Looking over the polarised 112th Congress that took office last week, it’s easy to despair of its ever making any progress on closing the yawning deficit. But don’t give up yet. There may still be a road to fiscal sanity, and it runs through tax reform.
Why tax reform? Because everyone, it seems, likes the idea — at least in principle. President Obama, who commissioned a limited tax reform commission headed by former Fed chairman Paul Volcker, last week told NPR that he wanted reform. From their opposite ends of the Senate, both Harry Reid and Mitch McConnell agree that the current tax code is, in McConnell’s words, “a disaster.” The Erskine-Bowles and Domenici-Rivlin deficit-busting proposals each called for radical tax reform, with signoff from both Republican and Democratic contributors. Isabell Sawhill, senior fellow at the Brookings Institution, told a Brookings panel on fiscal responsibility that the inclusion of tax reform “helped break open the stalemate here in Washington in a really significant way.”
The beauty of tax reform is that it starts with a belief everyone shares: The current system is horrible. Monstrously complex, unfair and inefficient, the code has fewer friends in Washington than Mahmoud Ahmadinejad, and in principle, throwing it over for something simpler is a sure bipartisan crowd pleaser.
Of course, simplification won’t lower the deficit — but it can provide political cover. In the name of tax reform, Congress could commit acts of fiscal responsibility, especially raising revenues, that their constituents otherwise might not stand for. Bruce Reed, executive director of the President’s Commission on Fiscal Responsibility (a/k/a Erskine-Bowles), told the Brookings panel, “This is all about tax reform. We’ll never be able to raise revenues in the absence of fixing the system we have.”
Here’s how it might be done:
Start by lowering tax brackets. This is not new: The linchpin of almost every reform proposal is the blend of lower tax brackets and fewer loopholes. Economists point out that lowering rates weakens the incentive to evade taxes and enhances economic growth; closing loopholes and broadening the tax base allows the government to collect the same (or more) revenues with lower rates. Erskine-Bowles, for example, would cut the top corporate tax bracket from 35 per cent to 28 per cent and the top personal bracket to as low as 23 per cent. Domenici-Rivlin would cut both down to 27 per cent. That may sound enough like a tax cut to make it safe for Republicans to support.
Put all tax expenditures on the table. The code is riddled with over $1.1 trillion in loopholes, ranging from middle-class favourites like the mortgage interest deduction to oddities like the railroad track maintenance credit, a break for taxpayers who just happen to own a railroad. Wonks refer to them as “tax expenditures,” since they amount to government subsidies delivered through the tax code. They account for more than their share of the code’s complexity, and their proliferation in recent years “horrified” Democrats and Republicans alike on the president’s commission, Reed said. “On personal taxes, the government only brings in $1 trillion a year,” he explained, “so there is more money leaking out in loopholes than there is coming in as taxes.”
Broadening the tax base means eliminating or phasing out most of these tax breaks. Interest groups can be expected to support the concept in general, but to passionately demand an exception for their own subsidy. Nina Olsen, director of the IRS’s Taxpayer Advocate Service, told Congress last week that a convincing call to shared sacrifice might persuade ordinary taxpayers to support tax reform anyway. “We cannot pretend that broadening the tax base means eliminating someone else’s tax break while preserving our own. [But] our experience in handling some 300,000 taxpayer cases a year [tells us that] lowering rates in exchange for broadening the tax base [will seem to taxpayers] like an excellent bargain.”
emphasise economic growth. By some estimates, tax simplification could add one percentage point to annual GDP growth, as businesses direct all the treasure and man-hours now wasted on compliance and tax avoidance schemes into truly productive efforts. That potential apparently persuaded Oklahoma Republican Senator Tom Coburn, normally a tax hardliner, to vote for the Erskine-Bowles plan even though it would raise taxes. “I think you’d see a massive expansion,” Coburn told The Wall Street Journal. “We have all this anti-competitive incentive in the tax code that makes people make all these strange calculations based on lowering their tax bill.”
Underscore fairness. Every middle-class American taxpayer now suspects that richer and more sophisticated households and corporations exploit the code’s complexity to avoid paying their fair share. The suspicions are well-placed: According to the Taxpayer Advocate’s report, the gap between taxes owed and taxes paid amounts to almost $300 billion a year. In other words, the average taxpayer pays $2,200 in taxes every year to subsidise evaders. A simpler code with lower tax brackets would reduce the incentive to cheat, increase compliance and make law-abiding Americans feel less like suckers. Meanwhile, Democrats voting for tax simplification could take credit for levelling the field between wealthy and middle-class taxpayers. Republicans in turn could boast they were eliminating “waste, fraud and abuse,” just as they pledged they would.
Obviously, passing tax reform would involve political trench warfare at its toughest. It would require a stiff investment of political capital by the president and Congress, and efforts almost certainly wouldn’t bear fruit for years. (Reagan’s tax reform plan, for example, didn’t become law until 1986, halfway through his second term.) Even so, the prospect of tax simplification and fairness allows Congress to embrace deficit reduction in an effort that could bridge today’s bitter partisan divide. At the moment, it may be the only thing that can.