In think-tank circles and academic conferences, former
top administration officials and other tax cut supporters
sometimes defend the tax cuts as a piecemeal approach to
fundamental tax reform and a way to move the nation
toward a consumption tax. Those defenses are clever,
since reform seems a more noble goal than merely
slashing taxes. But the defense is flawed in several
important ways:
Consistent with fundamental reform, the recent tax
cuts and Bush administration proposals have reduced
marginal tax rates on capital income and
flattened the rate structure. But the similarities end
there.
Studies show that a well-designed consumption tax
can modestly raise national saving and economic
growth. To obtain that result, though, the consumption
needs to (a) be revenue-neutral; (b) broaden the
base; (c) tax existing capital — that is, not provide
transition relief; and (d) treat interest income and
expense in a consistent manner. But the recent tax
cuts (a) lose substantial amounts of revenue; (b) do
not broaden the base; (c) reduce taxes on existing
capital; and (d) increase the difference in the tax
treatment of interest income and expense.
Some tax cut supporters downplay those concerns,
arguing that the criticisms represent the perfect
being the enemy of the good. But the underlying point is that the system that emerges from the Bush
tax cuts has many of the worst features of both the
previously existing tax system and a fundamentally
reformed system. The tax cuts will generate none of
the potential growth effects of fundamental reform,
and in fact will reduce long-term economic growth
(Gale and Orszag 2004d). There will be no efficiency
gains from broadening the base, because no basebroadening
has occurred. There will be efficiency
losses from increasing taxpayers' ability to shelter
income, because of the enlarged difference between
the taxation of capital income and capital expense.
One feature that the current tax system now shares
with fundamental reform, compared to the tax system
before 2001, is increased regressivity (Gale and
Orszag 2004b).
Recent tax cuts and current proposals do not move
the system toward a well-designed consumption tax
or a well-designed wage tax. Instead, tax policy and
proposals in the Bush administration move the tax
system toward a wage tax that is imposed only on
low- and middle-income households, because
upper-income households would be able to take
disproportionate advantage of the fact that capital
income would be increasingly exempt from taxation,
but interest payments would still be taxdeductible.
By cutting revenue and rates without implementing
any of the necessarily painful steps that real reform
would necessarily entail, the tax cuts have probably
also diminished the political possibilities of enacting
a well-designed tax reform.
Section II discusses the key features of fundamental
tax reform plans. Section III compares the rules and
effects of recent tax cuts to the rules and effects of
fundamental tax reform. Section IV discusses the ''five
easy pieces'' approach to tax cuts. Section V discusses
prospects for fundamental tax reform in light of the
recent tax cuts. Section VI is a short conclusion.
View the full article — (PDF - 244KB)