Tax Reform? Between a Rock and a Hard Place

During the political knife-fight known as the ‘fiscal cliff debate,’ there was one topic on which virtually everyone seemed to agree — that the income tax is a mess and needs reform. The idea on tax reform was straightforward. Broaden the tax base by curbing what are variously called tax expenditures, loopholes, special breaks, or simply deductions, credits, and allowances. Then, use the resulting revenues in part to lower rates and in part to lower deficits. The template for such reform was the Tax Reform Act of 1986 when Congress broadened the tax base and cut rates. We did it then, and we could do it again.

Now that most of the Bush tax cuts have been made as permanent as anything in the tax code can be, interest in tax reform has abated somewhat. But, the income tax remains a mess and still needs reform. So, it would be worth understanding why reform succeeded in 1986 — if only barely — and what it will take for it to succeed in the future. Unfortunately, the job will be even harder this time.

The key to success in 1986 was that Congress cut personal income tax collections. Although overall tax collections were to remain unchanged, tax burdens were supposed to be moved from individuals to corporations. The shift was large, equivalent to moving about $1 trillion in taxes in today’s economy from individuals to corporations over ten years.

Cutting taxes always makes reform easier. Tax reform is income redistribution. Tax breaks are of value to some people, rate cuts to others. Some gain, some lose. Of course, reform advocates always promise that everyone will gain because economic growth will increase and tax simplification will spare everyone needless hassle and compliance expense. But people know that some of these promises are not true and that even when they are true, the benefits take time to materialize. But who pays more and who pays less when tax breaks are ended is instantly clear once the legislative specifics are known.

Cutting personal income taxes greatly increased the appeal of reform. It reduced the number of people were net losers and the amounts they would lose, and it raised the number who were net gainers and the amounts they would gain. Nonetheless the Tax Reform Act of 1986 almost died several times and the outcome was in doubt until the very end. Many regarded its ultimate enactment as something of a political miracle.

Today, the job is even harder. Shifting taxes from individuals to corporations is now out of the question. The increased international mobility of capital and the proliferation of multinational corporations means that any attempt to raise business taxes will be largely frustrated by companies that can readily transfer profits to low-tax jurisdictions. Even worse, the need to narrow projected budget deficits means that taxes have to be increased.

To be sure, there are other ways to raise revenues. A new tax could be levied on energy or on value-added — a sort of national sales tax — and some of the resulting revenue could be used to cut the deficit and some to lower personal income taxes. But opposition to a new tax on energy or on value-added is currently fierce and unbending. New taxes of this sort are politically fanciful in the current environment.

Or the nation could avoid the need to raise taxes by walking away from its commitment to provide basic income and health care support to America’s elderly, disabled, and poor. But a majority of members of both parties opposes cutting Social Security or Medicare.

All this means that successful tax reform today will be tied to raising personal income tax revenue, not, as in 1986, to cutting it. Until such time as the nation is prepared to entertain a new tax on energy or value-added, tax reform means that most filers will see themselves as losers. Even if the partisan divide were not as wide and deep as it is today, there would be little chance that serious reform of the personal income tax could get through Congress without some way of lowering total personal income taxes to lessen the opposition from those who would lose the special tax breaks. With partisanship at current pathological levels, the chances are nil. A rock and a hard place, indeed!