What does tax reform really need to accomplish?

The new report on the state of tax reform begins with the premise that tax revenue is already adequate - and it's not.

During this last week of summer, I am barely keeping up with the August-recess fiscal policy news. Luckily there’s not much to keep up with. But last week the President’s Economic Recovery Advisory Board (sometimes affectionately(?) referred to as “pee-rab” (PERAB)) issued their long-overdue tax reform report. I was on a long drive to visit family in Michigan, but fortunately Dan Shaviro and Howard Gleckman, two of my favorite experts/commentators on tax policy, got right on the case and blogged on the report, right through their yawns. Both were disappointed as well as bored.

In my mind this report was always doomed to be a boring disappointment–a pretty useless rehashing of academically-noncontroversial tax reform ideas that would do little to advance the political debate in the direction it desperately needs to go. That’s because the effort began with the implicit premise that tax revenues don’t need to be raised–that what we need is revenue-neutral tax reform (raising the same level of revenue but more efficiently), when in fact the fiscal outlook makes it clear that we need revenue-gaining tax reform. Then on top of that, the PERAB was told they not only couldn’t raise taxes on average, they couldn’t raise taxes on any households with incomes under $250,000–i.e., all but the top 2-3 percent of households. This latter restriction makes it hard to do anything to address the major sources of economic inefficiency/distortions in the tax system, because people all over the income distribution currently benefit from the various and very expensive tax expenditures (”holes” in the tax base) under the current system.

As a result, the PERAB tax reform report is like the tax-side equivalent to a no-pain, “cut (only) waste, fraud, and abuse” report. It doesn’t tell it like it is in terms of what really needs to be done via tax reform to help our nation fiscally and economically. What we need to do isn’t complicated at all; it’s just kind of painful to hear. Here’s my list that is simple if not sweet:

1. Raise More Money. Raise revenues as a share of our economy above its “historical average” of 18 percent. The 18 percent figure is not the “right” number just because it’s been the average one. In fact, we need to raise it above where current-policy extended would take us (just read the CBO reports to understand why), which means we have to start thinking of tax reform as how to raise more revenue, not just the same amount of revenue, in the most economically efficient and equitable way possible.
2. Even Things Out. Raise revenues more efficiently by broadening and “leveling the playing field” called the federal income tax base. Revenue-increasing tax reform necessarily implies the overall, economy-wide average tax rate will go up–no matter how the reform is structured. But raising revenues by filling in the “holes” in the income tax base (reducing tax preferences or “tax expenditures”) keeps overall marginal tax rates low by raising marginal rates only on those forms of income that currently face very low or even zero tax rates. Raising effective marginal rates on those forms of income that are currently under-taxed would reduce rather than increase the distortionary effects of the income tax. (There are also fairness concerns that motivate such “leveling” of effective tax rates.)
3. Act European. Not in the way conservatives who oppose raising revenues/GDP warn about: those “European level (marginal) tax rates” necessary to close the fiscal gap using increases in marginal tax rates alone. I mean engage in more “European-style” taxation by taxing more things that are–if not more pleasant to tax–at least less economically harmful to tax than the things we tax now. The two prime examples I’m thinking of: (i) environmentally-harmful activities (e.g., carbon-based energy via a carbon tax), and (ii) consumption (via a value-added tax). This is really a corollary to the “even things out” directive: by adding tax bases that are more efficient to tax (in addition to broadening our existing income tax base), we can raise more revenue by leveling effective marginal tax rates across different sources and uses of income rather than simply raising marginal tax rates on the types of income or consumption that are already taxed most heavily.

The President’s tax reform panel was prohibited from uttering any of these three simple truths. I hope the President’s fiscal commission will be less constrained, because tackling the much broader task of achieving fiscal sustainability makes tax reform according to these truths even more critical to the overall mission.

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