Individual Taxpayers and Federal Tax Reform

William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

May 13, 2008

Chairman Baucus, Ranking Member Grassley, and other members of the Committee:

Thank you for inviting me to testify at this hearing on individual taxpayers and tax reform. The tax system needs to be simpler, more equitable, more conducive to prosperity, and sustainable. My remarks focus on some overarching principles that should guide reform efforts.

  • There is no clean line between individual taxes and business taxes. In particular, individuals – not businesses – bear the burden of taxes imposed on businesses.
  • The key item in any tax reform is to broaden the tax base. The goal should be to tax all income once, tax it only once, at the full, income tax rate. Broadening the base

    –taxes different types of activities at the same rate, and thus “levels the playing field,” and reduces the extent to which taxes distort economic behavior;

    –allows for lower rates in order to raise a given level of revenue, or allows an increase in the revenue level, if needed; lower overall rates, in turn, further reduce the extent to which taxes distort economic behavior; and

    –makes taxes simpler.

  • After base broadening, special attention should be given to the form of any surviving tax preferences. Deductions are regressive and are only justified if there is a true reduction in ability to pay, a condition that is rarely met among existing tax preferences. Converting the deductions to flat, refundable credits would in most cases be preferable on revenue, distributional, incentive, and efficiency grounds.
  • It is time to eliminate the AMT, but only if the revenue is replaced and the loopholes that would be created are closed.
  • A revenue system that is not adequate to finance government spending will be unstable and unsustainable.
  • The importance of simplifying the system can not be overstated. Taxpayers are overwhelmed by complexity, real and imagined, in the tax code. Oddly, although the need to simplify the tax system is the one goal everyone accepts in tax discussions, every year the system becomes more complex. If simplification is not the primary goal of reform, tax changes will likely make the tax system more complicated.

The remainder of my testimony elaborates on these comments.


In the next few years, several factors will push tax issues to the forefront of policy discussions. First, under current law, almost all of the Bush Administration’s tax cuts will expire at the end of 2010. The loss in revenues from making the tax cuts permanent would be enormous—equal to several times the resources needed to repair Social Security—and economic growth is unlikely to come anywhere close to covering that loss. As a result, the required spending reductions would be enormous, too. For example, if certain key programs—Social Security, Medicare, Medicaid, defense, homeland security, and net interest—were off-limits (since the first three need to be cut even in the absence of tax changes, and defense and homeland security are currently stressed), all other federal spending would have to be cut by about half.

A second factor is the rapid growth in the alternative minimum tax (AMT), which will increase the inequity and complexity of the tax system. Tax filers pay the AMT when their AMT liability exceeds their regular income tax liability. Designed in the late 1960s and strengthened in 1986, the AMT operates parallel to the regular tax system and was originally intended to capture tax on excessive sheltering activity. The tax has evolved, however, so that it does not tax many shelters and it does tax a variety of items—like having children, being married, or paying state taxes—that most people do not consider shelters. Moreover, the number of taxpayers facing the AMT is slated to grow exponentially, from about 3 million today to 30 million by 2010, because, the AMT is not indexed for inflation and because some temporary AMT tax cuts are about to expire.

A third issue – which may not require immediate action, but should nevertheless help frame the current debate – is the expected increase in government spending over the next several decades. Since 1950, tax revenues have hovered between 16 and 20 percent of GDP. Under current projections, however, government spending is projected to rise to about 27 percent of GDP by 2030. This increase is fueled mainly by increased entitlement spending for Social Security and especially Medicare and Medicaid. Unless elected officials are willing to suggest truly massive cuts in such programs, they will have to come to terms with the need for an increase in revenues to above 20 percent of GDP.

Despite these pressures on the system, tax changes are not inevitable, and achieving meaningful reform—that is, with substantial design improvements—will require strong political leadership.