Memo to Obama: Fixing the Tax System

William G. Gale and
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

Ben Harris

December 8, 2008

Innovative and sound tax policy may be one way out of our financial rut. An effective tax code can buoy an economic recovery; down the road, taxation can help achieve the administration’s goals in health care, in energy policy and, ultimately, for fiscal balance.

You promised broad-based tax relief to middle-class families, tax breaks for small businesses and companies that create jobs in America, the restoration of fairness to our tax code and a return to fiscal responsibility.

Now that we’re in crisis mode, taxes could play a role in the economic jump-start you intend to launch immediately upon taking office. However, key spending initiatives like investments in U.S. infrastructure, aid to hard-pressed states and help for struggling homeowners provide more bang-for-the-buck than tax rebates.

But don’t ignore the growing morass of the U.S. tax code. Our tax system needs repair of both chronic and urgent problems. Almost all of the tax cuts enacted since 2001 are slated to expire at the end of 2010. The alternative minimum tax (AMT) threatens to grow out of control. The nation faces a fiscal gap so large it will require both tax increases and spending reductions.

Health care reform is a must-tackle. As you stated often on the campaign trail, too many American workers are uninsured for medical catastrophe. Complex tax issues are at play here, most significantly the employer deduction for employee health insurance premiums.

Allowing such a large part of employee compensation to be deductible leads to gold-plated health insurance policies, gives a larger benefit to high-income taxpayers, and leads to billions of lost tax revenue every year, while disadvantaging families without employer-based coverage.

Consider converting the health care deduction into a fixed, refundable credit for individual workers — providing a boost for workers without health insurance. Supported by Sen. John McCain, such a proposal would give you a bipartisan platform to launch a discussion.

The nation’s long-term challenges related to energy production and consumption also require bold tax solutions. Government simply must make it more expensive to use and emit carbon by either a direct tax on carbon emissions or a “cap and trade” system. Both would provide significant incentives for development of alternative energy sources and would render unnecessary the existing panoply of targeted energy subsidies.

Once the economy is back on track, create a fairer tax system by restructuring tax expenditures and broadening the tax base. Then, use the increased revenues to lower tax rates and eliminate the AMT.  The U.S. tax system is anything but simple. Return from savings is taxed at greatly different rates depending on the type of investment. Taxpayers use these conflicting rules to their advantage, leading some analysts to conclude that the country collects little if any net revenue from capital income taxes. The solution is to tax all capital income once and only once at the full income tax rate.

Give taxpayers some relief at filing time. The IRS should implement a “return-free” system to give people the option of receiving pre-completed tax forms that require only their verification. Return-free filing could be achieved for as many as 50 million taxpayers with relatively minor changes to the tax code.

The tax code needs to be restructured to encourage more Americans to save and to equalize the tax benefits of saving for low- and middle-income taxpayers. Consider ways to require firms to enroll new workers automatically (with opt-out provisions) in a traditional defined-benefit retirement plan, a 401(k), or an IRA.

Support legislation that replaces current tax deductions for retirement saving with a new program that offers universal, 30 percent matching contributions from the government for household deposits to retirement saving accounts. This policy would boost saving incentives for low-income families but cost the Treasury no more.

Equip the IRS with the resources to enforce and administer the tax rules. Many taxpayers simply do not pay what they owe. Fortify the tax system. Doing so will help dig us out from under our nation’s financial and economic rut.