The Need for Fundamental Tax Reform

In our “Countdown to tax day” we have so far covered the pros and cons of a VAT, the limitations of only taxing income over $250,000, extending expiring tax cuts only temporarily, implementing new types of taxes, the true costs of tax expenditures, and the current state of revenues. For our grand tax day finale, we turn to the need for fundamental tax reform.

The tax code is complex, inefficient and it fails to raise enough revenue to cover spending. Starting with complexity, not even the smartest tax expert could explain in full all the twists and turns in the personal income tax code. The corporate side is perhaps even worse. An article in today’s Wall Street Journal claims that American businesses may spend as much as 89 cents preparing their taxes for every dollar actually paid in taxes. It isn’t a far jump then to the fact that the U.S. ranks – according to a World Bank survey – 61st out of 183 countries when it comes to the ease of paying business taxes.

All these tax breaks are more reflective of political handouts than economic reasoning. Since fundamental tax reform was last adopted in 1986, the tax code has become an increasingly cluttered maze of special exceptions, exemptions and rules. Plus, creating certain tax incentives leads to distortions in the economy that have served to marginalize both the efficiency and fairness of our system. Take housing, education, or healthcare – all have severely inflated costs because of all the related tax breaks.

And it fails on the final test: raising enough revenues to pay for government spending.

While revenues will likely have to go up, it matters how. Donald Marron points out in a recent post that higher tax rates can create economic distortions as well as set the path for prevalent tax evasion.

Fundamental tax reform would ideally not just tinker with the existing tax code, but overhaul the way we look at taxing the public. Some of the most promising ideas include base broadening (tax expenditures lead to a loss of approximately one trillion a year), a consumption tax, and energy taxes – reflecting the principle that we should tax bads not goods.

How narrow is our tax base? The Tax Foundation estimated in 2005 that we currently tax less than half of potentially taxable income. This leads to higher-than-necessary tax rates. Additionally, the 2005 President’s Advisory Panel on Tax Reform estimated the tax base in 2001 to be $4.8 trillion in an economy of around $12 trillion. The Tax Panel had a number of promising recommendations including simplifying the tax code, removing targeted tax breaks that have cluttered the system, instituting lower rates, and paring down taxes that target savings and investments.

There are a few interesting tax proposals out there, the pieces of which should be on the table for discussion on how to fundamentally reform the tax code. Paul Ryan’s “Roadmap for America’s Future” is one we have written about a number of times, including here, here, and here. Ryan’s plan would limit federal revenues to no greater than 19 percent of GDP (a bit above the historical average), while slowing spending growth. In terms of the tax code, his plan includes a full repeal of AMT, eliminates double taxation of savings, and simplifies income tax rates. It would broaden the tax base by eliminating most existing tax deductions, exclusions, and other special provisions.

The Wyden-Gregg proposal, “The Bipartisan Tax Fairness and Simplification Act of 2010,” would attack complexity by reducing the number of tax brackets from six to three; eliminating the AMT; increasing the standard tax deduction for middle- and low-income tax payers; eliminating many tax expenditures while keeping ones such as the Child Tax Credit, the Earned Income Tax Credit, and the Dependent Care Credit; reducing the corporate tax rate by consolidating the six corporate rates and eight brackets into one flat corporate tax rate of 24 percent; and increasing tax compliance. According to CRS revenue estimates for this proposal, although the tax reform (if enacted) would actually be a deficit-neutral piece of legislation and not bring down future debt levels, it would still create a more efficient tax code and slash tax expenditures for special interests.

Taxes are almost certainly going to have to go up (just try stabilizing the debt at reasonable levels through only spending cuts!). Therefore, having a more rational tax code is important for minimizing the damage to the economy. It would be best to start thinking in terms of a clean slate.

Fundamental reform is in the hands of the Administration now. As Economist Mom (a.k.a. Diane Lim Rogers) says in her letter to the president:

“[Y]ou’re in charge now! You aren’t stuck with the (not very smart) Bush tax cuts–not any part of them! You are the one who will have to sign an entirely new piece of legislation in order to keep any part of the Bush tax cuts after this year. You hold the reins. You don’t have to stay on the Bush path. You don’t even have to stay on the Bush tax policy horse. You can switch horses altogether and go down a better path on your better horse. You have the human capital to take these reins and do much better…. I know you made an unfortunate campaign promise on tax policy that you feel bound to–to not raise taxes on any households with income under $250,000. But isn’t it more important to keep your greater (at least implicit) promise to the American people on keeping our economy strong, putting us on a better path (”changing” course), and leaving the nation in decent shape for our kids? You can’t keep both promises, and to me as an economist and as a mom–and I hope to you as our leader and a dad–it’s obvious which one you should abandon.”