A New Bad Proposal: Lose Tax Breaks, Lower Tax Rates
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The Fiscal Times
December 3, 2010

A couple of weeks ago, the co-chairmen of the National Commission on Fiscal Responsibility and Reform, Alan Simpson and Erskine Bowles, released a draft report, updated this week, that contained an odd provision for a document that was supposed to be solely concerned with deficit reduction. It was a proposal to fundamentally restructure the federal income tax system by broadening the tax base and slashing tax rates. Simpson and Bowles would eliminate $1.1 trillion in so-called tax expenditures and reduce the top income tax rate from 35 percent to just 23 percent under one option.

Conservatives have been giddy ever since because there is nothing in the world that excites them more than cuts in tax rates. The flat tax has been the Holy Grail of conservative tax policy since at least the early 1980s. They even got pretty close to it in 1986, when Ronald Reagan succeeded in getting the top statutory income tax rate down to 28 percent. (His hand-picked successor, George H.W. Bush, quickly undid Reagan’s work and agreed to an increase in the top rate to 31 percent in 1990. Needless to say, the tax expenditures that were eliminated as part of the 1986 deal were not restored.)

Unfortunately, this obsession with statutory tax rates has blinded conservatives to two elements of tax policy that are substantially more important. The first is the tax base – what is taxed by the tax system. The second is the effective tax rate – the rate that actually applies once various adjustments have been made to gross income – exemptions, exclusions, deductions, credits and so on. Effective rates can vary substantially from those that nominally apply to a given income and are the ones that really matter for incentives. According to a recent study by the Tax Policy Center, even among the top one percent of taxpayers, effective income tax rates vary from 2.6 percent for those in the bottom 10 percent (of the top one percent) to 26.9 percent among the top 10 percent (of the top one percent).

The exclusion for health insurance wasn’t a carefully
thought-through issue that Congress considered in
terms of its impact on federal revenues or health policy.

It may surprise people to discover that nowhere in tax law is the basic term “income” defined. In practice, it basically means cash flow, but the Internal Revenue Service is not constrained from taxing noncash income. In many cases, it is simply historical practice and the constraints imposed by its limited resources that keep it from taxing many types of income. The most obvious is the exclusion for employer-provided health insurance. It’s obviously a form of employee compensation, but is completely tax free. Employers deduct the cost as a business expense, just as they deduct cash wages, but although workers pay taxes on cash wages they are required neither to report nor pay taxes on their health benefits.

Interestingly, the exclusion for health insurance wasn’t a carefully thought-through issue that Congress considered in terms of its impact on federal revenues or health policy. It came into existence in 1943 because wage and price controls prevented employers from increasing cash wages to attract workers at a time when there was a significant labor shortage. They began offering noncash benefits as part of their compensation and the IRS – no doubt to its everlasting regret – decided that health benefits were not taxable to employees as an administrative measure.

In other cases, court decisions have limited the government’s ability to tax certain forms of income. Probably the best example is unrealized capital gains, which the Supreme Court ruled to be nontaxable in a 1920 decision. Only realized gains may be taxed, it said, thus giving investors sole discretion on how and when to recognize that particular form of income.

Tax theorists don’t even agree exactly what income is. The dominant definition is one that is far broader than that which applies in practice. It was developed by two economists, Robert M. Haig and Henry Simons, who defined it as consumption during the course of a calendar year plus the change in net worth. Thus unrealized capital gains would be taxed annually, as well as many other forms of currently untaxed income. Theoretically, this would include not only things like health benefits, but even the imputed rent that homeowners pay to themselves by virtue of being both landlord and tenant in their own house. In 2009, imputed rent added more than $1 trillion to personal income according to the Commerce Department.

How one defines income will have enormous consequences
for the calculation of effective tax rates, incentive and fairness.

Many economists have long objected to the overly broad definition of income proposed by Haig and Simons, as well as the adverse economic consequences if it were applied in practice. The great economist Irving Fisher argued strenuously that consumption alone is the most appropriate tax base, and almost all economists agree that the full taxation of saving and investment would be a bad idea because it would reduce economic growth.

Bruce Bartlett’s columns focus on the intersection of politics and economics. The author of seven books, he worked in government for many years and was senior policy analyst in the Reagan White House.