Tax Reform is Really Hard But Worth The Effort

Update: The Tax Policy Center has released a distributional analysis of the reducing the top individual and corporate rates to 25 percent and eliminating the AMT.

With submissions in from Senators wishing to weigh in on the Finance Committee blank slate process for tax reform, both Chairman Max Baucus (D-MT) and House Ways and Means Committee Chairman Dave Camp (R-MI) are now undertaking the hard work of writing their marks. According to news reports, Camp has committed to producing a tax reform bill in October and Baucus plans to follow a similar schedule.

As we've argued before, tax reform is an incredibly worthwhile endevour both to promote economic growth and to help reduce the deficit. And with $1.3 trillion in annual tax expenditures out there, there is plenty of money to reduce rates and deficits. But those who support fiscally responsible reform with dramatically lower rates (including us) do need to accept a reality: tax reform is really, really hard.

According to new estimates by the Joint Committee on Taxation, eliminating the AMT while reducing the top individual and corporate tax rates to 25 percent could cost over $5 trillion over ten years. To be sure, there are enough tax expenditures in existence to finance these costs, with roughly $15 trillion worth under current law and perhaps in the neighborhood of $10 trillion after accounting for interactions with the rate. Importantly, that $10 trillion number is likely to shrink even more when accounting for taxpayer behavior to minimizing tax burden and the administratively difficulty of eliminating some preferences.


Source: JCT

When politics are added to the mix, the cash available from tax expenditures declines further. For example, policymakers are very likely to want to maintain some support for housing, health care, and charitable giving (see our list of options to make these preferences more efficient here) and will also likely want to continue to support savings and investment through the tax code. Trying to maintain the same level of progressivity, as the Senate Finance Committee has announced in its clean slate framework, adds an additional challange to cutting rates.

These realities have caused some groups, such as the Center on Budget and Policy Priorities, to be concerned about focusing on rate reduction in tax reform and especially about setting a rate target before identifying the specific tax preferences to cut. These concerns are merited, given research from the Tax Policy Center which recently concluded that "it is possible to maintain revenues in the face of large marginal tax rate cuts by pairing back tax expenditures, but it would be very difficult."

The flip side to this concern is that lower rates will likely make tax reform more politically appealing, can have real economic benefits, and can force a tougher look at a number of inefficient and distortionary tax preferences which might not be scrutinized without the prospects of substantial rate cuts.

In our view, rate reduction is an important part of the tax reform formula but only in the context of generating the revenue stream to help finance our government and pay down our deficits. The blank slate approach can help to maintain discipline on tax expenditures, but expectations must be managed.

Both the 2005 Tax Panel and the Simpson-Bowles Commission found that eliminating all tax preferences would allow for a top rate of 23 percent. Yet both plans included tax expenditure add-backs which required rates in the high 20s or low 30s. Ditto the Domenici-Rivlin tax plan. And importantly, none of these commissions faced that type of political pressure that Congress is likely to face on retaining tax expenditures.

As policymakers continue to pursue tax reform, we recommend that they keep this reality in mind. For those interested in substantially reducing rates, we also recommend doing the following:

  1. Keep All Tax Expenditures On the Table. As a number of major tax reform plans demonstrate, it is possible to achieve substantial deficit reduction without repealing every tax expenditure in the code. Yet once one tax expenditure is taken off the table for consideration, no matter how worthy, it opens the door to taking the next off the table. If each Member of the Senate was able to protect just one tax expenditures from reform, half would ultimately become unavailable. Given that the most popular preferences also tend to be the biggest ones, the amount of money left for rate reduction or deficit reduction would likely be minimal. Removing the top ten largest expenditures would take $900 billion out of $1.3 trillion in annual expenditures off the table.
  2. Be Creative: Think Beyond Tax Expeditures. Although the Senate Finance Committee has rightly identified tax expenditures as the first place they are looking to for revenue, it should not be the only place. A recent Tax Notes paper by CRFB's Marc Goldwein, Adam Rosenberg, and Jessica Stone identifies "non-tax-expenditure-base-provisions" (NTEBPs) as a part of the income tax base beyond tax expenditures to tap for revenue. Rate levels and bracket thresholds could also be adjusted in a number of ways to simplify the code and reduce the cost of rate reduction. In addition, other forms of revenue outside the income tax could be considered to help finance reform.
  3. Recognize Tax Reform is About More than Rate Reduction. All else equal, the lower the tax rates the better. Lower rates mean a smaller tax gap, smaller distortions from tax expenditures, and better incentives to work and invest. But rate reduction should not and cannot be the only goal of tax reform. Nor should deficit reduction, though achieving this goal is quite important. Tax reform also has the power to reduce economic distortions by getting government out of the business of picking winners and losers and subsidizing bad behavior. At the same time, improved simplicity, reduced compliance costs, increased equity and fairness, and clearer incentives where appropriate can all be benefits of tax reform. These would be important improvements, regardless of how much rate reduction is achieved.

Ultimately, tax reform should aim to push the envelope. Chairmen Baucus and Camp should push their colleagues to think as boldly as possible to achieve as much rate and deficit reduction as the political system will bear, given other important policy goals. But they shouldn't expect such reform will be easy.

Tax reform is very, very hard, so policymakers should work hard to achieve it.