A Preliminary Evaluation of the Tax Reform Panel’s Report

Introduction

The President’s Advisory Panel on Federal Tax Reform issued its final report on November 1, 2005. Established on January 7, 2005, by an executive order from President Bush, the panel was given the following charge:

to submit . . . a report with revenue neutral policy options for reforming the Federal Internal Revenue Code. These options should: (a) simplify Federal tax laws to reduce the costs and administrative burdens of compliance with such laws; (b) share the burdens and benefits of the Federal tax structure in an appropriately progressive manner while recognizing the importance of homeownership and charity in American society; and (c) promote long-run economic growth and job creation, and better encourage work effort, saving, and investment, so as to strengthen the competitiveness of the United States in the global marketplace.

In its 272-page report, prepared with the technical assistance of Treasury Department staff, the nine-member panel unanimously endorses two options for reforming the tax system: a simplified income tax (SIT) and a hybrid consumption and income tax called the “growth and investment tax” (GIT). The plans have many features in common. In a nutshell, the plans would repeal the alternative minimum tax, cut back on existing deductions, credits, exclusions, and exemptions, and reduce the tax rate on capital income. The GIT would reduce the tax burden on capital income by more than the SIT.

This report summarizes and offers a preliminary evaluation of the panel’s proposals, and discusses the overall effect on revenue, distribution, and growth, with the following principal conclusions:

 The report contains a number of interesting and important proposals that would generally move the structure of the tax system in the right direction, with simpler rules, a broader base, generally lower effective marginal tax rates, and more consistent treatment of different types of income. Perhaps the most notable and welcome contribution of the report is the continual emphasis on simplification.
 In some cases, however, the proposals contain design flaws, and for several of the broadest proposals (especially relating to business and international issues), the report omits important details.
 The biggest problem with the report, however, is its assumed baseline. Tax proposals are typically compared to a baseline, which usually is current law over the next 10 years. The panel’s 10-year baseline, however, includes very large, regressive tax cuts relative to current law. The baseline assumes not only that the recent (2001-2004) tax cuts, which are currently scheduled to expire in 2010 or earlier, are made permanent, but that the proposals in the president’s most recent budget are enacted, including the creation of new, large, tax-free saving accounts. The choice of that baseline makes the revenue, distribution, and growth implications of the proposal appear much more favorable than they would be relative to a current-law baseline.
 Despite the complete absence of revenue tables in the report, it is apparent that the panel’s proposals not only dramatically cut tax revenues compared with current law, but also significantly reduce longterm revenue, even relative to the low-revenue baseline employed. The panel’s proposals would also exacerbate the long-term financing problems faced by Social Security and Medicare by undermining a significant source of revenue for the trust funds. To make the panel’s proposals revenue-neutral in 2015 relative to current law would require at least a 16 percent increase in marginal tax rates over those proposed by the panel, or substantially more base broadening.
 The panel’s claim that the proposals would be distributionally neutral is also less meaningful than it might appear because the proposals are compared to a baseline that assumes the existence of a variety of large, regressive tax cuts that do not exist. Moreover, the distributional measures employed in the report can be very misleading.
 The report claims the proposals would raise economic growth, but the reported effects are quite large relative to other estimates in the literature and, even if the estimates are accurate, they compare the proposals with the baseline, not with current law. Indeed, considering their effect on long-term deficits and hence on national saving, the proposals are as likely to reduce economic growth as to increase it, relative to current law.

Section II offers preliminary remarks about tax reform. Sections III and IV describe and offer perspectives on the specific elements of the ”SIT” and the ”GIT,” respectively. Sections V through VIII examine the implications of the proposals for revenue, distribution, growth, and simplification. Section IX concludes by discussing some items that were omitted from the report.