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As we head toward the November elections, the debate over tax reform is intensifying. The simple truth is that the tax code has become riddled with ineffective social policy objectives and narrow, distortionary economic agendas. But two challenges face lawmakers seeking to rid the tax code of political favoritism and return it to its core function of raising sufficient revenue to cover the government’s obligations. First, there are the politically powerful forces bent on protecting various tax credits and preferences even if they are detrimental to the economy. Second but equally important are the complex economic questions involved in deciding which tax preferences are most harmful and which are actually helpful and appropriate.
“The simple truth is that the tax code has become riddled with ineffective social policy objectives and narrow, distortionary economic agendas.” -Alex BrillThe Joint Committee on Taxation reports that the number of tax preferences, or “tax expenditures” as they are often called, rose from 100 in 1981 to 150 in 2003 to 250 in 2009. As more of these special preferences have been added to the tax code, more decision-making in our economy is tax-motivated rather than economically efficient. As a result, tax compliance costs have risen, the tax base has narrowed, and higher tax rates are required to collect the same amount of tax revenue.
There is no doubt that many tax expenditures need to be curtailed or repealed to create a fairer, simpler, and more efficient tax system. In fact, both President Obama and Governor Romney have shown an interest in addressing the problem of tax preferences. The President’s own commission on deficit reduction, known commonly as the Simpson-Bowles Commission, detailed an aggressive proposal to limit or repeal a wide range of current tax preferences. While President Obama has not tried to act on any of the Simpson-Bowles recommendations, at least he created the Commission.
Governor Romney’s tax plan is in many ways like the Simpson-Bowles Commission’s, but the differences are important. The Romney plan would also broaden the tax base and lower ordinary income tax rates, but it would not change tax rates on capital gains and dividends, which the Simpson-Bowles Commission would raise. Furthermore, Governor Romney proposes revenue-neutral reform while the Simpson-Bowles Commission would raise taxes as a share of GDP.
Whether Governor Romney has the opportunity to pursue tax reform as president or President Obama is given another chance, either will confront powerful interests intent on protecting their tax preferences as well as the difficult task of determining which preferences should remain and which should be curtailed or repealed.
A prime example of the first challenge would be eliminating the tax exclusion for employer-provided health insurance or curtailing the home mortgage interest deduction. Both policies severely distort the market-the former has contributed to slower wage growth, and the latter has drawn capital away from the business sector into the housing sector. However, tinkering with either, while necessary, is tough politics.
The second, more complex challenge lies in assessing which preferences should be kept in the interest of national economic health. Consider just three policies that are technically tax expenditures but serve the objective of promoting economic growth.
First, a broad-based policy: IRAs, 401(k)s, and other retirement savings vehicles are tax favored, but trying to grow the economy while discouraging savings is illogical. There is powerful evidence that these savings accounts are effective in promoting retirement savings, which is a critical endeavor given the dismal outlook for Social Security.
Second, a somewhat narrow corporate tax benefit: The research and experimentation tax credit allows taxpayers to enjoy an above-normal tax benefit for expenses incurred during the R&D process. But numerous academic studies have shown that this policy promotes societal good because absent this incentive, firms would under-invest in basic research.
Third, a policy aimed at facilitating employee ownership: S corporation employee stock ownership plans (S ESOPs) are also a deviation from a pure income tax system, but the benefits of promoting employee ownership are broad based and well established. S ESOPs drive stronger worker commitment, higher wages, job stability, and higher retirement plan contributions. Research that I recently conducted using Department of Labor data concludes that employment within a set of S ESOPs operating continuously over the last decade rose 20 percent, while the overall labor market has been roughly flat.
The bottom line is clear: broadening the tax base to remove the social and industrial policies that have eroded the tax system is a good step toward a simpler tax system that promotes more growth. But the devil is in the details. Without carefully and objectively evaluating the pros and cons of each existing tax preference, bad economic (and political) outcomes may ensue if the good is tossed out with the bad. But only if the next president makes tax reform a top priority will anything meaningful come to pass.
Alex Brill is a research fellow at the American Enterprise Institute. He was formerly the chief economist and policy director to the House Ways and Means Committee.
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