Tax Notes

Bush Administration Tax Policy: Down Payment on Tax Reform?

Introduction

This is the sixth installment in a series that summarizes and evaluates tax policy in the Bush administration. This report examines the relationship between the proposed and enacted tax cuts and fundamental tax reform.

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.