A Plan for Mr. Paulson

Sunday, June 4, 2006

IN ACCEPTING President Bush's invitation to serve as Treasury secretary, Henry M. Paulson Jr. is said to have extracted a promise that he will be more than just a salesman for policies devised in the White House. So the big question is: How will Mr. Paulson use his clout? He is not going to reverse the administration's tax cuts; unfortunately, neither he nor Mr. Bush has any appetite for that. He is unlikely to tackle entitlements; unfortunately, congressional Democrats showed in last year's Social Security fight that they will frustrate any such effort. But if Mr. Paulson really has authority to push sound policy regardless of any misgivings of political operatives in the White House, he should focus on tax reform. Done right, this could be good for economic growth and for social equity. Indeed, it could correct the central failings in the administration's economic record: its indifference to long-term budget deficits and to the accumulating evidence that a rising tide no longer lifts all boats.

The goal of tax reform is to rationalize the deductions that clutter the tax code. There are tax incentives to encourage saving for retirement and education; to promote home ownership; to buy medical and life insurance; to own municipal and local bonds; to give to charities. Not all these tax breaks achieve what they are supposed to: Britain and Australia have no subsidies for home ownership in their tax codes, yet Britain has the same rate of home ownership as the United States and Australia has a higher one. But besides being sometimes ineffective, tax incentives are often scandalously regressive. According to the Congressional Joint Committee on Taxation, in 2004 more than 55 percent of mortgage-interest subsidies went to taxpayers with an income of $100,000 or more, even though that group represents only 12 percent of tax filers.

Tax incentives to buy health insurance are also egregious. In 2004 the 12 percent of households in that $100,000-plus group pocketed 27 percent of the tax breaks for health spending. These subsidies cause people who would buy health insurance anyway to choose overly inclusive Cadillac plans, which in turn fosters indifference to medical prices; the resulting boost to health inflation puts insurance beyond the reach of some lower-income workers. According to Treasury estimates, the ranks of the uninsured could be reduced by 1 million to 2 million if Cadillac plans lost their privileged status. Capping tax deductions for health insurance at around $11,000, a level sufficient to purchase an ordinary family plan, would simultaneously prevent affluent workers from shortchanging the Treasury by overspending on doctors.

Tax incentives to promote retirement savings cry out for reform also. In 2004, 49 percent of subsidies for IRAs, 401(k)s and other defined-contribution pensions flowed to the richest one-tenth of households, according to analysis done by the nonpartisan Tax Policy Center; the bottom two-fifths got only 3 percent of the subsidy. This upside-down system, in which savings incentives are directed at the people who least need them, is economically inefficient as well as socially unfair: Affluent households capture the subsidies by putting money they would have saved anyway into tax-favored accounts, so national savings are unchanged. Meanwhile households that are not saving don't get an adequate incentive to do so: A chance to boost national savings is squandered.

Badly designed tax breaks are not a marginal problem. Taken together, incentives in the tax code reduced federal revenue by a stunning $730 billion in 2004, according to the Government Accountability Office . That's the equivalent of nearly one-third of federal spending; it's more than three times the cost in 2005 of all the Bush tax cuts and seven times the annual cost of the wars in Iraq and Afghanistan. Eliminating just a quarter of these subsidies would generate twice as much money for redistribution as an increase of 5 percentage points in tax rates for the richest 1 percent, a measure we proposed in a previous editorial in this series.

Of course, some tax breaks either cannot or should not be eliminated, but they should at least be reformed. Many take the form of deductions: Taxpayers subtract privileged types of spending from their income before calculating what tax they owe. The value of these deductions depends on your tax bracket: The richer you are, the higher your bracket and the more valuable the tax subsidy. Converting these deductions into refundable credits that are worth the same to all taxpayers would reduce inequality sharply. Thus a poor family that pays no income taxes currently gets no tax subsidy if it puts, say, $2,000 into a retirement plan, whereas a rich family in the 35 percent tax bracket gets a federal subsidy of $700. Under a recent proposal that replaces deductions with credits, both families would get $600.

This sort of reform ought to attract support from both parties. Republicans should favor curbing wasteful subsidies because the alternative is higher tax rates. Democrats should seize the chance to refashion a regressive class of government programs and thus counter the forces of technology and globalization that are deepening inequality. Judging by the administration's rhetoric, which includes a number of creative claims about the progressive impact of the tax cuts, it should embrace both arguments for reform. Opposition will come from special interests that benefit from tax loopholes -- real-estate developers, mortgage lenders, health insurers and so on.

Those special interests have a powerful voice in politics, which is why the Bush administration has yet to act on last year's sensible proposals from its own tax-reform commission. But now, at least according to the spin from the administration, there is a brand-new Treasury secretary with the power to push serious policy ideas. We look forward to discovering whether that spin has substance.

This is the sixth editorial in an occasional series on inequality. Previous editorials in the series may be found athttp://www.washingtonpost.com/inequality.

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