Tax Reform Handcuffs

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 4, 2009

The state of politicians’ discussion on taxes in this country is downright embarassing and increasingly dangerous. One side says “no new taxes.” The other side says “no new taxes on the bottom 95 percent.” The way these two positions relate to tax reform is best captured by the phrase “you can’t get there from here.”

Tax reform involves improving the efficiency, equity, simplicity, and revenue adequacy of the tax system. Any effort to establish adequate revenue is going to require an increase in revenues – most likely through the creation of a new tax like a VAT. Any effort to improve the efficiency, equity, and simplicity of the system is going to involve structural reforms that will help some taxpayers and hurt others. None of these are options are even on the table to be discussed if the debate is between “no new taxes” and “no new taxes for the bottom 95%.”

The sina qua non of meaningful tax reform is to clean out and rationalize the exclusions, exemptions, deductions, and credits in the tax system. A broader base treats various activities on a more equitable basis, makes the tax system simpler and more efficient, and allows for lower rates in order to achieve a given revenue target. Chief candidates here include limiting itemizing deductions or converting them to credits and scouring corporate tax expenditures, especially industry-related measures. The tax code treats saving and investment in a haphazard and complex manner, taxing some forms of capital income twice, some once, and some not at all. Restructuring this part of the code to provide more consistent treatment across all forms of capital income and different organizational structures would be beneficial. In addition, the only way we are going to come close to raising needed revenue is to impose a new tax – preferably a VAT – that can raise between 5 and 10% of GDP.

Taxes can also help address the nation’s long-term challenges related to energy production and consumption. Government must make it more expensive to use and emit carbon by either a direct tax on carbon emissions or a “cap and trade” system, with the government selling “permits to pollute.” The two approaches are economically equivalent and would produce wide-ranging benefits: the societal cost of producing and consuming carbon would be included in the price of goods like gasoline and electricity; energy security would rise; environmental damage would decline; and federal revenues would increase. A carbon tax or a “cap-and-trade” system would provide significant incentives for development of alternative energy sources and would render unnecessary the existing panoply of targeted energy subsidies. A carbon tax could replace existing, less efficient taxes, or serve as a new revenue source.

Taxes can also help address health care reform. The most significant tax issue is the deduction for employer-provided health insurance premiums. Allowing such a large part of employee compensation to be deductible drives up the cost of health care, 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. Reform should convert the deduction into a fixed, refundable credit for individual workers or eliminate the tax benefit completely. This policy will only work, though, if well-functioning non-employer group insurance markets are developed first. The policy would also make it more likely that consumers paid the costs of their health care on the margin, which would help reduce expenditures and encourage consumers to choose the most productive expenditures.

Every year the U.S. tax system becomes more complex. Making simplification is priority in tax reform is necessary because without such an action, the code will continue to become more complex. Likewise, an intelligent reform plan would equip the IRS with the resources to enforce and administer the tax system as well as strict safeguards to ensure that abuse does not occur. Chief candidates here include repealing the AMT, consolidating saving incentives, consolidating education incentives, consolidating family subsidies, taxing dividends and capital gains at ordinary income tax rates (provided the top rates come down).

In short, a better tax system could address a host of social and economic ills. It would certainly not be painless, but in economics the right question is always “compared to what.” And, compared to doing nothing, serious tax reform that raises revenues and restructures taxes to be more efficient, equitable, and simple would be an enormous improvement over the existing system.