The Tradeoffs of Tax Reform

Often when tax reform is discussed these days, policymakers are gleeful to detail the ways in which they will cut tax rates or otherwise lower tax burdens under the current system, but much less forthcoming about how they will otherwise raise taxes to meet a certain revenue target (see here, for example). A new Tax Policy Center report, though, demonstrates what kind of tax base-broadening would be needed to meet revenue targets with lower rates. In doing so, they demonstrate the difficult choices and tradeoffs that lawmakers will face. 

TPC evaluates a "Current Policy with Reduced Rates" scenario, which cuts marginal tax rates by 20 percent across the board from the current system (i.e. the top rate falls from 35 percent to 28 percent) and repeals the AMT. They then detail how tax expenditures could be reduced or eliminated to meet both current policy and current law revenue targets (for a summary of the differences between current policy and current law, click here). They group tax expenditures into four categories, ranked in order of what they feel are most politically feasible. They are:

  • Group 1: This group includes the "big four" tax expenditures: the employer-provided health insurance exclusion, the mortgage interest deduction, the charitable deduction, and the state and local tax deduction. Other employment-related benefit exclusions are also in this category (such as those for life insurance and disability insurance) and certain education tax expenditures. This group is considered most politically feasible since many of these--especially the big four--are often tagged for reductions or eliminations in some of the major tax reform proposals such as Simpson-Bowles or Domenici-Rivlin.
  • Group 2: This group includes many provisions related to investment and retirement income as well as other savings provisions. Thus, this category includes preferential rates for capital gains and dividends, IRA and 401(k) provisions, and exclusions for interest earned on certain bonds.
  • Group 3: This group includes child and work benefits, mostly in the form of refundable credits like the child tax credit and earned income tax credit. It also includes the partial exclusion for Social Security benefits.
  • Group 4: This group is labeled as "other preferences," mostly exclusions that many people do not realize are tax expenditures or would be difficult to determine the value of if the excluded items were taxed. Some of these include exclusion of veterans' benefits, combat pay, and capital gains on home sales, as well as the exclusion for "inside buildup" of life insurance (the increased value of the policy before benefits are realized).

TPC notes that the size of tax expenditures is dependent on the marginal rates and how other aspects of the tax code interact with preferences. When marginal rates are lower, deductions and exclusions from taxable income become less valuable. In addition, the AMT does not allow some of these tax expenditures to be deducted for AMT purposes, thus limiting the value of preferences for people hit by the alternate tax.

Under current law, TPC projects there to be $1.4 trillion of tax expenditures in 2015 and $1.3 trillion under current policy. After accounting for interactions with the rate cuts and AMT repeal, TPC determines that there are $1.1 trillion of tax expenditures to work with in the "tax reform" scenario--$450 billion in Group 1, $330 billion in Group 2, $120 billion in Group 3, and $280 billion in Group 4.

Revenue Impact of Three Scenarios in 2015 (billions)
  Current Law Current Policy Current Policy w/ 20% Rate Cut and AMT Repeal
Total Revenue $3,289 $2,876 $2,556
"Group 1" Tax Expenditures $590 $525 $446
"Group 2" Tax Expenditures $439 $425 $327
"Group 3" Tax Expenditures $88 $128 $122
"Group 4" Tax Expenditures $249 $224 $182
Total Tax Expenditures $1,366 $1,305 $1,077

Source: Tax Policy Center

In order to make the tax reform revenue-neutral compared to either baseline in 2015, tax expenditure reductions must total $320 billion to reach current policy levels and $730 billion to reach current law (note that reform proposals generally are somewhere in between for revenue). However, the amount of tax expenditures that is available to work with shrinks compared to current law and current policy, as the table above shows.

From these data, one can determine any number of combinations to meet a revenue target. In total, one would need to cut tax expenditures by 30 percent and 70 percent under current policy and current law, respectively. One possible example is to cut Group 1 by about three-quarters to meet the current policy target, but would need to reach into other groups to reach current law. More likely, a reform plan will get some savings from all four of these groups, especially the first two. Both Simpson-Bowles and Domenici-Rivlin did so while increasing revenue above current policy and maintaining, if not increasing, progressivity. Ultimately, the composition of base broadening will depend on the policy preferences of those involved.

TPC's paper can be used to make a useful point: tax reform isn't all fun. Any rate cuts or other parameters that reduce revenue must be accompanied by offsetting base broadening or other changes--and ideally there would be more of the latter than the former. The four group framework that TPC provides is an interesting way of thinking about the tradeoffs of tax reform.