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Tax reform and the fiscal cliff

With the ongoing negotiations around the fiscal cliff — what taxes can we raise? what can we cut instead? — we’ve pulled a brief excerpt from Taxes in America: What Everyone Needs to Know by Leonard E. Burman and Joel Slemrod. When heated debates over taxation roil Congress and the nation, a better understanding of our tax system is of vital importance.

Taxes have always been an incendiary topic in the United States. A tax revolt launched the nation and the modern day Tea Party invokes the mantle of the early revolutionaries to support their call for low taxes and limited government.

And yet, despite the passion and the fury, most Americans are remarkably clueless about how our tax system works. Surveys indicate that they have no idea about how they are taxed, much less about the overall contours of federal and state tax systems. For instance, in a recent poll a majority of Americans either think that Social Security tax and Medicare tax are part of the federal income tax system or don’t know whether it is or not, and more than six out of ten think that low-income or middle-income people pay the highest percentage of their income in federal taxes. Neither is correct.

Thus, there is a desperate need for a clear, concise explanation of how our tax system works, how it affects people and businesses, and how it might be made better.

Should tax reform and deficit reduction be separated?

One critical point in the current debate about tax reform is whether it should be revenue-neutral. Some argue that it should be so as to follow the successful blueprint laid out in 1986. Also, many advocates of revenue-neutrality object to tax increases on principle. But some counter that our long-run budget problems are so severe that more revenues will be needed and potentially tying tax reform to lessening future debt burdens could be an effective strategy.

We side with those who think more revenue will be needed and that tax reform should be part of a revenue-raising, deficit-reducing plan. The two go together in that raising revenue is less damaging if done with a more efficient tax system. As discussed below, the Bowles-Simpson deficit reduction plan and the proposal by the Bipartisan Policy Center’s Debt Reduction Task Force both followed this approach. They would eliminate many tax expenditures to finance income tax rate cuts, as in 1986, but reserve some of the revenue gains for deficit reduction. The BPC plan cut fewer tax expenditures, but would introduce a new VAT to augment federal revenues.

Are there some sensible tax reform ideas?

Sure. President George W. Bush put together a blue ribbon panel to propose fundamental tax reform, and they came up with two alternative packages that would have each been simpler and more efficient than the existing tax code. One option would have radically simplified the tax code by eliminating many tax expenditures and converting many of the remaining tax deductions to flat credits. One insight of the Bush tax reform panel was that while tax experts view the standard deduction as a simplification—because people who do not itemize don’t need to keep records on charitable contributions, mortgage payments, taxes, and so on—most real people think it’s unfair that high income people can deduct those items while lower income people can’t. The proposal would have dispensed with itemization.

The “simplified income tax” under the Bush panel’s scheme would have reduced the number of tax brackets and cut top rates, eliminated the individual and corporate alternative minimum tax, consolidated savings and education tax breaks to reduce “choice complexity” and confusion, simplified the Earned Income and Child Tax Credits, simplified taxation of Social Security benefits, and simplified business accounting. The alternative “growth and investment” tax plan would have lowered the taxation of capital income compared with current law—somewhat similar to Scandinavian dual income tax systems.

The Bipartisan Policy Center Debt Reduction Task Force contained a tax reform plan aimed at simplifying the tax code enough so that half of households would no longer have to file income taxes. That plan would create a new value-added tax and use the revenue to cut top individual and corporate income tax rates to 27 percent.

President Obama empaneled another commission, commonly called the Bowles-Simpson Commission (after its two heads) with the mandate to reform the tax code and reduce the deficit. (The Bush panel had been instructed to produce a revenue-neutral plan.) The commission failed to achieve the super-majority required to force legislative consideration, but a majority supported the chairmen’s blueprint. Bowles-Simpson would have eliminated even more tax expenditures than the BPC Task Force, allowing substantial tax rate cuts without the need for a new VAT or other revenue source.

Senators Ron Wyden (D-OR) and Dan Coats (R-IN) produced a more incremental tax reform plan, designed to be revenue-neutral and preserve the most popular tax breaks. It would eliminate the AMT and cut the corporate tax rate to 24 percent while capping individual income tax rates at 35 percent. The cost of these provisions would be offset by closing or scaling back various tax expenditures. The proposal would raise tax rates on high income taxpayers’ long-term capital gains and dividends from 15 to 22.75 percent. It would revise the formula the federal government uses to adjust tax parameters for inflation, generally cutting the revenue cost of annual inflation adjustments. The plan would also reduce businesses’ interest deductions. It would consolidate and simplify individual tax breaks for saving and education. The most radical process change is that the plan would require the IRS to prepare pre-filled tax returns for lower-income filers.

Columbia law professor Michael Graetz has an even more sweeping proposal.6 He proposes to raise the income tax exemption level so high that 100 million households would no longer owe income tax. To make up the lost revenue a new 10 to 15 percent VAT would be enacted. Only families with incomes above $100,000 would have to file an income tax return. The plan would also substantially simplify the income tax for those few who continued to file, but the main simplification would be to take most households off the income tax rolls entirely. (However, households would still have to supply information to claim new refundable tax credits aimed at offsetting the regressivity of the VAT.)

Leonard E. Burman and Joel Slemrod are the author of Taxes in America: What Everyone Needs to Know. Leonard E. Burman is Daniel Patrick Moynihan Professor of Public Affairs at Maxwell School of Syracuse University. Joel Slemrod is Professor of Economics in the Department of Economics and the Paul W. McCracken Collegiate Professor of Business Economics and Public Policy in the Stephen M. Ross School of Business, at the University of Michigan.

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Image credit: Macro shot of the seal of the United States on the US one dollar bill. Photo by briancweed, iStockphoto.

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