1. Tax reform has bipartisan support.
The night he was reelected, President Obama said “reforming our tax code” was among his second-term priorities. A few days later, House Speaker John Boehner said tax reform could help solve the national debt.
Don’t be fooled. Republicans and Democrats mean different things when they talk about tax reform. Republicans are much more interested in lowering rates than in closing loopholes. During his presidential campaign, Mitt Romney said he would slash individual income tax rates by 20 percent across the board but was noncommittal about what tax breaks he’d scrap. When Obama says he’s for tax reform, he’s talking about limiting the value of deductions for the wealthy to 28 percent of their income. He has yet to propose lower tax rates and wants to raise them for the top 2 percent.
The two parties also have different ideas about which loopholes to eliminate. Obama, for example, wants to cap, but not eliminate, the tax break for charitable giving. His stimulus expanded the tax credit for college education, and he wants to make that permanent. Republicans generally want to protect lower rates for capital gains and dividends.
2. Eliminating tax breaks could raise more than $1 trillion a year in revenue.
To prove that there’s plenty of money available to lower rates, tax reform advocates such as the bipartisan Simpson-Bowles deficit commission often cite the annual cost of tax breaks as $1.1 trillion. One study by the nonpartisan Congressional Research Service (CRS) estimated that eliminating all those tax breaks would generate enough revenue to lower the top rate from 39.6 percent to 23 percent.
But that same study noted how hard that would be. Most people benefit from some kind of tax break, making them very popular. Ending them would be administratively difficult and politically treacherous. Some are part of the social safety net, such as the earned income tax credit and the child tax credit, which benefit lower-income workers and families, as well as the exclusion of most Social Security benefits from taxation, which helps the elderly.
Other breaks encourage things most Americans approve of: charitable giving, saving for retirement and homeownership. The mortgage-interest deduction cost $75 billion in foregone tax revenue in 2011, but it’s also immensely popular — 33 million households claimed it, according to the nonpartisan Tax Policy Center. Real estate agents, home builders and mortgage bankers would fight fiercely to preserve it.
After considering all these constraints, the CRS study concluded that it would be hard to gain more than $150 billion a year by eliminating tax breaks.
3. The 1986 tax overhaul is a good road map for reform.
“There’s a model for tax reform that supports economic growth,” Boehner said recently. “It happened in 1986, with a Democratic House run by Tip O’Neill and a Republican president named Ronald Reagan.”
Unfortunately, the very success of that act limits its use as a model. Reagan’s priority was to lower the top income tax rate, and he succeeded, bringing it to 28 percent from 50 percent. That option is no longer on the table; Obama has all but ruled out lowering the top rate. The only question is: Will it go up, and if so, by how much?
The 1986 reform also eliminated some of the most egregious distortions in the tax code, such as abusive tax shelters and the deductibility of interest on consumer loans, such as credit cards. So today there is less low-hanging fruit.
The overhaul was also meant to be revenue-neutral, meaning that every dollar raised by eliminating tax breaks went back to taxpayers in the form of lower rates. Because reducing the deficit is now the priority, tax reform would have to raise substantially more revenue, producing more losers and fewer winners, which makes the politics of reform much tougher.
4. Fixing personal, not corporate, taxes is the priority.
With the George W. Bush-era tax cuts about to expire,negotiators are consumed with figuring out what rates individuals should pay and which of their tax breaks should be tossed out. Corporate taxes have been an afterthought. And that’s a shame, because they’re in far greater need of an overhaul than personal taxes.
After the 1986 reform, the corporate tax rate in the United States was well below the international average. Since then, nearly every other industrialized country has lowered its rate, and the U.S. rate of 39.2 percent (including state and local taxes) is now the highest in the industrialized world. This gives multinational firms an incentive to shift profits and perhaps operations out of the United States. Indeed, corporate taxes raise less than they should because companies are so adept at sheltering profits abroad and exploiting domestic tax breaks.
Unlike with personal taxes, Obama and the GOP broadly agree on how to reform corporate taxes: Eliminate those breaks and use the revenue to lower the rate. Obama proposed doing just that earlier this year, though he has barely mentioned it since. It could become part of broader negotiations next year. It wouldn’t be easy; corporations would fight tooth and nail to keep their breaks. But the economic payoff would be bigger than with personal tax reform.
5. Tax reform would be great for the economy but is politically impossible.
Advocates of tax reform can turn giddy extolling its benefits. Advisers to Romney, for instance, said his plan would boost economic growth by 0.5 to 1 percentage point a year. That was pretty unlikely. More impartial analysis suggests that ambitious tax reform would, at most, boost growth by one- or two-tenths of a percentage point. Neither Reagan’s nor Bush’s tax cuts discernibly lifted the country’s long-run potential growth. The reason is simple: Taxes have a much smaller influence on growth than do human capital, innovation and the vicissitudes of the business cycle.
The political benefits of tax reform may be larger than the economic ones. Republicans have caved on Obama’s demand that taxes on the rich increase. In return, the president would be smart to agree with Republicans that taxes should rise in the least harmful way — through tax reform rather than jacking up rates, which at the margin dampens investment and encourages tax avoidance. That approach holds the best chance of producing a tax system that both sides will live with, rather than spending the next decade as they did the last, trying to tear down what the other party erected.
Greg Ip is the U.S. economics editor of the Economist and the author of “The Little Book of Economics: How the Economy Works in the Real World.”
As the nation’s leaders seek to keep the country from heading over the “fiscal cliff” — a set of mammoth year-end tax increases and spending cuts — nothing has proved more contentious than taxes. President Obama wants the rich to pay more; Republicans want to keep tax rates where they are. One popular proposal is to eliminate the tax code’s hundreds of loopholes and use the money to reduce the deficit without raising rates. But while tax reform is wonderful in theory, in practice it might not be as politically palatable — or economically effective — as advertised.