Tax Reform: Obama is Walking into the Neutrality Trap

Tax Reform: Obama is Walking into the Neutrality Trap

Iva Hruzikova/The Fiscal Times

In his State of the Union address, President Obama called on Congress to enact tax reform. Republicans all applauded because to them tax reform is just another excuse to cut taxes. However, their response was muted when he said that any tax reform legislation must be paid for by getting rid of loopholes and cutting spending through the tax code.

No one denies that there are many aspects of the tax code desperately in need of reform. The problem is that Republicans refuse to talk about anything except further cutting tax rates. But the idea of tax reform has always meant much more than that. It also means getting rid of tax preferences that bias individual and business behavior in ways that may not be optimal for them or the economy. In other cases, tax preferences simply waste money subsidizing people and businesses for no reason except that they belong to some politically favored group.

A key goal of tax reform must be to rid the tax code of unjustified tax preferences. The goal, which Republicans used to believe in, should be to achieve tax neutrality. This basically means that people and businesses should make economic decisions based solely on the economics and not because the tax system in effect subsidizes them to do one thing rather than another.

Perhaps the best example is the exclusion for employer-provided health insurance. This is clearly part of workers’ compensation, but they pay no taxes on it, while their employers are still allowed to deduct the cost. This makes $1 of health insurance far more valuable than $1 of cash wages, which is a key reason why health costs have risen so much; workers treat health care like something that’s essentially free.

Once upon a time, long ago – 2008 to be exact – Republicans like Sen. John McCain actually campaigned on getting rid of the health insurance exclusion as an essential element of health care reform. He argued, quite correctly, that there is little hope of getting health care costs under control unless the demand for it is reduced. The best way of doing so is by encouraging people to be more cost-conscious, which they would be if they paid health costs out of their own pockets. If the revenue now being lost to the health insurance exclusion were instead used to fund expanded Health Savings Accounts – a sort of Individual Retirement Account from which health costs can be paid – then workers would benefit financially from reducing their own health care spending.

Unfortunately, this sensible proposal got deep-sixed when Democrats initiated health care reform. Republicans quickly concluded that their political fortunes would be maximized by simply opposing whatever the Democrats were for without putting any alternative on the table. Those few Republicans who were willing to say that this was misguided, that Republicans had a responsibility to put forward legislation that embodied their vision of health reform, were completely ignored. One, David Frum, was fired by the Republican-leaning American Enterprise Institute for saying so publicly. Another, Senator Robert Bennett of Utah, was denied renomination by Republicans in his state because he co-sponsored a health reform bill with Sen. Ron Wyden, Democrat of Oregon.

Something similar is now happening with tax reform. Republicans claim they are for it, but they steadfastly refuse to name a single existing tax provision that is worth getting rid of; they are only for tax rate cuts and that is the sum total of their contribution to the tax reform debate. Their rationale, apparently, is that eliminating any tax loophole, no matter how egregious or unjustified, would constitute a tax increase; and they are against all tax increases, period.

The other factor in Republicans’ thinking is just cynical politics – they are for the sugar of rate cuts, but it is the sole responsibility of Democrats to come up with the medicine of actually reforming the tax code by proposing revenue offsets to pay for the rate cuts. Grover Norquist, president of Americans for Tax Reform and the man who, more than anyone else, lays down the Republican line on all tax issues, told me this when I asked him about coming up with offsets to pay for tax reform: “I recommend taking the corporate rate to 25 percent. The Dems can suggest tax hikes if they believe they need to ‘make up’ revenue. That is a bipartisan division of labor.”

The political trap is obvious. Any actual reform that would increase revenue will be relentlessly attacked by Republicans as a tax increase and they will quickly send out fundraising letters to whatever group or industry is affected, requesting campaign donations to prevent the Democrats from raising their taxes. No mention will be made by Republicans of the idea that the reforms would be coupled with tax rate reductions in a revenue-neutral manner that neither raises nor lowers net tax revenue in the aggregate. Unfortunately, this strategy will doom any hope of tax reform. No Democrat is going to put forward any revenue-raisers under these circumstances.

I questioned a number of Republican tax experts on whether they would name a single existing tax preference worth getting rid of. None were forthcoming. The only reform any of them would name is cutting tax rates, although all proclaimed themselves willing to replace the entire tax system with some comprehensive, idyllic reform with zero chance of enactment.

This was not always the Republicans’ philosophy. Back in the 1980s, they were perfectly willing to put the repeal of specific tax preferences on the table to pay for tax rate reductions. For example, my old boss Rep. Jack Kemp teamed up with Sen. Bob Kasten on a tax reform plan that would have gotten rid of the Investment Tax Credit and most other tax credits, the deduction for state and local income and sales taxes, the deduction for consumer interest, and other politically popular provisions of the Tax Code at that time.

Subsequently, Ronald Reagan endorsed many of the reforms in the Kemp-Kasten bill, as well as others, and sent a proposal to Congress in May 1985 that embodied both base-broadening reforms – i.e., tax increases – along with tax rate cuts in a revenue-neutral package. Today’s Republicans, it seems, don’t have Reagan’s wisdom, courage or fortitude; they only want what’s politically popular, especially with the Tea Party crowd.

Despite the unwillingness of Republican tax experts to name names and offer any potential reforms to pay for still more tax cuts, here are a few to get the ball rolling.

Deduction for Domestic Production Activities. This provision of the tax code was enacted by Republicans in 2004 to encourage domestic manufacturing. According to the Treasury Department, it costs more than $10 billion per year. But I can find no evidence that it has done anything to encourage domestic manufacturing activity. It’s really just a gift to manufacturing companies for what they would be doing anyway. And even if it did spur manufacturing, there’s no reason why the tax code should subsidize it. As noted earlier, a core principle of taxation is neutrality, which is clearly violated by this tax provision. To the greatest extent possible, all industries should be treated equally.

Tax Subsidies for Energy Production. There are a vast number of these in the tax code. Collectively, they reduce federal revenue by close to $20 billion per year. In a recent study, Tufts University economist Gilbert Metcalf concluded that energy tax subsidies, which constitute 75 percent of federal support for energy, contribute almost nothing to national security and increase consumption of fossil fuels by lowering their cost. Other studies have found that energy subsidies raise the cost of corn and bias technological development and investment away from that not favored by the Tax Code.

Special Tax Treatment of Carried Interest. Usually when one earns ordinary income it is taxed at regular income tax rates, which can go as high as 35 percent. But for some odd reason, a big part of the income of hedge fund managers is taxed as if it is actually capital gains at a maximum rate of 15 percent. It’s hard to find a tax expert who will defend this provision of the tax code unless they have been paid to do so by the Private Equity Council, the trade association for hedge funds. Unbiased tax experts mostly agree with University of Illinois law professor Victor Fleischer, who says the special tax treatment of hedge funds “is no longer a tenable position to take as a matter of sound tax policy.” This tax provision costs the Treasury about $3 billion per year and the benefits accrue almost exclusively to the obscenely wealthy.

Depending on one’s philosophy, there are a vast number of other tax provisions that could be considered unjustified either under the liberal idea of a comprehensive income tax or the conservative ideal of a consumption-based tax system. Space prohibits a listing of them, but both the Treasury Department and the Joint Committee on Taxation compile comprehensive lists of so-called tax expenditures that are considered deviations from basic tax principles. The latest Treasury list will be included in the administration’s budget, which will be released next month.

In my opinion, anyone who talks about tax reform without being willing to support tax neutrality and eliminate unjustified provisions from the tax code should be ignored. Any organizations that claim to take seriously the idea of tax reform, such as Norquist’s group, ought to be willing to put some actual reforms on the table and not play stupid political games by pretending it is the exclusive responsibility of Democrats to propose offsets to the obsessive Republican demand for tax cuts no matter how large the budget deficit.

I am not holding my breath waiting for the first responsible Republican to do what Reagan, Kemp, Kasten and others did in the 1980s and put together a tax package that includes specific revenue raisers to pay for further rate cuts. And pie-in-the-sky reforms that would abolish every tax preference in exchange for a flat rate don’t count because there is not the slightest chance such a radical change will ever be enacted. The best we can hope for is incremental improvement along the lines of the Tax Reform Act of 1986, which was a truly bipartisan effort. But that’s not going to happen if Republicans insist on playing by Norquist’s rules.