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November 02, 2005

Talking About Tax Reform: A Missed Opportunity

Eddie Lazear and Jim Poterba have an interesting opening to their "pro tax reform" piece this morning:

A Golden Opportunity: By EDWARD P. LAZEAR and JAMES M. POTERBA: A tax system should generate the government's required revenue with as little economic distortion as possible, while distributing tax burdens fairly. It should not discourage work, saving or entrepreneurship more than is necessary, and it should not discourage individuals from acquiring the skills and education that will increase their productivity. It should not discourage investment, or favor investments in one asset over those in another. In short, an efficient tax system alters economic decision-making as little as possible.

If you poll economists and budget people about what is most wrong with our tax system, they will tell you that the thing that is most wrong is that it does not do the very first thing that Eddie and Jim mention: our tax system will not generate the government's required revenue. As America ages and as health care costs rise, the government is going to be spending a larger and larger share of GDP. The Republican leadership has no plans to close this funding gap, either by reducing planned spending or increasing taxes. That's the big thing wrong with America's tax system today. And that's the one thing Eddie and Jim don't talk about. This is too bad: it's a very big missed opportunity, a place where they could have educated the public, but did not.

However, they do say a great many smart things:

The more than 15,000 changes to the tax code in the last 19 years have undermined many achievements of the 1986 tax reform... targeted incentives, phase-out rules, phantom tax rates, and complex and sometimes inconsistent provisions... unable to understand the rules... five different definitions of "child"... 401(k)s, 403(b)s, 457 plans, 529s, IRAs, Roth IRAs, Coverdell saving accounts and Health Saving Accounts...

The Alternative Minimum Tax... a parallel tax structure.... The AMT is most likely to affect taxpayers with large families in states with high state and local tax burdens... many Americans in these states face impending and surreptitious tax hikes...

A substantial body of economic research suggests that tax wedges between the before-tax and the after-tax return on saving and investment are particularly detrimental to long-term economic growth. The current tax system taxes corporate income once at the corporate level and again at the investor level. The Treasury Department estimates that, on average, the total tax burden on a new corporate investment project is 24%. By comparison, investments in the non-corporate sector, which are taxed only once, face a 17% tax burden. Investments in owner-occupied housing, which yield untaxed returns in the form of implicit rental income, are untaxed....

The Tax Panel endorses two reform proposals.... The first is the Simplified Income Tax. It preserves the income tax framework but cuts marginal rates to 15%, 25% and 33%. It provides for a large amount of tax-free saving, consolidates credits, and rationalizes the system of business taxation. The second reform proposal, the Growth and Investment Tax, builds on the Simplified Income Tax system, and by allowing full expensing of capital, shifts the tax system toward a consumption tax base.... Treasury estimates that moving from the current structure to the Growth and Investment Tax would lower the average tax burden on all investment from 17% to 6%. This would encourage new investment and significantly increase productivity and wage growth...

Both proposals trim many of the deductions... [keeping] a deduction for charitable contributions in excess of 1% of taxable income... a 15% tax credit on interest for loans up to 125% of an area's median home price, computed using the FHA's loan limits.... tax[ing] employer-provided health insurance, but only on the amount of insurance valued at more than $11,500 for a married couple and $5,000 for a single individual....

Both plans eliminate the federal tax deduction for payments of state and local income and property taxes.... [But] these... deductions [would] be eroded [anyway] as the AMT expands its reach under the current tax system....

If reform proposals are dissected by politicians in an attempt to promote provisions that reduce their constituents' tax liabilities while excising those that increase constituents' tax liabilities, reform will inevitably fail. But if reform proposals are viewed instead as a collection of provisions that leave most families in a position not very different from their current one, while also shifting the tax system toward a structure that will promote long-term economic growth and reduce the burden of tax compliance, then these proposals can command broad popular support and even enthusiasm...

The tax reform proposals seem, at first glance, to (a) broaden the base by whomping the big deductions that are primarily used by the upper middle class to reduce their tax burdens; (b) lower tax rates, especially on savings; (c) simplify; and (d) shift the tax base from income to wage and salary income--i.e., moving toward a system in which taxation falls on labor and not on capital.

Parts (a), (b), and (c) are very good, but it's never been clear to me that (d) is fully thought out. Taxing capital income does two things: (i) it taxes thrift--moving wealth and purchasing power forward in time--and thus causes us collectively to miss opportunities for productive investment; and (ii) it taxes luck--those who happened to be in the right place at the right time, and wound up with large piles of money. Looking forward in time at my great-great-great grandchildren, I don't want their thrift taxed: I do want them to take advantage of all the opportunities for productive investment there are. But I do want their luck taxed: some of them will be lucky and some will not, and I will be happier if some of the fruits of the good luck of the some are redistributed to ther others via the tax system. It's not at all clear that Eddie and Jim have included this factor in their thinking.

Posted by DeLong at November 2, 2005 09:49 AM