The Tax Reform Trap

June 23rd, 2012 at 9:10 am

A couple of my CBPP colleagues have written an important paper—a warning, really—on tax reform.  Chuck Marr and Chye-Ching Huang describe a trap that almost every tax reform effort I’ve heard about in recent months risks falling into.  It’s critical that we wrap our heads around this, because major tax reforms are rare and if one is coming—and it might well be—we can’t afford to blow it.

This is their warning:

–the mantra of all tax reform initiatives these days is “lower the rates, broaden the base” where the latter means ending certain tax expenditures (a wide variety of tax breaks and credits ranging from the Earned Income Credit—a wage subsidy for low wage workers—to the reduced rate on capital gains).

–but most of the actual reform proposals—like those of Rep Paul Ryan, Gov Romney, or the Bowles-Simpson commission—cut rates first, with an agreement to find the base broadeners later (Bowles-Simpson, to be fair, included “illustrative” cuts, but the members of the commission were unable to reach agreement on them).

Therefore, TAX REFORM THAT LOWERS RATES WITHOUT FIRST LOCKING IN HIGHER REVENUES WILL VERY LIKELY FAIL TO RAISE THOSE REVENUES.  The sequencing of tax reform therefore must be:

1) chose a revenue target, one that reliably reduces the deficit once the economy is back on track;
2) figure out the rates and base needed to hit that target;
3) ensure that a) a majority of policy makers accept the base broadeners and b) the changes do not make the code less progressive;
4) only then, once progressive base-broadeners and a deficit-reducing revenue target are locked in, should lower rates be considered.  If the lower rates violate any of the prior conditions, they must be rejected.

Reading through Chuck and CC’s paper, I cannot over-emphasize the importance of this sequencing.  In a way, it’s as simple as spinach first, then dessert.  But once you open your eyes to this problem, you see it everywhere.  Even the White House, folks who clearly understand the need for new revenues, gets it wrong.

I wrote a variation of this earlier, under the rubric of the DC Dodge.  But my colleagues add a lot more meat to these bones.  A few of their other key points:

–many of the “lower rates, broaden base” plans claim to be revenue neutral.  Um…neutrality is not the correct goal when we need net new revs;

–across the board rate cuts, ala Gov Romney’s plan, are regressive, delivering larger tax cuts to those at the top of the income scale (see CM/CCH’s figure 2);

–base broadening through cuts in tax expenditures is WAY harder than you’d think from hearing policy makers blithely invoke it:

…curtailing tax expenditures, especially if that must produce deficit reduction and offset the cost of large and regressive reductions in tax rates, is far harder than many proponents suggest. First, there are immense political and other obstacles to raising very large amounts of revenue through tax expenditure reform. Second, cutting tax rates reduces the revenue gains from base broadening [because lower rates mean smaller deductions; thus, ending those deductions raises less rev]. And third, it’s even harder to overhaul tax expenditures in a way that simultaneously offsets the cost of rate cuts, raises significant additional revenue for deficit reduction, and maintains or improves the progressivity of the tax code — especially if proponent insist on maintaining the preferential rate for capital gains.

Chuck and CC conclude that tax reform, done badly with the wrong sequencing, could end up exacerbating both inequality and the budget deficit.  And if you’ve spent any of your time in this debate in DC in recent years, you know that the likelihood of getting caught in the very trap they elaborate here is great.

So read this and be forewarned.  We’ve got enough problems without getting our fiscal legs caught in a trap.

 

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12 comments in reply to "The Tax Reform Trap"

  1. bakho says:

    Isn’t that the thesis of David Stockman’s book, The Triumph of Politics?

    Stockman thought that if he could get revenue cuts, he could force cuts to Social Programs. To his surprise, he found politicians much more willing to deficit spend than to cut social programs. By the time Reagan had handed out all the plums needed to buy support for his tax cut proposal, it passed but the budget deficit skyrocketed.

    Stockman never intended to create the Reagan deficits. He intended to cut social programs. However he was defeated by the politics and political support for social programs. The current Starve The Beast proposals may repeat that sorry history.

    jonny bakho


    • Jared Bernstein says:

      Haven’t read it but that sounds right.


      • Rob Lewis says:

        And of course, it’s been shown that “starve the beast” never works. By hiding the true cost of government, deficit spending makes government benefits look like a bargain, and as a result we get more of them, not less.

        No less an authority than William A. Niskanen of the Cato Institute looked at history and found no sign that deficits have ever acted to restrain spending. The way to limit government is to force politicians (and voters) to pay for all the government they use, not to drive up deficits by slashing revenue.

        http://www.politicsandcurrentaffairs.co.uk/peak-oil-economics-environment/24261-starving-beast-promotes-govt.html

        According to Niskanen, the “magic number” tax level that neither increases nor decreases spending is 19% of GDP. Where are we now?


  2. jchaus says:

    The addition problem is that even if we follow the script you advocate, future Congresses will add in the same loopholes that exist now. This is what happened after the 1986 reform: rates were cut, loopholes were added later. The first Republican controlled session of 1995-6 was especially bad in this regard. I even remember reading of members of Congress justifying their special tax provisions with the claim that they had to make the code really complicated if there were to be reform. Of course, the giveaways came in the process.


  3. Tom in MN says:

    It’s not a trap, it’s a con. They have no intention of broadening the base later.


    • tom says:

      No they do hope to broaden the base, they are fuming in their britches about the 40-some percent who don’t make enough to pay income taxes, thats their base-broadener. Also, debtor’s prisons.

      My suggestion would be this:

      a) Choose a progressive distribution of effective tax rates, including EIT etc., preferably one linked to the distributions of income and wealth.

      b) Choose the overall revenue target as desired, and modify the overall tax rate without changing the distribution.


      • Tom in MN says:

        They will go after the non-payers in the first step of lowering the tax brackets. Making sure the tax code is regressive is not something they would put off. I think the Ryan budget already has this feature, while it leaves unspecified any closing of loop holes to raise the amount of taxes collected.

        Your suggestion makes too much sense to even get discussed.


  4. procopius says:

    I don’t understand why this even needs to be said. It’s so obvious that “Lower the rates, broaden the base” is a flat-out lie that I can’t think why it needs to be discussed. The Republicans do not care about the deficit. That’s a total sham. Dick Cheney expressed it perfectly. They believe “Reagan proved deficits don’t matter,” and I’m sure when they’re laughing over their drinks together at night they think it’s absolutely hilarious that people really believe their screams about how American is broke (it isn’t) and the deficit will destroy growth (it won’t). I can’t believe the Democrats who are playing along with this believe it either. I think they just want cover so they can destroy Social Security and please their paymasters. There is no chance of following this program. This is presented as if we were dealing with people making serious proposals, and we are not. We either are dealing with real lunatics (the Ron Paul pseudo-libertarians) or utterly cynical used-car salesmen who have totally different goals.


  5. perplexed says:

    What gets measured gets done. The entire motivation for “tax expenditures” and reductions on the revenue side is concealment. It only works because we voluntarily go along with it. If economists started with the whole pie (including monopoly give-a-ways) and then showed the distributions of all government largesse, the chafe would disappear and we could then have a real discussion about who pays, who benefits, and by how much. Apparently economists benefit too much from the existing reporting system or they would participate in the clarification instead of the obfuscation of where the “government welfare” really goes.


  6. Alex Blaze says:

    One would almost think that the entire goal of “broaden the base/cut rates” is really to make the tax code more regressive while reducing revenues so that there’ll be a justification for cutting spending in the future.


  7. K. Hellauer says:

    Let’s try this first.

    Neither Congress nor the President does anything about the federal marginal tax rate reversion that will occur on January 1, 2013. Nothing. No meddling, no Simpson-Bowles, nada.

    We thus return to the Clinton era rates. That brings in about $3.7-4 trillion in revenues, wiping out most if not all of the deficit. It will also take a nice slice out of the inequality pie, as the money that billionaires and millionaires have had to flood the airwaves with anti-Democratic propaganda goes back to the government coffers.

    Once we’ve settled the deficit issue, which is supposedly so pressing, and we have money to get our economy humming again, we can talk about tax reform, but then ONLY as Professor Bernstein suggests it here.


    • perplexed says:

      Now this sounds like a great first step!

      NYU’s Edward Wolff estimates the U.S. wealth GINI to be 86.5, (http://www.levyinstitute.org/publications/?docid=1235a) a scandalously high concentration of wealth characteristic of totalitarian dictatorships in 19th & 20th century Latin America (and this is before he updates it with the latest SCF data which will no doubt raise it higher still). If we add adequate wealth and inheritance taxes to your proposed solution we can address the debt, wealth concentration, and income concentration problems simultaneously with minimal, if any, impact on spending. Its gone on long enough, we need to start discussing real solutions!


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