Comprehensive Tax Code Overhaul is Overdue

By John S. Irons
Special to washingtonpost.com
Monday, April 24, 2006; 12:00 AM

The tax code is ripe for comprehensive reform. There is no doubt that many specific areas in the tax code should be simplified and improved, but as a nation we also need to pursue broader reform. Many problems in the code can only be responsibly addressed in the context of comprehensive reform, and a piecemeal approach is not sufficient as a permanent fix.

For example, analysts from across the political spectrum believe we should repeal or significantly modify the Alternative Minimum Tax (AMT) since it is a complicated parallel tax code and because it will impact a growing number of increasingly middle-class taxpayers. But repeal can be done only in the context of comprehensive reform for two reasons. First, a simple repeal would result in an enormous revenue loss-well over $1 trillion over the next 10 years. Second, repeal would likely enable very high-income individuals to avoid paying their share. AMT repeal must be done in conjunction with broader reforms that limit individual loopholes and that raise revenue from other parts of the tax code. Former Council of Economic Advisors chair Gregg Mankiw suggests the AMT might be a "Catalyst for Reform."

A second example arises from the federal government's reliance on the payroll tax. Even before the 2001 and 2003 tax changes were enacted, close to 80 percent of taxpayers paid more in payroll taxes than in federal income taxes. For low- and middle-income taxpayers, over 90 percent paid more in payroll taxes. Since payroll taxes are assessed on the first dollar of wage income and since there is a cap on the amount of income subject to the tax, the payroll tax is regressive- those with low and moderate incomes pay a higher percentage than those with incomes above the cap. A comprehensive reform should look at integrating the payroll tax into the rest of the tax code so as to make the entire code more progressive.

The successful 1986 tax reform efforts, and subsequent inaction on reform, showed us that perhaps the only way, politically, to significantly broaden the tax base is to couple the elimination of deductions with savings on marginal rates. Simply calling for the removal or limitation of politically popular (or special-interest backed) tax breaks cannot be done in the absence of other sweeteners.

Putting these elements together, along with other needed reforms, would make the tax code fair and easier to understand.

An important question that arises when considering comprehensive reform is whether broad reform ought to be revenue-neutral. Some believe that from a political standpoint, only revenue-neutral proposals have a chance in Congress since the "winners" and "losers" from reform roughly balance out. According to this logic, any revenue-raising reform would create more "losers" and would thus have a harder chance at passing.

However, with large and persistent deficits adding to other economic risks, we have no choice but to find ways to increase the amount of revenue that the tax code brings in. We cannot simply grow our way out of the deficit, and even former proponents of the "starve the beast" strategy for limiting spending are admitting defeat.

Comprehensive reform, if done right, can couple reforms with revenue enhancements so as to minimize the impact on low- and middle-income taxpayers. Higher-income taxpayers- who have received disproportional benefits from Bush's recent tax changes and who are seeing the greatest benefits from the current economy- ought to bear a substantial burden of any deficit reduction plan.

The 1990s showed us that deficit reduction and economic growth can be mutually reinforcing. By reducing the deficit we would be expanding national savings, encouraging private sector investment and enhancing overall economic growth. A comprehensive, revenue-raising reform would thus be good for the nation's economy as well as individual taxpayers.

Given the current political climate (and the fact that it is an election year), it is hard to see how any comprehensive reform could make it through Congress in the near future. Further, it takes significant analysis, expertise and political skill to broker a comprehesive reform. In shelving the Tax Reform Panel's final recommendations- and by abandoning tax reform more broadly- the Bush administration does not seem willing to put in the effort.

The administration has largely followed the "five easy pieces" approach to tax reform -- an incremental march of the tax code towards a flat tax that leaves capital income untaxed. This approach has, predictably, left the tax code in pieces.

The bottom line is that we need a fiscally sound tax reform in order to improve the tax code to meet coming fiscal challenges; including those that will arise from an older population and the resulting revenue demands from Social Security and Medicare. This means reversing the tax cuts for those at the top, ensuring that hard work is rewarded and making the tax code work for low- and middle-income taxpayers, not against them.

In the spirit of short-term pragmatism, there are a couple of changes that could be pursued immediately to improve the nation's fiscal health. Both policies should find broad-based bipartisan support.

" Close the tax gap. It is estimated that well over $300 billion per year is lost due to noncompliance. A recent poll found that 79 percent of respondents viewed "not reporting all income on your taxes" as morally wrong. It's hard to determine how much of this gap could be recovered, but providing the IRS with additional resources and retargeting enforcement activities would be easy first steps. A simplified tax code would likely yield higher compliance rates and easier enforcement as well.

" Restore effective budget process provisions, including a balanced PayGo rule. The PayGo budget rules that existed in the 1990s helped to enforce budgetary restraint on both the spending and the tax side. The process also needs to be changed to ensure that the budget reconciliation process is used for deficit reduction only, and can no longer be used to fast track deficit-increasing tax changes, as has become the norm. While process changes are unlikely to solve the entire fiscal problem, they are an essential element in formulating good policy. Unfortunately, many of the process changes being considered by Congress would do more harm than good- why not stick with what worked in the 1990s?

Some right-wingers in Congress claim that PayGo is not needed for tax legislation since, supposedly, "tax cuts pay for themselves." Despite their insistence, there is ample evidence and general expert agreement that they do not. (Fed Chair Bernanke recently wrote that "under normal conditions, tax cuts do not wholly pay for themselves.") The Right's rhetorical flourish is the fiscal equivalent of the used-car salesman's pitch: "the more you spend the more you save!"

John S. Irons, Ph.D., is the director of Tax and Budget Policy at the Center for American Progress.


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