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Broadening the tax base makes possible significant cuts in marginal rates
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‘What is tax reform?”
That’s the Jeopardy-like question matching the answer: “The best step the government could take now to promote growth and employment.” The Obama administration has been responding with “What are higher marginal tax rates and more stimulus?” But fundamental tax reform offers three key benefits.
First, reducing marginal tax rates on saving and investment and on work and entrepreneurship will increase capital formation and productivity, raising wages and output. Broadening the tax base and sharply lowering marginal tax rates can raise gross-domestic-product growth by a half to a full percentage point per year over a decade, according to an analysis of U.S. tax policy by economists Alan Auerbach and Kevin Hassett. A sustained economic expansion will reduce America’s high rate of joblessness.
“And the imminent expiration of the 2001 and 2003 tax cuts guarantees a big tax discussion.” — R. Glenn Hubbard
Third, tax reform is a necessary precondition for any serious national discussion of long-term deficit reduction. President Obama’s repeated calls to raise marginal tax rates on upper-income Americans call to mind the image of a dog chasing a car, then stopping to wonder what to do with it when he catches it. The near-term price of a presidential victory here would be lower growth and employment. Over the longer term, the president could not hope to raise sufficient revenue from the present tax system to fund his proposed federal spending share of GDP of 25% or more. I raise this observation not to advocate raising taxes, but to note that we cannot have a serious conversation about “taxes” versus “spending”–with an eye toward a larger state–without tax reform.
Serious national discussion of fundamental tax reform should not be difficult to begin. The Bowles-Simpson commission, the president’s own, offered one version last December. President Bush’s Advisory Commission offered two others in 2006. The Treasury Department offered a prototype for income tax reform in 1992. And numerous economists have evaluated options for transformation of the income tax or shifting to a consumption tax.
How could we accomplish tax reform in the present environment? One version, suggested by then-Treasury Secretary Nicholas Brady in a 1992 speech at Columbia Business School, would be to use a broad-based consumption tax to replace the current personal and corporate income tax systems, retaining a wage tax on very-high-income households for progressivity. Another approach is the X-tax suggested by the late Princeton economist David Bradford, combining a consumption tax with a progressive wage subsidy, which would maintain progressivity while encouraging saving, investment and growth. The Treasury Department’s corporate tax integration proposal would end the distinction between noncorporate and corporate tax systems for business income, with no deduction for interest and no taxation of interest, dividends and capital gains.
While there are many prototypes for reform to consider, they all share three features. First, broadening the tax base makes possible significant cuts in marginal tax rates. Second, business taxation is reformed to eliminate double taxation of certain types of business investment. Third, the tax code would no longer provide costly incentives for debt financing over equity financing. And if tax reform results in a consumption tax instead of a corporate income tax, depreciation for business investment would be replaced by expensing, thus further stimulating investment.
In our search for growth, investment and jobs, tax reform is the best answer. The Treasury Department is set to offer thoughts for tax reform in the coming months. And the imminent expiration of the 2001 and 2003 tax cuts guarantees a big tax discussion. Let’s hope that in this Final Jeopardy round, the Obama administration remembers the question.
R. Glenn Hubbard is a visiting scholar at AEI.
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