Talk of tax reform is in the air. And no wonder. A good tax system should raise enough revenue, do so while interfering as little as possible with the efficient operation of the economy, and redistribute income in accord with society's concept of "fairness."
Unfortunately, our federal tax system now scores poorly on all three criteria.
Revenue: A few years ago, raising revenue was not a problem. At least when the economy was operating at high employment, the tax system generated enough revenue to pay the government's bills. Now there is a yawning gap between high-employment expenditures and receipts -- the so-called structural deficit.
We all know the origins of the structural deficit: President Reagan's tax-cutting program reduced federal receipts at high employment from about 21 percent of gross national product in 1981 to about 19 percent today, opening up a structural deficit that is now over $100 billion and is expected to go much higher.
Inefficiencies: The basic commandment of sound taxation in a market economy is: Thou shalt distort economic incentives as little as possible. Where income taxation is concerned, this translates, roughly, into a commandment to tax all sources of income at the same rate, and to make this rate as low as possible.
That low tax rates distort incentives less than high ones is clear to everyone. Some economic activities (such as taking leisure time) are taxed at a zero rate. If other activities (such as working for pay) are taxed at high rates, people will be encouraged to shun the highly taxed activities (working) and pursue the untaxed ones (leisure). Hence, if we want the tax system to distort patterns of economic activity as little as possible, we should strive to keep tax rates low.
Precisely the same reasoning shows that taxes on different types of income should be made as equal as possible. Suppose the government taxed income earned on Mondays at a 40 percent rate, but taxed income earned on Tuesdays at only 10 percent. A tremendous incentive to shift income- earning activities to Tuesdays from Mondays -- either in fact or via fictitious paper transactions -- would be set up. What a wonderful way to throw a monkey wrench into the market economy.
Yet that is more or less what is done by our current personal income tax code when it offers preferentially low tax rates to capital gains and to scores of different types of "sheltered" income; when it allows tax deductions for certain favored types of expenditures; when it fails to adjust interest income and capital gains for inflation; and when it exempts certain types of saving from taxation but taxes others at high rates. (Your accountant can surely add more things to this list.) People are encouraged to do the things the tax man favors, and to shun the things he penalizes -- regardless of the underlying productivity of these actions.
The corporate tax code is even worse. Because depreciation schedules bear little resemblance to true economic depreciation, different investments are taxed at wildly different rates. For example, Professors Don Fullerton and Yolanda Henderson estimated that the effective tax rate is 41 percent on industrial buildings, but minus 7 percent on ships. Differentials such as these can only encourage overinvestment in ships and underinvestment in industrial buildings. And to what social purpose? The answer is: none.
Redistribution: On the old-fashioned view that taxes should redistribute income in the same direction that Robin Hood did, the tax system is now doing a worse job than it used to. The principal facts seem to be these:
1.Over the long haul, the federal tax burden has shifted away from taxes on capital and toward taxes on labor. For example, in 1950, the corporate income tax raised 34 percent of federal tax revenue while the payroll tax raised only 11 percent. By 1983 these percentages were 7 percent for the corporate tax and 37 percent for the payroll tax. Little John would have been displeased.
2.More recently, the Reagan tax cuts reduced the share of the progressive personal income tax in total federal taxes -- from 47.8 percent in 1980 to 45.6 percent in 1983. This might offend Friar Tuck's sense of fairness.
3.The 1981-1984 income tax cuts enriched the wealthy, but offered essentially nothing to low-income families, whose payroll taxes were rising rapidly. Meanwhile inflation continued to erode the real values of the two items that shield the poor from the income tax: the $1,000 personal exemption and the $3,400 standard deduction. Will Scarlet might turn red.
What to Do: This brings us back to tax reform. The broad outlines of the necessary reforms are clear. We need more revenue. We need to equalize tax rates on different activities. And, if we agree with Robin Hood, we need to halt the erosion of the progressivity of the tax system.
To me, these considerations all point to a thoroughgoing reform of the personal and corporate income taxes that would give us fewer loopholes and more revenue, but would maintain graduated rates.
The Bradley-Gephardt proposal has many of these features. If enacted, it would leave us with graduated tax rates (though not as graduated as those we have now), would drastically reduce (though not eliminate) tax differentials among different economic activities, and, by broadening the tax base, would allow us to raise more revenue with lower tax rates.
Now, as always, the tax reformer's battle cry should be: "Broaden the base, lower the rates."