The landmark Tax Reform Act of 1986 is the inspiration for most tax reform efforts of the last decade, and with good reason. Against all odds, President Reagan and a Democratic Congress overcame what many believed were insurmountable political difficulties to pass into law a reform plan that reduced the top individual rate from 50 percent to 28 percent and the top corporate rate from 46 percent to 34 percent, and in the process jettisoned and downsized hundreds of tax benefits in the code.
TRA 1986 stuck to the same basic framework for tax reform originally laid out by Reagan in 1984. It did not raise or lose revenue. And it did not significantly change the tax burden distribution.
Most prominent detailed reform efforts that have since been floated have retained the twin goals of revenue and distributional neutrality. For example, these guiding principles were incorporated into proposals developed in 2005 by President George W. Bush’s advisory panel for tax reform and in the draft reform plan of House Ways and Means Committee Chair Dave Camp, R-Mich., released in February.
Unfortunately, despite the wealth of effort and expertise involved in their development, these and other prominent Reagan-style reform efforts haven’t progressed through even the earliest stages of the formal legislative process. And there is little prospect of enactment in the foreseeable future. So despite its considerable merits, it is not obvious that Reagan-style reform is the best or only way to proceed.
Presumably, we are not doing tax reform for its own sake but to promote economic growth (that is, to create jobs). Tax reform is generally defined as lowering the rate and broadening the base. The idea is to reduce as much as possible the code’s interference with economic decision-making and allow market forces to find the most efficient ways of doing business. There is also the possibility that tax reform can reduce efficiency-draining administrative and compliance costs (though in practice that may difficult to achieve).
What other tax changes could be more effective at promoting that goal? The possibilities are endless: investment credits, research credits, energy credits, and other reductions in business taxes.
Perhaps the most direct approach to spur job creation is a business tax credit for hiring new employees. But, although appealing at first, it often gets bogged down in definitional and operational complexities. And it is always important to ask how targeted tax benefits are being financed. If there must be offsetting tax increases, these will undo much of any economic benefit. Similarly, if the tax breaks are financed by increasing the federal debt, there will be negative implications for long-term growth.
Even if the benefits of tax reform are deemed superior to those of more limited approaches, given the political realities -- that is, the extreme difficulty of enacting tax reform in the foreseeable future -- it might be preferable to pursue more limited tax changes that promote job creation.
The next question we must ask ourselves is whether we really want to eliminate existing tax preferences. Almost all tax preferences have broad popular appeal and political support. There are, for example, tax breaks for charitable contributions, low-income housing, domestic manufacturing, retirement saving, and expenditures on research and development. The difficulty of repealing them is obvious. Despite all the rhetoric about closing loopholes for special interests, most of the tax breaks that would have to be repealed to fund any significant reduction in tax rates are popular with the public or have broad support in the business community. This point cannot be overemphasized. It is why even if partisan disagreement over whether tax reform should raise revenue can be settled, tax reform will face enormous political hurdles in Congress.
Finally, we must consider whether new revenue sources, like a value added tax, should be part of tax reform. Most of us are familiar with the conventional political wisdom about a value added tax: Conservatives see a VAT as a “money machine” that will make it easy for government to grow, while liberals see it as an unfair tax that disproportionately burdens the poor because it is a tax on spending. That’s why the Senate passed a resolution expressing opposition to value added taxation with an 85-13 vote on April 15, 2010.
But 160 countries, including all 33 other OECD countries, have a VAT. Because a VAT is a consumption tax, it is less economically damaging than an income tax and far less damaging than a corporate tax. For this reason, economists, policy experts, and (privately) business leaders support using a VAT to reduce individual and corporate income taxes. Professor Michael Graetz of Columbia Law School has proposed using a 13 percent VAT to exempt the first $100,000 of family income from income tax (which would eliminate 120 million tax returns) and cutting the corporate tax rate to 15 percent. To offset the added burden a VAT puts on low-income families, there would be cuts in payroll taxes and refundable income tax credits.
The VAT is not the only new alternative source of revenue. There is a progressive consumption tax that looks a lot like our income tax, but because it exempts capital income from tax, has many of the same economic benefits as a VAT. Other less sweeping possibilities include a carbon tax, an increase in the federal gas tax, a tax on financial transactions, and a tax on financial institution liabilities.
Instead of a new source of revenue to reduce both individual and corporate taxes, another possibility would be target tax relief on the corporate tax. From an economic perspective, reforming and reducing the corporate tax is low-hanging fruit. Because it is a terribly distorting tax, corporate tax reform is the most obvious way of improving our tax system. If corporate tax reform must be revenue neutral, the tax breaks that would have to be repealed to pay for lower rates -- accelerated depreciation, the deduction for domestic manufacturing, and the research credit – have strong support in Congress. Moreover, they are especially important to manufacturing businesses that most politicians are actively seeking to promote. Paying for lower rates with non-corporate source of revenues is one way of avoiding this obstacle.
All these considerations leave us with a spectrum of possibilities. At one extreme we can forgo tax reform, leave the code in place, and promote small-scale tax changes that encourage job creation. At the other extreme we can eliminate or downsize our individual and corporate income taxes and replace the lost revenue with a new tax, such as a VAT.
There are also possibilities in between those extremes, including:
- Classic Reagan-style 1986 reform that lowers individual and corporate tax rates while broadening the tax base.
- Corporate-only tax reform, the approach endorsed by President Obama. In a September 3 interview on CNBC’s Squawk Box, Senate Finance Committee member Rob Portman, R-Ohio, suggested it may be practical to pursue corporate-only tax reform.
- Tax reform that reduces the corporate tax and makes up for lost revenue by raising individual income taxes, particularly for high-income individuals. Eric Toder and Alan Viard have proposed repealing the corporate tax and replacing it with a system whereby capital assets are marked to market each year.
Before the tax technicians are ready to work out the details of a major tax reform effort, they need their political bosses to provide guiding principles and a basic framework. As is often the case in policymaking, the trick is to identify the best economic outcomes that lie within the range of political feasibility.