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What Will It Take to Reform the Tax System?

Tax reform is back in the news. Building on the momentum created by last month’s $900 billion tax deal, and consistent with the themes of both the new Republican majority in the House of Representatives and long-standing Obama Administration policy, political leaders are beginning to discuss options to change the structure of the nation’s revenue system.

The Administration recently held meetings to discuss corporate tax changes. New Ways and Means Committee Chairman Dave Camp (R-MI) announced that he will hold the first in a set of hearings on 'fundamental' tax reform on Thursday. What do we make of these developments? Here are a few thoughts:

(1) What is tax reform?

Reforming the system involves two issues – the structure of taxes and level of revenue. Politicians often discuss “revenue-neutral tax reform.” Right now, however, we need to consider not only structural reforms, but also changes that help align revenue levels with spending levels. These revenue increases should be implemented as the economy recovers.

In terms of the structure of taxation, the there are two issues. First is reform of the taxes we have right now. Our current system, both the income and corporate tax, taxes a “narrow” base – that is, it allows a lot of deductions, special exemptions, credits, allowances, etc. These items are called tax expenditures because they essentially replicate spending programs, but are embedded in the tax code. Essentially, everything one would want to do in tax reform – make taxes simpler, fairer, more conductive to economic growth – involves broadening the current the tax base – that is, reducing the use of tax expenditures.

The mortgage interest deduction, for example, could be replicated by a spending program that gives more money to people who own their home, have higher income and have bigger mortgages. If that sounds like a poorly designed spending program – expensive, regressive, unlikely to affect home ownership rates – the same criticism applies to the provision when it is structured as a tax deduction. Examples like these help explain why both the President’s National Commission on Fiscal Responsibility and Reform and the Bi-Partisan Policy Center's Debt Reduction Task Force (Rivlin-Domenici) favored a sharp curtailing and restructuring of tax expenditures in the income tax.

A second part of restructuring would be moving the tax system toward taxation of nonrenewable and polluting energy use – either via higher gasoline taxes or a carbon tax – and moving the system toward taxing consumption spending via a value-added tax.

(2) How likely is broad-based tax reform?

Tax reform, as opposed to cutting or raising taxes, is a rare event. We have only had one major structural reform in the past 50 years and that was in 1986. There are always numerous obstacles to serious reform. It is always deemed “impossible.”

Yet, it’s worth noting sentiments expressed by former Senator Bill Bradley, the patron saint of the 1986 act, to the effect that tax reform was basically thought to be impossible even then, until about 15 minutes before the vote.

(3) Why is reform so hard?

Taxes are already built into the fabric of almost everything people and businesses do. Whether it is a business hiring a worker, making an investment or offering health insurance, or an individual giving a charitable contribution, buying a house, getting married or divorced, having a child and so on, taxes are affected and affect the choices made.

As a result, reform involves creating visible winners and losers. The winners happily collect their gains, the losers either oppose the reform or demand relief from the transition to a new system that is less generous to them. The politicians’ trick is to sugar-coat the losses in some way that make them palatable, which is quite difficult to do in a convincing manner. For example, in Social Security reform, the basic idea was to sugar-coat the reduction in future benefits with the creation of private accounts, a political strategy that did not work so well.

To gauge a sense of how difficult meaningful reform will be, think about two issues. First, the tax cut negotiated in December was not a reform, it simply cut taxes. There was no real compromise there. Neither party gave up something that directly affected their constituents, and instead just agreed to subsidize each others’ favorite groups. Yet even that decision was difficult.

Second is tax complexity. Everyone agrees the system is too complicated, yet every year it gets more complicated. Ask yourself, how much more would you be willing to pay in the sum of taxes and preparer fees to have a simpler system? For most people, I believe, the answer is close to zero. That’s why we end up with a complicated system that everyone dislikes.

(4) What would it take to get reform?

If the mantra in real estate is location, location, location, the equivalent for enacting tax reform is a little more clunky but just as accurate: White House leadership, White House leadership, White House leadership.

Likewise, it will also require a change in tune from a Republican party that seems to like every tax cut and oppose every closure of a tax provision.

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