There's no free lunch on tax reform

Tax reform, a major component of the Simpson-Bowles Commission report, Governor Romney's economic agenda, and a recent bill passed by the House of Representatives, is gaining traction and might just be possible next year if there is sufficient political will in Washington. One key metric by which to judge any reform proposal is its ability to promote economic growth. Tax reforms can potentially affect economic growth in many ways: increased labor supply, increased savings and investment, and improvements in the allocation of capital are but three. But there is no free lunch and the more constraints - fiscal, social, or political - the harder it becomes to achieve the growth objective.

Recent discussion of Governor Mitt Romney's tax reform plan by the Tax Policy Center (TPC) focused on that plan's implications for work incentives, but that's just one factor that affects growth. Although TPC cited an article we wrote last year on the do's and don't's of base-broadening and statutory tax rate reduction, they overlooked our observation that "it is particularly important to avoid increases in the tax penalty on saving."

Unfortunately, the Simpson-Bowles plan would increase tax penalties on saving because it would raise tax rates on dividends and capital gains and narrow other savings-related tax preferences.

In contrast, Governor Romney's tax plan for individuals would lower statutory tax rates on ordinary income while leaving tax breaks for saving largely untouched. His corporate tax reform plan would further improve the allocation of capital and foster economic efficiency. Overall, the governor's plan translates into a reduced tax burden on saving and investment, which are key drivers of long-run growth.

As the debate over tax reform intensifies, our key message is this: Income tax reform can be pro-growth only if it carefully distinguishes between the right way and the wrong way to broaden the tax base.

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Alan D.
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Alex
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