A better way? The case for a new kind of tax reform

The Congressional Budget Office’s latest update, released today, provides a snapshot of fiscal policy in the short run, the medium term, and the long run. CBO disclosed its short-term analysis in May: If automatic spending cuts and tax increases kick in as scheduled at the end of the year, the U.S. could be thrown back into recession. Meanwhile, few quibble that in the long run, demographics and the continued rapid growth in medical costs will require spending that exceeds the capacity of our current tax system.

CBO’s midterm projection, however, is more controversial. The agency warns that over the next decade, continuing temporary tax policies – in particular the 2001/03 personal income tax cuts – will lead to unsustainable levels of annual deficits and debt.

But there is nothing inevitable about this excessively glum estimate. There is a far better alternative.

What if Congress retained the level of taxation set by current law, but collected the money in a much smarter way?

Of course, Congress could just do nothing. Allowing temporary tax policies to expire as scheduled would result in small and manageable federal deficits over the next ten years. However, many aspects of tax policy implied by “current law” are problematic—most notably, the Alternative Minimum Tax would hit an additional 50 million middle and upper-middle class households by 2022.

There is a better way. In an article published yesterday in Tax Notes, Ed Kleinbard, former Chief of Staff of the Joint Committee on Taxation, and I present an alternative post-2012 personal income tax regime, the “Better Base Case”. Quite simply, the Better Base Case would raise the same level of revenue as the CBO’s current-law baseline, but in a way that addresses the most troubling aspects of reverting to the tax laws in place in 2000. Specifically, we would let the temporary tax cuts expire as scheduled under current law and then make the following changes:

1. Limit the value of personal itemized deductions to 15 percent
2. Permanently patch the alternative minimum tax (AMT)
3. Retain the child tax credit at its 2012 level
4. Tax qualified dividends at the same 20 percent maximum tax rate that applies to long-term capital gains
5. Restore the estate tax to its 2009 form ($3.5M indexed exemption and a 45% rate)

 The resulting tax system is more efficient, more equitable, and (most importantly) meets the most basic requirement of a tax system—it raises the revenue required to fund the spending needs of the federal government. If nothing else, it provides a useful benchmark against which to measure other competing tax proposals.

We recognize that the level of revenue implied by the CBO baseline is uncomfortable for many to accept. Indeed, it is more than President Obama has proposed in his annual budgets. But we argue that it represents a minimum level of revenue necessary over the next decade to meet our current spending needs. And despite hyperbolic claims to the contrary, it would not significantly impact people’s work effort, or the pace of economic growth and job creation going forward.

We also acknowledge that an abrupt transition to this new regime would be inappropriate in a still weak economy. The Better Base Case is fully compatible with policies that would provide additional temporary fiscal support, either by phasing in tax increases or pairing them with other more stimulative tax and spending changes.

None of this is to say we oppose additional and more ambitious efforts to reform the tax system. However, those discussions, along with more fundamental debates about the role and size of government, should take place in a stable and rational fiscal context. That is what the Better Base Case achieves.