On July 18, four former assistant Treasury secretaries for tax policy testified before the Senate Finance Committee on the prospects and challenges of achieving tax reform. I focused on two ideas: Guardrails to guide tax reform and lessons Congress can learn from previous reform efforts.
I described four basic principles --what I called guardrails-- that should frame any serious tax reform effort. They are 1) the main purpose of the tax code is to produce revenue to pay for the goods and services that Americans demand from their government 2) the revenue code should tax people who make the same amount of income equally 3) the tax law should be progressive so those who make more pay more 4) taxes should be as simple as possible.
The lessons from the past are that tax reform is both politically and technically difficult, that bipartisan legislation is more likely to endure than a partisan bill, and that Congress can take advantage of both big and small opportunities to repair the tax code.
To start with those guardrails:
Why we have a tax code: Today, the Federal tax system raises around $3.3 trillion per year or about 17 percent to 18 percent of Gross Domestic Product. But that still leaves an annual deficit of over $500 billion. Given demographic trends, expenditures will rise as the Baby Boomers age. If we are serious about getting the deficit under control, we will need higher revenues in the medium to long-term. The last time the federal budget was in balance, in fiscal 1998-2001, federal receipts were 19 percent to 20 percent of GDP.
Taxing equal incomes equally. Economists call this “horizontal equity” and it means that the source of income should not determine its tax rate, unless there is a compelling reason to do so. Thus, a construction worker should be taxed the same as a business owner with a similar income; and a lawyer at a partnership should be taxed the same as a legislator with similar income. Violating this notion of fairness brings into question the overall fairness of the tax system.
Those with the greatest ability to pay should bear a proportionally larger financial share of the responsibilities of government. Economists call this concept vertical equity and it is associated with the progressive tax system, where the average effective tax rate goes up with income. Today’s overall federal tax system is fairly progressive. Reform should retain this feature.
Simplicity. Taxpayers believe the tax code is too complex to understand. They are frustrated at having to pay tax preparers or software firms to help them do their civic duty, and they believe they are missing out on benefits being claimed by others. A lot of the complexity reflects the increasingly complicated economic and social world in which we live. However, we all have been complicit in making the code more complicated. For example, social policy is increasingly being run through the tax code. While this can be an efficient way to deliver benefits, each provision carries with it eligibility rules and benefit calculations that can overwhelm taxpayers.
With these four principles in mind, there are three main take-aways from previous tax reform efforts:
Tax reform is technically difficult. The essence of reform is turning the many moving pieces of the tax code into a single package that meets the goals of improving efficiency, equity, and simplicity while meeting a prudent overall revenue target.
Tax reform is even more difficult politically. When undertaking “broaden the tax base, lower the tax rate” reform, key constituencies often break along geographic or demographic or industry lines rather than partisan lines.
Bipartisan tax reform may be the most durable The Finance Committee’s long tradition of bipartisan legislating bodes well for playing a leading role in developing a consensus on tax reform that can stand the test of time.
There are targets of opportunity for tax reform. Perhaps the largest is business tax reform. In theory, broadening the business tax base can generate revenue to reduce the corporate income tax rate and reduce the tax burden on smaller pass-through businesses. Plans developed by former House Ways & Means Committee Chairman Dave Camp and by President Obama presented such pathways.
There are also more modest opportunities for reform. Complex and confusing tax incentives for education could be simplified in a revenue-neutral and more effective way. Congress could address the income inclusion rules for student debt forgiveness. This problem affects student borrowers in all fifty states who have been taken advantage of by unscrupulous schools and cries out for an equitable solution. Expanding access to cash accounting can help truly small businesses replace complex tax rules with a system as easy as keeping a checkbook. The Bush Administration developed an alternative along these lines that has merit.
Tax reform is not easy, but it is possible, and it can be done in a fiscally responsible way that does not make the Federal budget situation worse.
