returns it audits, to 2%. Most audits focus on one or two items, and many are conducted by mail. But a record 153,000 will be chosen at random to face the bureaucratic equivalent of a rubber-hose interrogation: a line-by-line, show-us-your-bank-statements gauntlet known as the Taxpayer Compliance Measurement Program, which triples in size this year. Even scarier for cheaters -- and more annoying for honest taxpayers-4,500 IRS auditors have undergone 32 hours of training in new "economic reality" techniques for intruding deeply into the life-styles of those audited to find evidence of unreported income: for example, questioning where they go on vacation and how they can afford that Lexus in the driveway.

Taking their lead from opinion polls and soundings in their districts, Republican leaders, as well as a few Democrats, are lining up to push for a radical overhaul of the tax system-not just "reform." Their plans seek to replace a tax system that has become a crushing burden on taxpayers and the economy, costing at least $40 billion a year in direct compliance costs-and 3 billion hours of taxpayer time. It renders U.S. exports less competitive and discourages savings and investment. It erodes the sense of fairness and trust that is critical if taxpayers are to abide by the law.

Just last week Gingrich and Senate majority leader Bob Dole jointly announced the appointment of Jack Kemp, former Housing Secretary, to lead a task force that will hold hearings this summer and recommend legislation to simplify the tax system radically. Last week the Senate Finance Committee heard testimony on proposals for a flat income tax, with a single rate, a large personal exemption and few or no other deductions. One such plan is sponsored by House majority leader Dick Armey of Texas and another by Senator Arlen Specter of Pennsylvania, a candidate for his party's nomination for President. Another presidential hopeful, Senator Richard Lugar of Indiana, last week announced his plan to abolish both the income tax and the irs in favor of a national retail-sales tax, to be collected by the states. Under his system, Lugar said, "the money you earn is yours. You need not account for it, report it or hide it ... You are no longer guilty until you prove your innocence to the IRS."

IRS and White House officials think tax reformers are misreading the public: what really angers honest taxpayers is the prevalence of cheaters. "We do make mistakes from time to time," says IRS commissioner Margaret Richardson. But she adds, "I think people are more concerned about fraud in the system, and they need an advocate so that everyone pays their fair share." Martin Freeman, a tax preparer in Chicago Heights, Illinois, reports that most of his clients support the IRS crackdown. "They know the new rules are cutting down on fraud," he says. The IRS points out that 98% of all tax returns this year will not get audited; rejections because of errors affect only 20% of electronic filers and 3% of paper filers. Moreover, says the IRS, the tax code's complexity doesn't affect most filers, 70% of whom take the standard deduction and file the short form.

Nonetheless, about half the individuals who file tax returns each year are sufficiently intimidated that they pay for professional help. That leaves 52 million Americans who wrestle with dozens of forms and hundreds of pages of ever changing instructions. The IRS estimates that it takes about 27 hours for the average family to keep records and prepare an itemized Form 1040 with a few additional schedules. But if a family has income from a part-time business or has to pay taxes for in-home child care, the filing time can eat up several weekends.

The burden on business is worse. Some large companies play reluctant hosts to teams of IRS agents camped out permanently in their offices. The annual tax return for Chrysler Corp. stands 6 ft. high and is prepared by a staff of 55. Many small businesses find they must buy computers or hire accountants just to comply with irs record-keeping requirements for inventory. One sentence in a tax instruction used by many small-business owners runs 436 words-170 words longer than the Gettysburg Address.

Glenn Silverman, 36, owner of Glenn's Custom Photo in Chicago, quit his job as a tax accountant three years ago and so abhors tax season that he pays to have his return prepared. Still, as a small-business owner, he spends three hours a week handling records and forms for federal, state, local and payroll taxes. "I'd love to see the elimination of the IRS," he says. Martha Nelson, 32, who owns a gift shop in Northampton, Massachusetts, says she would gladly surrender her tax deductions in exchange for a simpler system, so long as her tax bite did not significantly increase. Like a majority of Americans, she believes the tax code is designed for "people who can afford experts to find them loopholes and shelters."

Estimates of the direct costs of tax compliance run all the way from $40 billion to $200 billion. The indirect costs to the economy of tax laws that steer resources away from their most efficient uses are even more difficult to measure but are estimated to exceed the direct costs. Then there's the $7.6 billion cost of the irs itself. The tax code runs 1,378 pages, helpfully divided into 1,563 sections, while the companion Federal Tax Regulations 1994 occupies an additional 6,500 pages. A pair of prominent flat-tax proponents, Robert Hall and Alvin Rabushka of Stanford University, estimate that 293,760 trees are felled yearly to print all this paper.

The IRS in recent years has encouraged tax preparers to file returns electronically. As an incentive, it offered quicker refunds -- until this year. Prompted by lawmakers alarmed at reports of $1 billion to $5 billion in fraud among electronic filers, the IRS has responded by cross-checking tax returns against new data from Social Security records. And woe to the taxpayer whose particulars don't fit neatly onto the forms, as Charles Howard Hayes Darcy Jr. can attest! When he filed to pay taxes on his $28,000 in wages for 1994, Darcy, 37, a construction worker in Pittsburgh, Pennsylvania, listed his son as a dependent, just as he had done for all of the boy's 15 years. But this year the IRS was on the prowl for mismatched names, and the younger Darcy, who shares his dad's two middle initials, somehow confused the computer, which read the name as "Charles H. HDarcy III" and rejected the return. The boy's mom, Mary Darcy, finally got the mess straightened out but complained that "you have to give them everything but your measurements to get any answers."

Also caught in the cross fire of the IRS war against fraud are women who when they married neglected to change their name with the Social Security Administration. If the names on a tax return don't exactly match those from SSA, the IRS will reject the returns. That's how Lisa Broeker, 32, a nurse's aide from South Milwaukee, Wisconsin, learned that the SSA still had her listed as Lisa Lopez, even though she had paid taxes under her married name for nine years. She was forced to stand in line at the local Social Security office to change her name -- and ran into five women in similar straits. Each would have to wait weeks for the changes to be processed, then resubmit her return to the IRS.

The crackdown on electronic filing has struck hardest at the very class the Clinton Administration has held up as the main focus of its good intentions: the working poor. For example, a worker with two or more qualifying children who earns less than $25,296 a year, is eligible for an earned-income credit of as much as $2,528. The credit operates as a sort of "negative tax," available to workers too poor to owe income tax and is intended to make work more attractive than welfare. The credit, however, has been susceptible to fraud. In order to catch the cheats, the irs has also punished honest taxpayers. Low-income workers for whom the earned-income refund is the biggest chunk of cash they see all year have been waiting eight to 12 weeks or longer. Emma Mejia, 48, a single mother of two, has been waiting for her $2,528 refund since the first week of February -- and has lost her job washing laundry in a Chicago-area nursing home. "I'm looking for a job," she said, "but I haven't been able to pay the rent in three months." Her tax preparer, Betty Kafka, believes the IRS antifraud program has been poorly designed in ways that are "especially unfair to the working poor."

Like good revolutionaries, top Republican lawmakers and thinkers see this crackdown by the ancien ragime at the IRS as a sign of its desperation and imminent collapse. "When you get to the point where you have government snooping in people's drawers and talking to neighbors, you know that something has gone desperately wrong with the system," says Stephen Moore, a budget expert at the libertarian Cato Institute. Representative Bill Archer of Texas, chairman of the tax-writing Ways and Means Committee, observes that the irs stirs more resentment than ever because "it has been given more power, more penalties." All of which only furthers his cause of radical reform. "Any discontent with the current income-tax system," he says sunnily, "is going to be helpful."

Into this tax hell come proposals for salvation: everything from tinkering with the system to imposing a flat tax. The intellectual cheerleaders for the flat tax are Hall and Rabushka, both economists at Stanford's Hoover Institution. Their writings inspired the flat tax for which Jerry Brown won a flurry of attention during the 1992 Democratic primaries. Another disciple is House majority leader Armey, sponsor of the leading flat-tax plan now before Congress.

Perhaps the strongest selling point of the Armey plan is that its tax return would fit on a postcard and could be completed in 15 minutes. Armey would abolish all tax deductions and assess all personal and corporate taxpayers at a flat rate of 17% of their taxable income. Individuals and families would enjoy generous personal exemptions. A married couple filing jointly, for example, would reduce their taxable income through a $26,200 personal exemption and subtract an additional $5,300 for each dependent child. A family of four with an income below $36,800 would owe no income tax under the Armey plan, as opposed to the $3,100, or 8.4%, that such families pay, on average, today.

Because of the Armey plan's large personal exemptions, only high-income taxpayers would pay close to the full "flat" rate of 17%. The tax would appear quite progressive for those with middling incomes: 5% for a family of four earning $50,000 in wages and salary, as opposed to an effective rate of 9% under the current system; 9% at $80,000, vs. 12% at present. Meanwhile, those with the highest incomes would gain the most: a family of four with an income of $200,000 would pay 14%, vs. 23% today; with an income of $1 million, 16%, vs. 26%. The wealthy would also profit because their capital gains (from sales of stock or other investments), interest and dividends would escape being taxed as personal income, as they currently are.

Everyone appears to come out ahead under the Armey plan for two reasons. First, Armey's 17% rate would produce about $40 billion less revenue each year than the current system, thus swelling the budget deficit and requiring further spending cuts on top of those already promised by Republicans -- and not yet delivered -- to balance the budget by 2002. To raise as much as the current system, Armey's plan would have to set a rate of between 19% (according to Hall and Rabushka) and 23% (according to the Clinton Treasury Department).

The second reason the flat tax appears to create no losers is that the losers are hidden in the business tax. It is designed to bring in three times as much revenue as today's corporate tax. It would do this by assessing higher, effective, corporate tax rates and by subjecting all businesses-even unincorporated, part-time businesses run out of a home office-to the same 17% corporate-tax rate.

Any judgment on the fairness of Armey's plan, then, turns on the question of which individuals end up paying the greatest share of corporate taxes. Owners and shareholders? Employees? Consumers? Economists are sharply divided on this question, and the public is scarcely aware of it.

On a Sunday evening in early March, Armey and Senator Bob Packwood, chairman of the tax-writing Finance Committee, journeyed just outside Washington to Bethesda, Maryland, seeking to learn how the flat tax might play among voters. There they viewed, through a one-way mirror, a focus group of 12 taxpayers of diverse political leanings, all with incomes below $100,000 a year, who were led by a moderator in a discussion of the current tax system and the flat-tax alternative. The group raised the usual objections to the current tax system. More surprisingly, they uniformly preferred the flat tax-even after the moderator told them it would cut taxes disproportionately for the wealthiest Americans. A woman who earns $30,000 a year explained that she hoped to be rich one day herself. The results of this session, bolstered by similar focus groups and polls, have given Republicans confidence that they can push the flat tax and withstand the Democrats' strongest rebuttal: it throws more money back to the rich.

Armey would eliminate the withholding of income tax by employers and force taxpayers to write a check to the Treasury each month: a measure that he hopes would remind taxpayers how much of their pay is taken by Washington. This gimmick, however, undercuts one of the biggest advantages of a flat tax: the simplicity and efficiency of withholding virtually the exact amount of tax owed each year. Such withholding would collect far more of the estimated $100 billion in taxes that are evaded each year-and with less intrusion by the IRS into the privacy of individual taxpayers. "It's easier to tax 50,000 businesses than 200 million individuals," says Rabushka. In Britain and Japan, which have similar "taxing at the source" systems, most taxpayers with one job need not file a regular tax return.

While flat-tax proponents are, for the most part, concerned with simplicity, another group of economists and lawmakers emphasize the need to encourage savings and investment. They would more radically transform the system by ending the income tax entirely and by shifting to taxes on consumption.

Lugar's national sales tax is one variety of consumption tax. But it stirs opposition on several fronts. It is regressive, falling most heavily on the poor, who spend the highest share of their income on consumption. Joel Slemrod, a University of Michigan economist, calculates that to raise as much revenue as the current income tax, Lugar's sales tax would need to be not 17% but 25%. And the world's considerable experience with sales taxes shows that tax rates above 10% encourage widespread cheating, with buyers seeking to pay under the table or in barter.

The value-added tax, or VAT, common in Europe and supported in principle in the House by Texas' Archer and Sam Gibbons of Florida, is far easier to enforce, as goods are taxed at each stage of production and distribution. But to replace the income tax with the VAT, or with any other consumption tax, would require a painful and costly transition. Senators Sam Nunn of Georgia, a Democrat, and Pete Domenici of New Mexico, a Republican, have proposed a plan for an "Unlimited Savings Allowance" that would permit taxpayers to deduct all savings and investments from the income they declare for tax purposes. In that manner, it would tax consumption. It would be at least as complex as the current system, but include generous expensing provisions that have won support from capital-intensive firms like Chrysler and Alcoa. But other companies, such as retailers, would suffer under this plan and will fight it.

Indeed, the history of tax reform is one of powerful interests rising up to dilute attempts at greater simplification, efficiency and fairness. But even if radical reform once again proves politically impossible, prospects for serious progress look hopeful. Already, a strong coalition is forming around a modified flat tax on income that would preserve such sacrosanct deductions as home-mortgage interest and charitable donations. That's what Gingrich and Kemp favor, and it's in line with proposals by Richard Gephardt, the House minority leader, and New Jersey Democrat Senator Bill Bradley.

The slope will be slippery under any such compromise version of a flat tax. There will be strong pressure to add just one more deduction, and exemption, and incentive. That should have been clear when Armey found himself unable to testify at the hearing on his flat-tax proposal because he had to rush to line up votes for the grab bag of special-tax preferences that passed the House last Wednesday. --With reporting by Wendy Cole/Chicago, Jeanne McDowell/Los Angeles, Jeffrey H. Birnbaum, John Dickerson and Suneel Ratan/Washington, Hilary Hylton/Austin.

With reporting by WENDY COLE/CHICAGO, JEANNE MCDOWLELL/LOS ANGELES, JEFFREY H. BIRNBAUM, JOHN DICKERSON AND SAMUEL RATAN/WASHINGTON, HILLARY HYLTON/AUSTIN SUNEEL RATAN