Thursday, April 14, 2011

Is Tax Reform Really on the Table, or Not?

Last October I wrote a lengthy post explaining why tax reform is the best path to growth-friendly deficit reduction. At that time, six short months ago, hardly anyone in Washington was talking about tax reform. Now both the Republicans, in the Ryan plan, and President Obama, in this week's deficit-reduction speech, are trumpeting tax reform as the centerpiece of their respective proposals. Does that mean tax reform is finally on the table? Should we expect a dramatic, bipartisan breakthrough soon? I'm afraid not.

Economists are in rare agreement about the basic principles of tax reform. The objective of reform should be, first, to lower marginal tax rates, that is, the rates paid on each additional dollar of income or profit, as much as possible. Low marginal tax rates minimize distortions and maximize incentives for growth and job creation. Second, for any given amount of revenue to be raised, the way to get tax rates low is to make the tax base as broad as possible, that is, to eliminate loopholes that allow some income or profit to go untaxed while  the rest bears a disproportionate share of the burden. Unfortunately, agreement on the principles of tax reform is easier to achieve than agreement on the politics of it.

The first barrier to achieving political agreement lies in a difference between Republic and Democratic notions of the purpose of tax reform. Republicans are interested in tax reform only if it is "revenue neutral." Any base-broadening must be fully offset by rate reduction. Democrats, on the other hand, view tax reform as a way to help close the budget gap. They would only partially offset the effects of closing loopholes with reductions in tax rates.

I think Republicans are making a strategic mistake. By insisting on revenue neutrality, they are, in effect, divorcing the discussion of tax reform from the issue of deficit reduction. In doing so, they are missing a historic opportunity to reform the catastrophically complex, perverse, and inefficient US tax system they constantly complain about.

Instead, Republicans should seize on the big bargain chip presented by the Democrats' recent, grudging, admission of the need for deficit reduction. They should be saying to Democrats, "OK, we will meet you part way. We will go along with closing the budget gap partly with increased revenue, provided every penny of that added revenue comes from genuine, growth-friendly, loophole-closing, marginal-rate-reducing tax reform." Several Republican members of the Bowles-Simpson deficit-reduction commission endorsed such a deal, but not those currently serving on Capitol Hill.

By refusing to make this offer, the Republicans in Congress are going to come away empty handed. They are going to get neither deficit reduction nor tax reform. Is the mantle of ideological purity more important to them than making real improvements to public policy? If so, it's just plain sad.

So much for the differences between the Republican and Democratic approaches to tax reform. The second reason tax reform isn't yet truly on the table lies in a fundamental similarity between between them: Both parties endorse tax reform in the abstract, but neither is ready to designate which specific loopholes they want closed.

What should they be looking at? Here is a dirty-dozen list of tax expenditures from the Urban Institute and Brookings Tax Policy Center (figures in parentheses show the 2008 value in  billions of dollars):
  1. Employer-paid health care (131)
  2. Pension contributions and earnings (117)
  3. Mortgage interest deduction (89)
  4. Accelerated depreciation (56)
  5. State and local tax deduction, other than property taxes (49)
  6. Charitable contributions (47)
  7. Deferral of income from foreign corporations (31)
  8. Exclusion of capital gains on sale of homes (30)
  9. Property tax deduction on homes (29)
  10. Child credit (28)
  11. Capital gains rate (24)
  12. Capital gains basis step-up at death (22)
 Notice that elimination of any one of the top six, or any two of the second six, would exceed the "historic" $38 billion deficit reduction passed by Congress this week. Some of the twelve are beloved of Republicans, some beloved of Democrats, and none (yet) hated enough by both to be placed on the chopping block.

The bottom line: Tax reform, the idea, may be in the air, but tax reform, the thing itself, is not yet on the table. It will remain off the table until Republicans wake up to the fact that compromise means giving up part of one thing you want (revenue neutrality) in order to get other things you want (tax reform and deficit reduction). How will we know when things have changed? When either party starts listing which of the dirty dozen tax expenditures it would like to eliminate. Until then, it's just hot air.

Follow these links to view or download slideshows from earlier posts on tax reform: Pro-growth fiscal consolidation; the case against the mortgage interest deduction.

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