Tax Analysts Blog

Tax Reform is Nice, But ...

Posted on Apr 13, 2009

My colleague Marty Sullivan seems more than a little dubious about the prospects for a value-added tax. And he may be right. A VAT would mark a sea change in the history of American public finance—the kind of tax innovation that only comes along every century or so.

But I’m not convinced that old-style tax reform is the answer to our fiscal woes (which Chris Bergin has nicely laid out for us). Sure, the income tax would be fairer and simpler if we repealed the myriad credits, deductions, and other preferences littering the tax code. That sort of reform would also raise a lot of money. (Although how much depends entirely on which preferences actually got the ax, since it’s safe to say that some would survive the slaughter).

But income tax reform is not enough. It is a necessary but insufficient response to our long-term fiscal crisis.

For a variety of reasons – most of them good, none of them welcome – politicians are spending money like water these days. And over the next couple of decades – for reasons that are also good, if equally unwelcome – we’re going to spend even more.

Over the short term, the need to spur economic recovery trumps every argument for fiscal restraint. But over the long term, entitlement financing poses a serious threat to American prosperity. Left unchecked, Social Security, Medicare, and Medicaid will consume all available tax revenue by 2050 (with health programs responsible for the lion’s share of this spending).

Old-style tax reform can’t solve this problem. To begin with, it’s benefits are temporary – some might say ephemeral. Let’s assume that politicians, in a fit of collective madness, decide to stop selling favors and clean up the tax code. What’s to keep them from changing their mind in the years that follow?

History suggests that they will do exactly that. The landmark Tax Reform Act of 1986 was a good and wonderful thing. But by most accounts, it was well on its way to oblivion before the ink was even dry.

Milton Friedman once suggested that tax reform was just a sly way of keeping the favor game going; by repealing old favors, it gave lawmakers a chance to resell them to the same taxpayers. If Friedman was right, then lobbyists don’t buy preferences, they just rent them.

Politicians have been handing out favors through the tax system for quite some time –220 years, by my reckoning. These favors are the currency of democratic politics. The only way to get rid of them (for good) is to de-democratize the tax process. Entrust revenue policy to a bunch of experts and let them figure out the best way to pluck feathers from our collective goose.

That’s not likely or desirable. But it does mean that revenue-stealing tax preferences are a fact of life. Tax reform is still worthwhile. It’s like cleaning out your closet: you have to do it once in a while or the mess gets overwhelming. Just don’t expect it to stay clean.

Which brings me back to the VAT. Unless I’m badly mistaken, health care reform is quickly becoming a political and economic necessity. Americans are clearly interested in revamping the system of employer-provided coverage. Mounting job losses seem likely to enhance that interest, since lost jobs mean lost coverage for millions of people.

I’m dubious that a reformed income tax would produce enough new revenue to pay for health care reform. (And it’s only fair to point out that Marty never said it would.) Even if we could squeeze enough out of the income tax, we shouldn’t. It’s not wise, prudent, or fair to create a spending program for the many using a tax system that applies to a relative few. Roughly 40 percent of Americans pay no income tax at all (although they pay plenty of other taxes, including payroll levies for Social Security and Medicare). In recent decades, the income tax has been returning to its roots as a rich man’s burden.

If we use narrow taxes to fund broad programs, then we obscure the cost of those programs from non-taxpayers. At the same time, we breed resentment among those who are footing the bill; witness conservative complaints about the narrow scope of the income tax.

Health care is not free, and Americans – including those who don’t pay income taxes – should never be allowed to think it is. The signal virtue of a health care VAT (other than the money it would raise) is the visibility it would give to health care costs. Len Burman of the Tax Policy Center has made exactly this point.

      Since everyone would pay the VAT, the higher rate could build widespread support for effective measures to control health care costs. Moreover, the lowest-income 40% of households [who don’t pay income taxes] would have a stake in controlling government spending, addressing one of the major complaints by conservatives regarding the current system.

A health-care VAT would not be cheap. According to Burman, it might reach 25 percent. That’s a scary number, and certainly a hard one to sell to voters.

But I don’t see what choice we have. Doing nothing is not an option: fiscal catastrophe awaits. Reforming the income tax would help, but it’s not enough. A VAT is starting to look like the last best hope for fiscal responsibility.

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