Unique Opportunity Is at Hand for Far-Reaching Federal Tax Reform

Published July 1, 2008

For the first time since 1986, the stars may be aligning for a grand bipartisan compromise on fundamental federal tax reform.

Regardless of who wins in November, the next president and Congress will have to deal with the collision of two cataclysmic tax events: The 2011 expiration of the Bush tax cuts and the growing irritation of the Alternative Minimum Tax (AMT).

The seeds for compromise lie in the fact that both sides have something to gain by addressing these problems at once. Naturally, Republicans want to avert the largest tax hike in history by maintaining the lower tax rates on income, capital gains, dividends, and married families with children. Meanwhile, Democrats will be brought to the table by the fact that the AMT is largely a Blue State problem, mostly affecting those living in high-tax and high-income states such as California, Massachusetts, New Jersey, and New York.

43 Million Pay Nothing

The first land mine is the distribution of the tax burden itself. The 2001 and 2003 tax cuts knocked millions of lower-income people from the tax rolls. When Bill Clinton left office, some 29 million tax filers had no income tax liability after they took advantage of their credits and deductions. Today, the number of “non-payers” has grown to more than 43 million, or one out of every three Americans who file a tax return.

And since so many lawmakers see the IRS as a giant ATM dispensing “refundable” credits, such as the Earned Income Tax Credit, it will be very difficult to convince them to support fundamental tax reform.

With the nation’s tax burden now so concentrated at the top–the top 20 percent of taxpayers pay about 86 percent of all the income taxes–any tax reform plan is caught in a rhetorical Catch 22; tax reform equals “tax cuts for the rich.” Enter land mine number two: AMT and the interests of Democrats.

Although the vast majority of households affected by the AMT earn between $100,000 and $500,000, Democrats have masterfully positioned it as a middle-income issue. Wrapping fundamental tax reform around AMT reform could inoculate the debate from the predictable class warfare diversions.

Considering these land mines, how do we craft a politically realistic tax reform plan?

Step 1: Eliminate tax exemptions and deductions.

More than 80 percent of the benefits of these tax deductions flow to households earning more than $80,000, and more than half of the benefits flow to those making more than $118,000.

Eliminating these deductions would solve several problems. It would free up dollars for marginal rate cuts to keep effective rates down, and it would add greater simplicity and equity to the tax code.

Affluent taxpayers may be the initial beneficiaries of these tax exemptions and deductions. But in the end, the real economic subsidies flow to well-heeled interest groups such as the housing industry, state and local governments, and public employee unions.

In particular, the state and local tax deduction allows local politicians and school districts to shift as much as one-third of the cost of any tax hike along to Uncle Sam–and thus other taxpayers.

Step 2: Make any tax reform a tax cut and tax simplification.

Next, one must recognize that tax cuts will always generate more support than a revenue-neutral tax shift. A 2007 Tax Foundation/Harris Interactive Poll found about half of all American adults would give up their credits and deductions for an across-the-board cut in their income tax rates.

The repeal of deductions, as outlined above, would fund significant marginal rate cuts. However, the task of mobilizing the other half of Americans who said they were not sure or who rejected the idea will require the sweetener of a lower tax bill as well as the promise of a simpler 1040 form.

Step 3: Continue to shield low-income earners with a super-deduction.

Politicians are not likely to put the non-payers back on the tax rolls by shrinking the value of the personal exemption, standard deduction, or child credit. With the political consensus that some low-income people should be protected from income taxes, the practical solution is to collapse the various credits and deductions into a super-deduction that accomplishes what current policies already do inefficiently: Eliminate the income tax bill for a family of four earning up to about $42,000.

Continuing to protect low-income taxpayers in this way will help earn goodwill from the left without actually creating any new programs.

Step 4: Make everyone a stakeholder.

An ideal plan would take this process a step further (as did the 1986 act) by slashing all tax rates equally, giving every taxpayer a stake in the reform. Better yet, the plan could condense the number of brackets to no more than two, as existed in 1988.

Such a tax code would be simpler, fairer, and closer to the kind of efficiency economists have long called for. It would reduce the compliance costs for families and small businesses. It would almost certainly strengthen the American economy and help move the tax code back to its proper purpose of revenue-raising and away from its current distorted function of social policymaking.

Step 5: Fend off the special interests.

None of this is to say that fundamental tax reform will come easily or cheaply. With absolute certainty, every interest group and lobby will line the halls of Congress demanding their interest have protections carved into the new legislation. Advocacy groups of every stripe will take to the airwaves bemoaning the plight of their specific interest. They will scream that this new tax bill will evict people from their homes, leave children hungry on the street, and force seniors into destitution.

Of course, like most cries from special interests, none of this would be true. What would be true is that the United States would enjoy one of the best and most effective tax systems the world over. The new tax code would still show compassion for the poor and take a hefty chunk from the rich, while becoming considerably more fair and equitable.

Scott Hodge ([email protected]) is president of the Tax Foundation. An earlier version of this essay appeared in the February/March 2008 issue of The Ripon Forum, www.riponsociety.org. Reprinted with permission.