Left, Right, and Wrong on Taxes

Given the furor from both the left and the right, one would be tempted to think that the initial proposal from the co-chairmen of President Obama's fiscal commission, Erskine Bowles and Alan Simpson, must offer an excellent starting point for a discussion of deficit reduction.

Indeed, it does--particularly when it comes to tax policy. America's fiscal mess is real. As Messrs. Bowles and Simpson aptly demonstrate, we are in a difficult situation in large part because we have designed entitlements for a welfare state we cannot afford. And, perhaps less obviously, they show how we have used the tax code as a vehicle for special-purpose spending that weakens both the efficiency and fairness of our tax system.

Not only are those higher rates a drag on overall growth, but because the tax preferences are often more valuable to affluent households than to poorer ones, they also make the tax code less fair.

When I left my job as the deputy assistant Treasury secretary for tax policy in 1993, I left a message on my office blackboard for my successor. I wrote, "Broaden the base, lower the rates" repeatedly until I filled the entire space. I then had it covered with wax so it could not be erased. (Yes, the government charged me for my bit of vandalism. But it was worth it.)

The Bowles-Simpson report seems to have taken that message to heart, recognizing that when we provide tax advantages to spur certain types of spending--with, say, a deduction for interest payments on home mortgages--we in turn require higher marginal tax rates to raise offsetting revenue. Not only are those higher rates a drag on overall growth, but because the tax preferences are often more valuable to affluent households than to poorer ones, they also make the tax code less fair.

This is why the two chairmen suggested that the government reduce marginal tax rates for households to a range from 8 percent to 23 percent, based on income (as opposed to 10 percent to 35 percent now). This cut in rates--which should promote job creation, entrepreneurship, saving and investment--would be made possible by limiting many of the deductions that make the tax code so complicated and often inequitable.

The loopholes proposed for elimination or at least reduction include not just the mortgage-interest deduction, but also exemptions for charitable contributions and for employer-provided health care subsidies, as well as the earned-income tax credit. (It's worth noting that the Bowles-Simpson plan does allow for some flexibility: Congress could add back deductions and exclusions it feels are vital, but at the expense of higher marginal rates.)

The co-chairmen also wisely propose a cut in the corporate income tax, which holds back both investment and wages, reducing it to 26 percent from 35 percent. This cut shouldn't actually require much in terms of offsetting revenue, as research from the Organization for Economic Cooperation and Development suggests that the new level would not be far from the "revenue-maximizing" rate.

This is not to say the commission's proposal is ideal. For one, it missed a chance to make better, more radical changes to the revenue system--like a shift to a consumption tax rather than taxing incomes. My greatest concern, however, is that the plan is more about "principal" (cutting federal debt) than about "principle" (what we want taxes and spending to accomplish).

To meet the nation's fiscal challenges, we need to refocus our economic activity--primarily with less reliance on consumption and more on investment and exports. The Bowles-Simpson plan to cut marginal tax rates and the corporate tax would help. But their proposal to treat capital gains and dividends, which are now taxed at favorable rates, as ordinary income would not; in fact, it would hamper saving and investment. And the proposed increase in gasoline taxes seems designed simply to plug a budget hole, not to spur energy innovation.

What of the critics on the left and right? I understand the complaints of liberals. The proposal essentially claims that maintaining a broad welfare state is inconsistent with planning for a long-run fiscal trajectory that includes economic growth and social insurance. This idea is anathema to Democratic Congressional leaders. The proposal also lays bare the fallacy on the left that any lowering of marginal tax rates is necessarily "tax cuts for the rich." The plan's limits on tax deductions and cutbacks in the generosity of entitlement benefits for upper-income households render the plan a progressive reform.

The right's criticisms are more puzzling. Groups like Americans for Tax Reform insist that any member of Congress who supported the proposal would be voting for a tax increase. It is hard to share the view that no tax increase of any sort can figure in a fiscal solution. The proposal calls for taxes and spending to be capped at 21 percent of gross domestic product, which, while higher than I might design, is a serious suggestion worthy of debate.

Second, it is not reasonable to argue that there is no single activity that can face higher taxation. If the economy must pivot toward investment and exports, tax policies must be changed to encourage productive investment over consumption.

Two cheers for this first draft of our economic future. If President Obama embraces its structure and Republicans embrace the tradeoffs it presents, the proposal will begin a discussion that, one hopes, will end in fiscal sanity and economic growth.

R. Glenn Hubbard is a visiting scholar at AEI.

Photo Credit: iStockphoto/alexsl

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