The Tax Code Is a Hopeless, Complex, Economy-Suffocating Mess

Throughout our population, experts and non-experts alike, the verdict is nearly unanimous. The U.S. tax code is a hopelessly complex mess, antithetical to growth, and is crammed with conflicting incentives, which screams for reform. But there is little agreement on how to repair it. My preferences are necessary, just, and ordained in heaven. Your preferences are unnecessary, unjust and counter-productive.

Tax reform is the most difficult and complicated piece in the U.S. budget battle. It is integral to both the Republican House and the Democratic Senate budgets. As in every budget item, there is a conservative vs. liberal confrontation, but tax reform is loaded with more confusing detail, and it adds extra layers of difficulty to the budget debate.

Some liberal and conservative inclinations tend to intersect when the conversation focuses on elimination of tax preferences. But, both sides have their favorite exceptions. Democrats love tax expenditures for the less affluent. Republicans love the preferences they suspect will stimulate growth.

Additionally, there are wide divergences about how the deficit savings from eliminated tax preferences should be used. Republicans like deficit-neutral solutions which invest all savings in lowering rates for growth. Democrats would like to spend those savings, either for compassionate spending or for Keynesian growth stimulus.

More real difficulties arise when tax preferences, individual and corporate, are considered one at a time. This is where powerful lobbying interests intervene. These are the interests that finance campaigns and parties. Regional factors arise, too. The normal political “rules” are often overridden. In some committee votes, it is hard to distinguish Democrats from Republicans.

Three of the four largest individual preferences are interesting examples. The first is the homeowners’ preference, which allows deductions for mortgage interest and real estate taxes. Homeowners’ enthusiasm for those benefits is exceeded, exponentially, by the real estate lobby, including real estate and mortgage firms, sun-belt governors, etc. The lobby, with bi-partisan support, easily defended its prize in the 1986 Tax Reform Act, and again, more easily, in President Bush’s Commission on Tax Reform in 2005.

The other two large preferences are charitable deductions and medical insurance (untaxed income for employees, and a deduction for corporations). Taking on the Little Sisters of the Poor, the big universities, or the United Fund is a fool’s errand. And standing up to powerful unions and corporations is not much easier.

Because these three big preferences, and others, are so well defended, many observers have suggested that placing a limitation on total individual preferences, a la Martin Feldstein, is a better approach. That strategy offers some hope, but it’s no piece of cake, either.

Reforming individual preferences is tough, but corporate preferences are, in some ways, even more perplexing. The last tax reform was achieved, at least partly, by shifting individual tax burdens on to corporations. That was okay in 1986. Today the common wisdom in both parties, and among knowledgeable observers, is that the U.S. corporate income tax rate must be reduced for reasons of international competition.

The task would be easier if individual and corporate income tax reform could be considered separately. Here again, there is a problem. Much of American business is transacted by small companies taxed as individuals. Separating these companies from their corporate competitors may not be practical.

Business operations are scattered over the U.S. supply chains extend everywhere. The tentacles of strong lobbying organizations also extend everywhere. Our system of territorial representation in Congress makes nearly every member a special defender of certain companies, industries, or unions. This factor tends to upset tax reform strategies. Sub-contracts loom large. Majorities appear, and disappear, unexpectedly.

Some budget observers believe that tax reform could be the key to long term fiscal compromise. Instead, some of these extra dimensions could make it the enemy. The devil is always in the details. Tax reform teems with details. Its politics are sometimes treacherous, even for seasoned politicians.

On the positive side, the tax committees of both houses are primed and ready to move forward. Chairman Camp and Baucus, while not exactly political soul-mates, have some similar ideas, a good business relationship, and regular communications. Both parties seem to want to try it.

Speaker Boehner has assigned tax reform the precious number of H.R. 1. If President Obama can extend his Congressional charm offensive, tax reform will never be the odds-makers’ favorite, but it is not out of the question for 2013.