June 12, 2011

GIVE FORMER Minnesota governor Tim Pawlenty partial credit. While other candidates for the Republican presidential nomination have talked in general terms about getting the economy moving again, he is the first to lay out a comprehensive policy, which he calls “A Better Deal.” While his “big positive goal” of 5 percent yearly growth is wildly unlikely, it at least optimistically leavens the Republicans’ grim discourse about budget cutting. And when he calls for slashing the corporate tax rate in return for eliminating loopholes, Mr. Pawlenty is embracing a concept that enjoys support, at least in principle, across the political spectrum.

For the most part, though, his “Better Deal” departs from the promising realism and candor Mr. Pawlenty displayed in calling for a phaseout of ethanol subsidies and trims to Social Security. He proposes a two-rate individual income tax system, with a top rate of 25 percent instead of today’s 35 percent — without specifying offsetting cuts in big tax expenditures such as the mortgage interest deduction. On top of that, he would eliminate the capital gains tax, the dividends tax, the interest income tax and the estate tax.

But how is the government supposed to finance itself after these tax cuts — half of which would accrue to people who earn $500,000 per year or more, according to the nonpartisan Tax Policy Center? Mr. Pawlenty assumes that 5 percent annual growth over 10 years would generate $3.8 trillion in additional revenue. Even if that miracle occurs, he would still need another $3.8 trillion to pay for the cuts, according to the Tax Policy Center. Budget cuts will do the trick, Mr. Pawlenty says, contrary to political reality.

Our current tax code, obviously, is far from ideal, and one of its flaws is that the top ordinary income rate of 35 percent is 20 points higher than the 15 percent rate on dividends and capital gains. This gap is the result of tinkering with the tax code by both Republicans and Democrats; President Obama has himself favored a zero capital gains rate for certain small-business investments. But no matter who’s responsible, differential tax treatment of capital gains gives top earners a big incentive to seek them — either through productive investment that creates jobs or through tax shelters and other gimmicks that create jobs for accountants and lawyers.

By increasing the difference between the top income rate and the capital gains rate to 25 points, Mr. Pawlenty would compound this wasteful market distortion. Indeed, since the top corporate rate would drop to 15 percent under his plan — 10 percentage points less than his proposed top rate on ordinary income — high earners would also have an incentive to incorporate and declare erstwhile ordinary income as business profit.

This is the opposite of fairer, simpler taxation. We’re all for slashing rates and consolidating brackets but only if the tax base is simultaneously broadened. That’s the sound concept behind the Simpson-Bowles deficit reduction commission’s approach to individual taxes (and, to be sure, in Mr. Pawlenty’s corporate proposal). Lower rates, broader base was also the guiding principle of the tax reform law of 1986, which taxed ordinary income and capital gains at the same top rate, 28 percent. The president who signed it into law was Tim Pawlenty’s political hero: Ronald Reagan.