U.S. Senate Committee on Finance

The Concept of Neutrality in Tax Policy

Chairman Baucus, Ranking Member Grassley and other members of the Committee, thank you for inviting me to testify at this hearing on tax policy. In my remarks I will focus on the concept of “tax neutrality.” The basic concept is simple: generally the tax system should strive to be neutral so that decisions are made on their economic merits and not for tax reasons. In some cases, neutrality is impossible and policymakers have to accept a certain level of distortion to behavior as inevitable. In other cases, neutrality may be undesirable if policymakers intend to promote specific goals like the provision of health insurance or contributions to charity. Examining ways that the tax system approximates or departs from neutrality can be a helpful lens for thinking about a range of tax policy and economic problems.

Tax neutrality is a widely accepted concept in principle. In practice, however, tradeoffs between different concepts of neutrality and different goals can be difficult to resolve. But in several cases this concept can provide a useful way to cut through some of the debates about tax policy and identify a more economically efficient way to organize the tax system.

In my testimony I first provide a general introduction to the concept of neutrality and then applications to five specific areas of tax policy. To preview my substantive conclusions in these areas:

1. The concept of neutrality is the underpinning of the canonical goal of tax reform: achieving a broader base with lower rates.

2. To the degree that policymakers depart from neutrality to achieve specific goals like encouraging homeownership or childcare, it is generally better to implement these measures through refundable tax credits rather than deductions.

3. The tax treatment of healthcare is the most economically important way that the tax code departs from neutrality. Reforms to this tax treatment can make it more neutral with regard to some decisions (like how much insurance to purchase) while providing more incentive to purchase basic insurance.

4. The tax code also departs from neutrality to discourage specific activities, like smoking and alcohol consumption. In these cases, the tax should be set to capture the cost of the activity that individuals do not take into account. This is also the principle underlying carbon taxes and cap-and-trade systems to address climate change.

5. Although the proper level of capital taxation is highly controversial, there is little or no justification for the widely varying rates on different forms of capital income. Establishing more uniform rates would improve the allocation of investment and finance, reduce wasteful tax avoidance expenditures, and ultimately enhance the productivity and stability of the economy.