Tax reform is going to be really, really hard

August 10, 2012

Last week, I wrote about the nonpartisan Tax Policy Center’s effort to run the numbers on Mitt Romney’s base-broadening, rate-lowering tax reform plan. The numbers, as you may have guessed, didn’t add up. And that’s not just a problem for Romney. It’s a problem for anyone committed to the idea of tax reform.

As polarized as Washington is over tax and budget issues, a base-broadening, rate-lowering tax-code overhaul has become the one policy every wonk in town can agree on.


Think tax reform will be easy? Think again. (Photo: Andrew Harrer/Bloomberg)

It formed the core of the Simpson-Bowles deficit-reduction plan, as well as the Domenici-Rivlin proposal. It was the cornerstone of the supercommittee’s failed negotiations. It has been talked up by Sen. Max Baucus, the top Senate Democrat on tax issues, and by Rep. Dave Camp, the Republican who heads the tax-writing House Ways and Means Committee. Romney, President Barack Obama and House Budget Committee Chairman Paul Ryan have all endorsed the idea. But in being all things to all kinds of politicians, it might, as the Tax Policy Center convincingly argues, amount to nothing at all.

A bit of explanation is in order. “Base-broadening and rate-lowering tax reform” involves cutting deductions, loopholes, and sundry other “tax expenditures” in order to lower marginal tax rates and/or raise more revenue. The possible benefits are many: It reduces complexity in the tax code; offers policy makers an opportunity to wipe out tax breaks and giveaways that have outlived their purpose; and permits politicians to raise taxes even as they look to be cutting them.

Perhaps most importantly, it provides cover for Republicans to end policies that look a lot more like spending than like tax cuts -- former Federal Reserve Chairman Alan Greenspan has argued that tax expenditures should be classified as spending -- and allows Democrats to sell the result as a tax increase. That makes it a possible way out of the impasse over taxes in Washington: Perhaps Democrats and Republicans who can’t agree on what to do with the Bush-era tax cuts can find common ground in root-and-branch reform of the code.

That’s the hope, anyway. But hope, as they say, isn’t a plan. And in a study released July 10, four of the Tax Policy Center’s scholars -- Hang Nguyen, James Nunns, Eric Toder and Roberton Williams -- showed just how hard it will be to come up with a road map for tax reform, even one that doesn’t include Romney’s implausible targets.

The trouble is that just as tax reform offers a slew of benefits and political possibilities that simply raising taxes doesn’t, it also presents a slew of technical and political difficulties that simply raising taxes doesn’t. The Tax Policy Center’s paper points to five of these.

The first is that as you lower rates, the various deductions and loopholes you are looking to cut become worth less money. If you cut rates by 20 percent, you wipe out about 20 percent of the value of deductions. That makes it harder to pay for your tax plan, much less to raise new revenue with it.

The second problem is that it can be politically difficult to cut tax breaks. If you listen to Democrats, you would think these benefits mainly accrued to corporate jet owners and oil companies. But if you are going to seriously lower rates -- not to mention raise any revenue -- you’re talking about cutting or eliminating the deduction for home-mortgage interest, charitable contributions, state and local taxes and employer-provided health insurance. These are, by and large, regressive, but they are also widely used by the middle class, and exceedingly popular. And even when you are going after oil companies, those guys have really good lobbyists, and they are much more committed to retaining their tax breaks than the rest of the public is to eliminating them.

The third problem is that it’s very hard to retain progressivity in the code while attempting this kind of reform. That’s what tripped up Romney: His promised cuts for the rich are simply larger than the tax preferences they currently receive. But a more reasonable plan that cut rates more modestly and also raised new revenue would probably find itself in similar trouble quite quickly. And when “tax reform” starts being accurately portrayed as a “middle-class tax hike,” it stops sounding so sweet to politicians.

The fourth problem is that the bigger the tax reform, the slower you have to move. Wiping out the mortgage-interest deduction tomorrow would throw the housing market into chaos. Ending the tax exclusion for employer-provided health care would lead to employers dropping coverage for millions of workers. These kinds of changes will need to be phased in slowly so the affected sectors have time to plan and adjust. But the more gradually they take effect, the longer it is until we see the benefits of tax reform, be they more revenue or a simpler code.

The fifth is that vast swaths of tax expenditures are essentially off-limits. In 2015, and assuming no changes in policy, the Tax Policy Center estimates that the tax code will contain $1.5 trillion in deductions, exclusions, loopholes, and so on. But a third of these will be tax preferences for saving and investing, which Republicans have said they oppose changing. An additional 10 percent is made up of extremely progressive policies that help children, the poor and the elderly, and Democrats will fight like hell to retain these measures. And a further 17 percent comes from a category of miscellanea, much of which would be very difficult to change, like the exclusion of imputed rent on owner-occupied housing.

The closer you look at base-broadening, rate-lowering tax reform, the less it looks like an exception to the normal rules of Washington policy making and the more it looks like it will inevitably fall victim to them. It is clean and elegant when imagined by technocrats who don’t worry about the politics, clear and simple when endorsed by politicians who omit the crucial details, and likely to become polarizing and disappointing if it is actually taken up by Congress.

Indeed, over the last week we’ve seen how superficial the commitment to a fairer, flatter tax code really is: Sen. Marco Rubio has proposed, and Obama has endorsed, a new tax break so Olympians won’t pay any taxes on their prize money.

In their conclusion, the study’s authors note that there isn’t even the barest hint of an agreement between the two parties as to an acceptable target for revenue, a necessary first step for tax reform. So we are nowhere near the point where we can start working out the details of how to broaden the base and how far to lower the rates. But if we ever get there, the authors write that those details “might be the most difficult hurdle of all.”

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williamsm | August 10, 2012