A Four-Step Plan

This is the second installment in a series about the two keys – Medicare reform and tax reform – to a comprehensive agreement to solve the budget problem.  These commentaries will explain the details of the two issues, and show where it is that each political party – the Democrats and the Republicans – must give ground to resolve this crucial issue.

Last week’s post started a series on Medicare reform and tax reform as the two key elements of a solution to the nation’s budget problem – as well as important contributors in their own right to our collective well being over the long haul.  It so happens that this week there was a potentially important contribution to the debate over tax reform, which is worth a second installment in this series about these two critical issues.

Douglas Holtz-Eakin is the President of American Action Forum, which is a policy ideas shop for Republicans in Washington.  Doug served as Director of the non-partisan Congressional Budget Office, and as Chief Economist of the Council of Economic Advisers during the George W. Bush administration.  He also has a distinguished record as an academic, at Columbia University and at the Maxwell School at Syracuse University.  He is therefore a noted voice on economic policy issues.

In an address at the spring policy conference of the National Tax Association, Doug presented a simple four-step path to tax reform (click here for an account of Doug’s talk written by Howard Gleckman of the Tax Policy Center in Forbes magazine).  This approach seems to be highly constructive.  For one thing, it can rule out some dead ends to the policy process.  For another, it provides a reasonable bird’s-eye view of the process, so that people might understand more clearly what is involved.

However, it seems to me that the process that Doug lays out isn’t quite right, on the basis of either how tax reform was done in the past (in 1986), or in terms of how it could or should be done going forward.  This isn’t to quibble, but I do think that some of the details could prove important.

So let me first simply state what Doug presented, and then shamelessly plagiarize his basic approach but re-write the specifics.  Along the way, I will try to explain how this process worked in the past, and how it might work in the future, and why certain details matter – some crucially.

Here is Doug’s simple four-step approach:

1. Recognize that the United States will have a progressive tax code (as opposed to a “flat tax” with a single rate).

2. Agree on a top rate.

3. Agree on how much revenue you want to raise.

4. Eliminate or scale back the tax preferences you need to accomplish the first three.

This process would, in fact, get you to a solution: a combination of tax base (i.e., what income is subject to tax) and rates that would meet the stated required conditions – a progressive tax system that has an acceptable top-bracket tax rate and that collects a target amount of revenue.  This framework certainly is a helpful way to begin to grasp how tax reform would be debated in Washington.  It does come close to touching all of the bases of the task.

But let me try a slightly different layout that I believe is more complete, and that would be more likely to yield both a good and a politically acceptable result:

1) Agree on how much revenue you want to raise, including both the individual income tax and the corporate income tax.

The revenue target for tax reform is absolutely fundamental, and should come first.  It defined the 1986 process; Ronald Reagan set a ground rule that tax reform would have to be “revenue-neutral” or “deficit-neutral,” and that rule steered the debate.  It could be a stop-or-go criterion at the very outset for a tax reform debate in 2012 or 2013.

But this straightforward condition in 1986 encompassed one important detail that will be a part of the current debate, and another detail that went unstated then but could either facilitate the current debate or stop it in its tracks.

The first detail was that President Reagan defined “revenue” for the purpose of revenue neutrality as the sum of revenues for the individual income tax and the corporate income tax.  The two must be considered together – contrary to the contention of some in the last year or two who have suggested reforming the corporate income tax in isolation.  There are important rules that affect both taxes in ways that must be coordinated.  Just to name two among the most important, business investments in plant and equipment are depreciated at set rates over time, and those rates logically should be the same for both individuals and corporations; and the corporate tax rate and the top-bracket individual income tax rates need to be in the same general neighborhood.  Failing reasonable coordination on these (and other) scores, businesses could have reason to try to change their status between subchapter C (free-standing, generally large) corporations and subchapter S (generally smaller, “pass-through”) corporations in otherwise irrational and economically wasteful ways.  So the two taxes need to be reformed to yield sound results.

In the 1986 Tax Reform Act, President Reagan accepted a significant increase in the revenues collected under the corporate income tax, with an equal amount of revenue cut under the individual income tax.  That individual income tax cut enabled the tax reform to look much more attractive to household tax payers – that is, voters.  And as it turned out, surprisingly enough, the leaders of major corporations – the tax liabilities of which increased – were also, themselves, individual income taxpayers.  These corporate managers saw a benefit to themselves, and to their shareholders, from the overall tax reform, and therefore tended either to support the new law or to oppose it much less vociferously than they otherwise might.

The situation today is different from that in 1986.  Back then, the federal budget deficit was large, but the situation was not so dire as to rule out a “deficit-neutral” tax reform.  Now, the budget predicament rules the day.  Deficit-neutral tax reform would be a waste of time that is in critically short supply; the tax system must bring in more revenue before the unknowable but inevitable future date when the debt overflows its banks, destroying the economy.

Which raises the second, unstated but important detail of the 1986 tax-reform debate:  When President Reagan talked about “revenue,” there was no question that he meant revenue as projected under standard, “static” rules.  Today, some try to revive the old “Laffer Curve” or “dynamic scoring” argument that lower tax rates collect higher tax revenues, and vice versa.  Experience has shown that at reasonable levels such as we have today, modest changes in tax rates do not alter incentives enough to move the entire economy, and so lower tax rates will reduce revenues.  Ronald Reagan did not insist on a “Laffer Curve” scoring bonus, and arguably none should be allowed today.  However, at the very least, the choice of static versus dynamic scoring must be made up front to have a rational debate.

2) Agree on an approximate distribution among households of the burden of the taxes to be paid – which will require progressive tax rates, not a “flat tax.”

Doug Holtz-Eakin is correct that the United States needs a progressive income tax rate structure.  However, a dictum merely that rates be progressive does not go nearly far enough to establish the conditions for a successful conclusion to the process.

Any new tax system will be a prisoner of the current tax system to the degree that drastically reallocating tax obligations is not acceptable.  Surely, if some individuals are found to be abusing and manipulating the system to pay much less than is equitable, then those individuals should pay more – and good riddance.  But a slick, clever new system that significantly increases the tax liabilities of typical, middle-income families will not – and probably should not – be acceptable politically.  The everyday family with pre-determined and unalterable mortgage and car-loan bills every month, with just enough left over for the basics plus one night out with the children, cannot absorb a big hit on its tax bill.

This is why policymakers pay attention to the “distribution tables” that are produced by the tax experts in the Congress and the Treasury during the legislative process.  Some believe that such distributional analysis is manipulated as a political tool to drive toward an ever-more-progressive tax system.  To be fair, it could be.  But done properly, it merely keeps the debate within realistic bounds, and ensures that all taxpayers are treated equitably.

A guiding principle of the income tax since its modern inception in 1913 was taxation according to the “ability to pay.”  The ability to pay, of course, is in the eye of every beholder.  But the nation can have only one income tax, not one income tax to suit each taxpayer; and so the uneasy consensus on the ability to pay that necessarily guides our decisions must be judged in the democratic process.  And in a time of economic stress, with substantial unemployment and under-employment alongside conspicuous accumulations of wealth, it should not be surprising that a healthy share of the additional revenue needed to cut off the growth of the public debt will – and should – come from those with the largest incomes.

At the same time, we need a realistic view of the budget problem.  It is huge.  We cannot escape the debt pit if we give middle-income households a free pass.  A $250,000 income minimum to pay an additional sou of taxes is unrealistic; a $1 million threshold, as some suggest today, is wildly off the mark.  But this means that middle-income taxpayers will have to pay a measured additional amount, based on their ability to pay – not that they should bear the entire burden, with better-off households getting off scot-free because they are “job creators.”  Many – perhaps most, based on tax data – extremely wealthy individuals are either portfolio investors or employees at highly successful businesses such as law firms or financial institutions.  They can legitimately claim to create jobs – just as much as the middle-income persons who go to work every day, and make their employers successful.

The distribution of the tax burden, not just the tax rate in the highest bracket, will be a crucial criterion in the making of a tax-reform deal.  But the top-bracket rate will have an independent role in the process, to be discussed later.

3) Eliminate or scale back tax preferences to achieve the best possible tax base, which will increase economic efficiency, fairness, and revenue.

My item (3) is similar to Doug Holtz-Eakin’s item (4), but this is probably my most significant difference with how Doug sees the tax reform process.  Doug puts this item last:  Close those “loopholes” necessary to hit the revenue goal and the target top rate.  Done.

I see this issue very differently.  There is an ideal tax base, which entails a minimum of departures from a simple measurement of income.  You do not stop improving the tax base because you have justified a particular top-bracket tax rate, or hit a revenue target.  You go absolutely as far as you can go toward that ideal.

To put this another way, Doug’s formulation implicitly assumes almost (I exaggerate, but there is no operational difference) that there is an infinite supply of tax loopholes to close, and when you have closed enough to hit your revenue goal with a top-bracket tax rate equal to your target, you can stop.  In practice, the supply of closable loopholes is far from infinite.  You could run out of loopholes to close before you hit your revenue goal, with the top-bracket rate at the level you would wish.  Furthermore, Doug’s formulation implies that with those two goals achieved, you accept whatever distribution of the tax burden that implies – even if middle-income taxpayers are saddled with much higher burdens, and the very wealthiest households get big tax cuts.  That would not fly.

So trimming tax preferences is not the final, balancing item in the process.  Rather, that balancing item is an element that Doug’s approach missed.

4) Set the tax rate schedule, including personal exemptions, standard deductions and income-related tax credits, to achieve the prior three objectives.

The last step in the process is determining the tax rates.  This follows fairly directly from having both a revenue and a distributional constraint, and because the amount of taxable income is not determined until the tax base (i.e., the cutting of tax preferences) is finalized.  Without those prior decisions, there is no way to know what tax rates will satisfy the other objectives.  And because there is a distributional constraint, all of the tax rates, not just the top bracket, are indeterminate until the very end.

This sequencing makes sense logically looking forward, but it also is demonstrably true looking back.  The final decision in the formulation of the Tax Reform Act of 1986, just before it passed the conference committee on its way to President Reagan for his signature, was the setting of the tax rate schedule to meet the President’s revenue-neutrality requirement and to satisfy the distributional standards of the members.

There is an important sense in which decisions about the tax base and the tax rates interact, and it relates to Doug’s focus on only the top-bracket tax rate.  As noted earlier in this space (see here and here), a key decision about tax preferences is the treatment of capital gains and dividends.  Under the current tax law, income from capital gains and dividends is taxed at sharply lower rates than wages or other business income.  Persons with very high incomes receive a much higher proportion of their income from capital gains and dividends than do typical working families.  Thus, how much tax reform can reduce the top-bracket rate will depend heavily on what is done about the tax preferences for dividends and capital gains.

Doug suggests that the process essentially start by choosing a top-bracket tax rate, and then move on to decisions about tax preferences.  But I would contend that his ordering is backwards.  If we are not willing to eliminate the tax preferences for capital gains and dividends, then the top-bracket rate will have to be much higher – a truly quantum difference.  This is a key reason why I believe that the tax preference or tax base decisions, along with the decisions about revenue and distribution, must be made first.

The Bowles-Simpson National Commission on Fiscal Responsibility and Reform, for all of its good work, created a problem on this front.  The commission made no precise decision on a tax system, but presented as one of three alternatives a “zero option,” which would eliminate all preferences (or “tax expenditures”).  Under the zero option, the top-bracket tax rate could be 23 percent, and the corporate tax rate would be 26 percent.  As an educational device, this seemed helpful.  But once on the table, it has been misunderstood and misinterpreted.  Specifically, some have missed the key point that those tax rates are attainable only with the repeal of all tax preferences.  Others have assumed that a tax system with only very slightly higher tax rates would leave substantial freedom to pick and choose among tax preferences to retain, which factually would not be true.

For example, House Budget Chairman Paul Ryan’s “Path to Prosperity” budget plan declares up front that it will reduce the top-bracket individual and corporate tax rates to 25 percent, but delegates all decisions on the tax base to the Congress’s tax writing committees, at a later hour.  The plan specifies precisely how much tax revenue it will collect, however.  Clearly, there is no way to make a precise revenue forecast, even if you predetermine the tax rates, if you do not know what you are taxing.  Furthermore, with the individual top-bracket tax rate so close to the zero-preference level in Bowles-Simpson, and the corporate rate even below the Bowles-Simpson level, the Ryan plan would require the elimination of virtually all tax preferences, which is not made clear in the presentation.  Notably, the “Path to Prosperity” document cites the earlier Bowles-Simpson report as support for its recommendations.

There is a further element of confusion about tax rates that could slow or derail tax reform.  In past tax reform efforts, once the tax base was broadened as much as possible, tax rates were set as low as possible to collect sufficient revenue and meet the distributional constraint.  The presumption always has been that, once enough revenue is collected and high-income taxpayers pay the share that public consensus specifies, the legal tax rate that those high-income persons pay on an extra dollar of income should be as low as possible.  After all, the lower the statutory tax rate, the lesser the incentive to avoid tax, and the greater the incentive to work and invest in ways that pursue the greatest economic value in the marketplace.  However, some people do not understand the distinction between statutory marginal tax rates (the rate you pay on an additional dollar of income) and average effective tax rates (the percentage of total income that you pay in tax).  Those people, who tend to come from the liberal end of the spectrum, judge fairness on the basis of the marginal rate, not the average rate.

That view of taxation can yield insufficient attention to broadening the tax base in a way that promotes economic efficiency and fairness.  It can make it harder to strike a deal with low statutory tax rates that could attract otherwise hostile conservatives.  But perhaps less obviously, there can be an implicit bargaining tradeoff between lower rates and eliminating tax preferences.  When an interest group makes its case for its tax preference to survive tax reform, part of the argument tends to be that the preference is justified because overall tax rates are too high.  But if you retain that tax preference, tax rates have to go higher, and then other interest groups show up at the door to ask that their preferences be restored.  If that vicious circle is allowed to turn, before too long the tax law winds up back where it started.

Except that in the current context, the nation needs to collect more revenue – to reduce the budget deficit.  If too many tax preferences survive, we wind up with a tax rate increase, not tax reform in any meaningful sense.  The tax-rate-increase option is at the bottom of everyone’s preferred list.  So realistically, I would add a fifth step to Doug’s four-step program for tax reform.

5) Repeat the four steps above until you reach a consensus.

In 1986, the administration and the Congress iterated probably seven distinct times over more than two years.  There was the initial draft within the Reagan administration, “Treasury I;” then the administration’s official revision, “Treasury II;” the House reasonably could be said to have produced two distinct versions; the Senate clearly did (with the transition from the first to the second being the famous pitcher of beer that Finance Committee Chairman Bob Packwood (R-OR) shared with his chief of staff, Bill Diefenderfer, at the Irish Times pub on Capitol Hill); and then the conference committee melded the two bills into the version that became law.  There is no reason to expect that a tax reform as part of a budget deal today will move any more quickly – which is part of the reason why it is so hard to imagine that a “lame duck” Congress could reform the federal income tax in the less than the two months between the election and the new year in 2012.

But kudos to Douglas Holtz-Eakin for encapsulating at least each iterative round of such a process into four simple steps – simple to explain, perhaps, though the actual process may prove rather difficult.  With the friendly amendments described above, this approach could be a road map for success next year.

1 comment

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s


Get every new post delivered to your Inbox.

Join 67 other followers

%d bloggers like this: