Tax Reform: These Small Steps Could Help Deficit, Economy

Is the American system of taxation nearing a watershed moment? It doesn't seem like it, considering the political brawl in Washington over the soon-to-be-expired 2001 and 2003 tax cuts passed during the Bush era. Lawmakers have known for the past several years that, if they did nothing, the tax breaks would automatically end on Dec. 31, 2010. Now, Washington is scrambling as the deadline looms and the economy sputters.

The Obama Administration is pushing to keep all the cuts except those for individuals making more than $200,000 and couples earning more than $250,000. Some congressional Democrats would like to let the package expire. Congressional Republicans are rallying around the policy of either extending the cuts or making them permanent.

At first glance, what we're witnessing is the same old, same old about taxes in Washington. The pitched battles between supply-siders and advocates of raising taxes on the rich mostly lead to tax cuts here and tax hikes there. And that tax approach over the past quarter-century past has created a bewildering maze of exemptions, exclusions, deductions, credits, carve-outs, loopholes, income phase-ins, and income phase-outs. Economists, let alone taxpayers, despair at the waste from the billions of hours and billions of dollars spent on filing, administrative, and compliance costs.

Despite unanimity about the problem and a brief moment of improvement under President Reagan in 1986, the tax code continues to accumulate ever more complexity. Reform is hard since far too many industries and individuals actually support the current setup, either because reform would hurt their pocketbooks by removing things like mortgage-interest deductibility or because they are adroit at ordering their finances around existing incentives (and disincentives). Washington lawmakers from both parties like handing out tax goodies to favored constituents in return for power and votes.

Four Major Shifts

That said, major reforms have swept the nation before. Specifically, the tax historian Elliott Brownlee argues in Social Philosophy and Tax Regimes in the United States, 1763 to the Present that there have been four major shifts in U.S. tax policy. The turning points were all associated with fiscal crisis: the Civil War, World War I, the Great Depression, and World War II. The common thread is that each crisis forced the government to come up with another way to raise money.

For example, the post-Civil War federal government largely relied on steep tariffs and excise duties on such items as alcohol and tobacco. The flaws of the system were increasingly apparent in the late 19th and early 20th centuries, but the trade disruptions of World War I forced an overhaul. The tax regime that held sway from 1916 to 1931 was dominated by new corporate and individual income taxes, as well as excise levies on consumer goods.

"Ultimately, durable tax reform happens when it must, not when it should. It happens when old taxes just can't keep up anymore—not with fiscal demands, not with changes in the economy," writes Joseph J. Thorndike, of the Tax History Project at Tax Analysts, a nonprofit publisher of tax information.

Inadequate Tax Regime

The cumulative crises of the past decade have shown that the current tax regime isn't up to the funding task. Following the tragedy of 9/11, the wars in Afghanistan and Iraq, and the fallout in financial markets from the September 2008 bankruptcy of Lehman Brothers Holdings, the federal government's obligations have greatly expanded. Yes, much of the federal government's red ink reflects the fiscal pinch from the worst downturn since the 1930s. Eventually, an economic recovery will boost the tax coffer and some of the costs associated with war, bank bailouts, and spending to jump-start the economy will dissipate, too.

But entitlement spending is growing along with an aging population. Economists Alan Auerbach of the University of California at Berkeley and William Gale of the Brookings Institution calculate that if the economy reaches full employment in 2014 and stays there for the rest of the decade, staying the course with current fiscal policies would lead to a national debt in the range of 90 percent of gross domestic product by 2020. (The Congressional Budget Office says the debt will reach 62 percent of GDP by yearend; it was nearly 35 percent of GDP in 2000.)

That said, Washington seems spent after the political fights over fiscal stimulus, health care, and financial-services reform. With midterm elections coming in November, it's hardly an auspicious time for grand negotiation and bold bargains. But in the absence of consensus on a massive overhaul of the U.S. tax regime, there are still smaller steps lawmakers could take that might prove more politically palatable.

Starting Points

For instance, a growing number of tax mavens believe a Value Added Tax, or VAT, is needed in the U.S. to restore fiscal sanity. While that is not likely to happen anytime soon, there are a number of steps shy of a VAT-like initiative that could move the country toward a healthier tax regime. Just ask James Poterba, head of the National Bureau of Economic Research and an economist at MIT. He headed up the 2005 White House task force on tax reform. The commission came up with several good blueprints that deserve a hearing. The starting point: trading for a broader tax base in return for lower tax rates. In other words, start going down the list of tax deductions and tax credits, phase-ins and phase-outs, and make a concerted effort to broaden the income tax base by eliminating as many of these tax twists and turns as possible.

However, Poterba notes that each loophole has fierce defenders. So, rather than single out specific deductions for limitation or elimination, it might be more politically expedient to adopt an across-the-board limit on tax credits and deductions to, say, a maximum rate of 25 percent. It's a good starting point. A practical guide that shares Poterba's spirit of simplicity while recognizing the importance of trade-offs is by Joel Slemrod, professor at the Stephen M. Ross School of Business at the University of Michigan. In "My Beautiful Tax Reform," Slemrod takes comfort in the wisdom of Albert Einstein, who cautioned that "everything should be made as simple as possible, but not simpler."

Another potential way to get the tax reform process going comes from Andrew Samwick, economist at Dartmouth College. He went to the President's Council of Economic Advisers in July 2003 and served as its chief economist for a year. He suggests leaving the income tax system alone for the moment. Instead, he would raise the federal gasoline tax and use the proceeds to reduce the deficit or temporarily offset a portion of the payroll tax. At a very basic level, you get less of what you tax and more of what you don't. "We get less congestion, emissions, and pollution," he says. "We get more payroll."

The best hope for jump-starting the reform conversation may be President Obama's bipartisan deficit commission. Its report is due on Dec. 1, and a tax overhaul plan will be critical if the commission wants to come up with a genuine blueprint for restoring the nation's long-term fiscal soundness over time. With the midterm elections in the rearview mirror by then, perhaps Congress will become more attentive to the urgent task of fixing the broken U.S. tax system.

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