Perspectives on Tax Reform from Rudy Penner and Donald Marron

By :: February 17th, 2012

In the current issue of the journal The International Economy, ten economic thinkers shared their views on how best to restructure the tax system. Their opinions crossed the political spectrum, ranging from House Budget Committee Chairman Paul Ryan (R-WI) to the Economic Policy Institute’s Andrew Fieldhouse. Two of my Tax Policy Center colleagues—TPC director Donald Marron and Urban Institute  fellow Rudy Penner—wrote for the special section and TaxVox is reposting their short essays here. But read the entire debate on The International Economy Website. It is well worth it.

Here is Rudy’s essay:

Were it not for the growth in spending on Medicare, Medicaid, and Social Security, the United States wouldn't have much of a budget problem. The two biggest programs—Social Security and Medicare—are retirement programs that are extremely popular politically. Both need to be reformed, but they cannot be cut abruptly and they cannot be cut drastically. Consequently, it's hard to avoid concluding that some revenue increases will be needed to solve our fiscal problems.

Once that need is accepted, we have to ask, "What kind of revenue increases?" The least desirable approach would raise income tax rates in the current system without fixing its complications, inefficiencies, and inequities. If raising rates is rejected, we must either create a new tax— such as a value-added tax or an energy tax—or design a significant, revenue-raising tax reform.

A VAT or an energy tax is probably a nonstarter politically. Republicans see a new tax as a money machine that would finance a much larger government. Democrats worry about the complexity of making such taxes sufficiently progressive

The Bowles-Simpson presidential fiscal commission showed that there are income tax reforms that can raise revenues progressively and efficiently. In one option, they got rid of a host of special tax provisions while limiting, but not eliminating, some of the most politically sensitive, such as the charitable and mortgage-interest deductions. That allowed them to lower the top rate for individuals to 28 percent while still raising $80 billion more in 2015. With three rates—12.7 percent, 21 percent, and 28 percent—the top 0.1 percent of the income distribution lost 11.8 percent of its after-tax income and the top 1 percent lost 7.8 percent. The middle three quintiles lost less than 2 percent.

Erskine Bowles and Alan Simpson achieved a high degree of progressivity by taxing capital gains and dividends at ordinary income tax rates. That imposes a very high double tax on corporate profits. A more radical option would limit the double tax by integrating the corporate and individual tax systems. An even more radical change would move toward a progressive consumption tax. Capital gains and dividends wouldn't be taxed if reinvested, but would be hit if used to finance consumption.

None of this discussion implies that radical tax reform is easy. The revenue-neutral reforms of 1986 were anything but. A revenue-raising reform greatly increases the ratio of losers to winners. Accomplishing reform seems easy only when compared to persuading Americans to accept a VAT or new energy tax.

Here is Donald’s:

America’s tax system is a mess. It’s needlessly complicated, economically harmful, and often unfair. And it doesn’t raise enough money to pay our bills. That’s why almost everyone agrees that tax reform should be a top priority. Democrats, Republicans, and independents. Accountants, lawyers, and economists. Elected officials and ordinary citizens. All know our tax system is deeply flawed.

Unfortunately, they don’t agree on how to fix it. Some want revenue-neutral tax reform, while others want higher revenues to cut deficits and pay for rising entitlement spending. Some want to fix the income tax, while others want to tax consumption. Some want to cut tax rates across the board, while others would lift rates for high earners.

Public discourse, meanwhile, is hung up on the idea of attacking “loopholes” when the real action is in tax breaks that benefit millions of taxpayers. Tax reform isn’t just about corporate jets or carried interest. It’s about the mortgage interest deduction, the tax exemption for employer provided health insurance, and generous tax incentives for debt-financed corporate investment. Those policies have major flaws, but they are not loopholes. They reflect fundamental economic and social choices, and they benefit well-defined constituencies.

Tax reform will thus involve a prolonged political struggle, as reformers seek some compromise that can attract enough support to overcome the inevitable inertia against change. That won’t be easy, but given our sky-rocketing debt, weak recovery, and flawed tax system, it’s clearly worth the effort.

Even as they seek a reasonable compromise, reformers should continue to articulate their visions of an ideal tax system. Mine would reflect five principles. First, the government should raise enough money to pay its bills. That likely means higher revenues, relative to GDP, than we’ve had historically. Second, it’s better to tax bads rather than goods. That means greater reliance on energy and environmental taxes. Third, it’s better to tax consumption than income; policymakers should thus limit how much they tax saving and investment. Fourth, the tax burden should be shared equitably both across income levels and among people of similar means who make different choices (for example, renting versus owning a home).

Finally, the best tax systems have a broad base and low rates. Policymakers should thus emphasize cutting tax breaks rather than raising tax rates. Indeed, some rates, like the 35 percent rate on corporate profits, should come down.

To afford such cuts, policymakers should go after the dozens of deductions, credits, exclusions, and exemptions that complicate the code and narrow the tax base, often with little economic or social gain. Many of these provisions have been sold as tax cuts, but are really spending in disguise. They should get the same scrutiny that policymakers devote to traditional spending programs.