Hopes for Tax Reform in 2007

Will 2007 be the year of fundamental tax reform? It should be, but in all likelihood, it will not be. Still, there are plenty of changes that could be made to move the tax code in the right direction.

First, the reasons there should be tax reform. Everybody hates the tax code. There is no better political rallying cry than "I am going to reform the tax code to make it simpler, fairer, and better for the economy." The same line is used by the most liberal and conservative would-be reformers. Unlike other public policies in need of reform -- Social Security, agriculture subsidies, and defense procurement, for instance -- there is no single organized and entrenched group defending the current code. However, once one gets into the details and it becomes apparent that tax reform will have losers as well as winners, the vast we-hate-the-tax-code coalition starts to fray.

In addition to general dissatisfaction with the status quo, there are other reasons that large-scale reform is in order. The coming expiration of the recent tax cuts, the desire to permanently reform the alternative minimum tax, and the likelihood that revenues will have to be a significant component of entitlement reform all make tax reform necessary. Making those changes in a compartmentalized manner rather than as part of fundamental reform is likely to lead to an even more complex and patchwork tax code than we already have.

A Grand Bargain on Taxes

Ideally, there would be some type of "grand bargain" on tax reform, as in 1986 when liberals got a cleaned-out tax base in return for conservatives getting lower rates. But conditions are different this time around. Taxes will go up -- not too much, hopefully, because higher rates will take their toll on the economy. But Congress has shown itself unwilling to cut spending anywhere near enough to close the fiscal gap, so taxes are going up.

That will make reform more difficult, and it will make it more important to improve the tax structure. On that front, conservatives who tend to support a consumption rather than an income base have it right. A tax code that encourages rather than punishes saving would be far better-suited for our savings-starved economy.

On the fairness front, more liberal supporters of a progressive tax system have the edge. A reasonable response to growing income inequality in this country is to increase the progressivity of the tax code, particularly if it is done in a way that does not harm the economy. Thus, the ideal grand bargain would be a progressive consumption tax to replace many existing taxes, thereby creating a more redistributive tax that is also better for the economy.

But a necessary ingredient for reform -- the political opening -- is still missing. To get from here to there, an honest assessment of what tax reform will involve is necessary. And there will have to be bipartisan cooperation to lend political cover for the distasteful parts of reform. That environment is unlikely to emerge until after the 2008 election.

The Tax Base: Filling in the Holes

In the meantime, there are important improvements that could be made. If there is one overlooked part of the budget that is out of control, it is tax expenditures. The progress of the 1986 reforms in clearing out the tax base has been chipped away as both parties have come to rely on spending through the tax code as their favored approach to budgeting. Want a policy to help working families, encourage alternative energy sources, stimulate depressed areas of the country, or give some industries a boost? Just create a new targeted tax break.

The problem is that these tax breaks tend to make terrible policy. First, they are really spending programs designed to look like tax cuts to make them easier to pass. No matter the label, they drain money from Treasury and expand the scope of government. That they are so easy to pass probably increases government’s size.

Further, they are poorly targeted, unnecessarily expensive, and extremely regressive, and they do not get nearly the level of scrutiny they should. Billions of dollars of targeted tax cuts have been passed in the past few years with little or no discussion about the worthiness of their goals. And unlike spending programs, which are subject to review, tax expenditure programs are on automatic pilot.

As politicians of both parties look for ways to offset the costs of new initiatives on both the tax and spending side of the budget as well as to reduce the deficit, this area of the budget holds tremendous promise. Capping the home mortgage interest deduction -- which currently subsidizes mortgages up to $1 million -- and the exclusion for employer-provided healthcare, for instance, could provide over $50 billion a year in savings. (Both policies would also be desirable for many other reasons.) Considering that tax expenditures total more than $700 billion annually, that is just the tip of the iceberg.

Going Green on Taxes

Also in need of change is the country’s underreliance on energy taxes. The United States is dependent on foreign oil and engages in many policies that harm the environment. Yet, perversely, the tax code subsidizes numerous environmentally harmful activities and does little to encourage conservation or energy independence.

Adopting a new revenue stream in the form of an environmental tax -- such as a gas tax or a broad-based carbon tax -- would help curb energy consumption and lead to reductions in environmental degradation, all the while providing a new revenue stream. Politicians have been resistant to back such taxes since the failed attempt to create a Btu tax early on in the Clinton administration, but it was a good idea then, and the political climate may be more receptive to the idea now.

Don’t Turn to Businesses for the Answer

Many politicians are quick to point out that the corporate tax’s contribution to federal revenues has dropped significantly over past decades. There are sure to be plenty of tax plans that promise middle-class tax relief paid for by increasing taxes on businesses. That is a losing battle and one that should not be fought.

First, as any good economics professor teaches his students, corporations don’t pay taxes -- people do. Levying taxes at the business level merely hides the costs from the people who pay them. Further, in an era of multinational corporations, highly mobile capital, and alluring tax environments abroad, collecting corporate taxes is becoming increasingly difficult. It will only become more so over time. We would do better to pursue policies to maximize U.S. businesses’ competitiveness while making the tax code more progressive to reflect current economic conditions.

Beware Tax Gap Mania

One final warning: The tax gap may well prove not to be all that it promises to be. Sure, $350 billion in free money sounds tempting. But really, if that money were easy to come by, wouldn’t politicians searching for new revenues in the past already have claimed it?

The tax gap is likely to become this decade’s "waste, fraud, and abuse" with politicians relying on the theoretical savings to pay for all their new initiatives. The prudent path would be to instead first ensure that the money is collected and then, and only then, dedicate it to other priorities. Otherwise, the tax gap’s promise may never materialize and enlarge the budget deficit rather than close it.