2011 in Review: Lots of Debate on Individual Tax Reform

Tax policy was front and center in 2011 — during the debates on the debt ceiling, in the negotiations of the Supercommittee, and by the GOP candidates for president. Although these discussions failed to produce significant tax changes, they could occur by the end of 2012 when the Bush tax cuts expire.

Payroll Tax
The most pressing issue is the extension of the payroll tax cut, which will expire on January 1, 2012. In 2011, the employee’s share of the Social Security part of the payroll tax was reduced by two percentage points, from 6.2% to 4.2%. I believe that Congress will extend this cut for at least another year because nobody wants to be seen as raising taxes on workers in a soft economy. Currently, the two parties differ mainly on how to pay for the extension: Democrats want to charge a 1.9% surcharge on income above $1,000,000 for ten years, while Republicans want to freeze the pay of federal workers for two years.

Income Tax
2011 saw many Presidential candidates proposing serious tax reform. Unfortunately, many of these proposals are simply unworkable. Of the major candidates, only Mitt Romney and President Obama have made credible proposals.

Former candidate Herman Cain offered the boldest changes to the tax code. His 9-9-9 plan would charge a 9% tax on individual income, retail sales, and “business income.” However, Mr. Cain did not make clear that his tax on “business income” was really structured as a value-added tax. This meant that his plan would impose an effective 18% consumption tax (9% from the retail sales tax and 9% from “business income”) on all Americans, creating an extremely regressive tax system.

A small step up from 9-9-9 are the optional “flat” taxes proposed by Rick Perry and new frontrunner Newt Gingrich. Under both frameworks, individuals could choose whether to pay taxes that they owe under the current system, or those that they would owe under a “flat” tax. Thus, these plans would increase the complexity of the Internal Revenue Code by requiring two computations for most taxpayers.

Rick Perry’s “flat” tax would charge 20% of income, after a $12,500 exemption; it would retain major deductions, except for the deduction for health insurance. Gingrich’s plan would have a 15% rate after a $12,000 exemption; it would retain all major deductions except for state income tax. It would also keep major tax credits such as the child tax credit. The Tax Policy Center estimates that Rick Perry’s plan at 20% would reduce revenue by $500 billion per year on a static basis. At 15%, Gingrich’s plan would cost at least $800 billion per year. Although both candidates are asserting their plans would make up the difference by increasing economic growth, it would be very hard for higher growth to make up $500 billion per year in lost taxes.

Mitt Romney has proposed more modest changes to the tax code. In the short-run, he would exempt capital gains and investment income from taxation for those who earn less than $200,000. In the long-run, Romney supports reducing tax rates, while broadening the tax base by reducing tax expenditures.

On the other side of the aisle, President Obama generally advocates for an increase in the progressivity of the tax code. First, he would repeal the Bush tax cuts for the wealthy (those who earn above $250,000), saving $800 billion over ten years. Furthermore, he proposes to cap the value of certain deductions at 28%-also affecting those who earn over $250,000-saving an additional $400 billion over ten years.

Sensible Principles
Most mainstream policy experts agree that an “optimal” tax reform package should lower or maintain rates while raising revenue by reducing tax expenditures. Congress could do this by limiting specific deductions-say, by eliminating the mortgage interest deduction for second homes. Alternatively, Congress could cap an individual’s total tax deductions at a percentage of income, as suggested by Harvard Professor Marty Feldstein. Feldstein’s proposal is more feasible politically since it would dilute the lobbying for specific tax expenditures.

To move toward optimal tax reform, both parties must shed some deeply held convictions. President Obama might have to forego his desired rate increases on the wealthy. Similarly, Republicans need to be less resistant to any sort of revenue increases. In short, both parties must show much more flexibility if they want to pass serious tax reform in 2012.