3 Dangerous Myths About 'Revenue-Neutral' Tax Reform
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By Andrew Fieldhouse,
The Fiscal Times
June 21, 2013

In its drive to deliver tax reform this year, Congress seems intent on simply refashioning a new version of the Tax Reform Act of 1986. This would be a serious mistake.

The basic approach of the 1986 act was to broaden the tax base and lower tax rates. “Broadening the tax base” refers to eliminating or curbing tax expenditures, such as deductions, exclusions, credits, exemptions and preferential treatments of investment income — changes that would subject more gross income to taxation. The 1986 reforms paired such base-broadening with marginal rate reductions so that the total effect was both revenue-neutral and distributionally neutral, meaning that average tax rates would remain roughly unchanged across the income spectrum.

The emphasis on lowering tax rates is strikingly pervasive in today’s discussion. For example, the Moment of Truth report by National Commission on Fiscal Responsibility and Reform co-chairs Erskine Bowles and Alan Simpson; the report of the Bipartisan Policy Center’s Debt Reduction Task Force led by Alice Rivlin and Pete Domenici; and the U.S. Senate “Gang of Six” budget blueprint all have proposed variations of the “broadening the tax base and lowering rates” framework that would raise modest amounts of revenue. House Ways and Means Committee Chairman Dave Camp (R-MI) and House Budget Committee Chairman Paul Ryan (R-WI), meanwhile, have endorsed revenue-neutral tax reform in name, but have identified only their preferred lower tax rate structure without any of the base-broadening changes to pay for it.

Myth 1: Lower Tax Rates Always Lead to Stronger Growth

This fixation with cutting tax rates is largely based on the false premise that lower marginal rates are always a powerful spur to economic growth. Yet recent economic research on behavioral responses to taxation, as well as historical and cross-country regression analyses of top tax rates and macroeconomic performance, suggest that these alleged growth effects are widely exaggerated by supply-side advocates. Economic analyses have found that post-war decreases in top tax rates have had a statistically insignificant impact on overall economic growth and driving factors, including labor supply, productivity, and savings.

Another problem with the 1986 model is that revenue-neutral tax reform is not an elixir for the factors hampering our current economic recovery. Lower tax rates implemented as part of revenue-neutral tax reform might, to a slight extent, boost long-run potential growth by giving workers a bit more incentive to enter the labor market, or to work longer hours. Even so, these supply-side effects cannot generate real traction until the demand shortfall constraining our economy has been addressed. Under current conditions – with aggregate demand running $1 trillion below noninflationary potential output – increased labor supply simply will not boost economic output. And if the forthcoming reform is designed to leave the distribution of taxes where it is stands, just as the 1986 act was meant to do at the time, the changes would have no impact on this near-term demand shortfall.

Myth 2: Higher Tax Rates Can’t Raise Much Revenue

The false premise that low tax rates are a big spur to growth correspondingly suggests that higher rates won’t raise much revenue because they will choke off growth. But modern economic research similarly refutes this belief.

The best estimates of behavioral responses to taxation suggest the revenue-maximizing income tax rate is 73 percent (combining federal, state, and local taxes), implying that policymakers could raise the top statutory federal income tax rate to roughly 66 percent—more than 26 percentage points above the prevailing 39.6 percent rate—before maximizing revenue. This is not to suggest setting the top income tax rate to maximize revenue, merely that there is considerable room to raise tax rates without unduly hindering productive economic activity. And some research suggests that higher rates could have a big impact in slowing market-based growth in income inequality.

What economists know but Congress seems to ignore is that base-broadening tax reforms that reduce the opportunities for tax avoidance would actually strip some inefficiencies from the existing tax rate structure and further increase the revenue-maximizing top marginal rate. High-income households would have less ability to avoid taxes by shifting the form or timing of their compensation. With fewer opportunities to “game the system,” as it were, the behavior of those high income earners wouldn’t change as much in response to higher rates. Contrary to the dominant paradigm in Washington, this means base-broadening tax reforms and higher marginal rates should be seen as complements, not substitutes — diametrically opposed to the 1986 model.

Myth 3: Fewer Tax Brackets Are Better

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Some tax-reform advocates ascribe additional benefits to another aspect of the 1986 reform: what they call “pro-growth tax simplification,” broadly taken to mean compressing the number of tax brackets along with reducing rates. The 1986 reforms cut and compressed 15 tax brackets down to five. While there can be real efficiency gains from broadening the tax base to curb avoidance, there are no comparable efficiency gains strictly from compressing the individual income tax schedule, say from seven brackets to two as Camp and Ryan propose. Most tax complexity stems from calculating taxable income after exclusions, deductions and exemptions as well as credits against taxes owed, not applying the progressive rate structure to taxable income.

Well before the advent of tax return software, citizens managed to navigate a much longer schedule of marginal tax rates; the tax code had between 24 and 26 marginal rates between World War II and 1978. While the income distribution has become markedly more skewed since this period, the tax code has been compressed in the opposite direction, with the inflation-adjusted taxable income cutoff for the top tax rate falling from roughly $3 million in the 1950s to $1 million in the 1970s, to under $400,000 for the last two decades.

Because the number of brackets is itself unrelated to efficiency and there is great scope for higher tax rates without substantially hampering growth, base-broadening reforms should be complemented by adding new tax rates at higher taxable income thresholds so the rate structure better matches the income distribution (as opposed to raising the top tax rate while holding its taxable income threshold at $450,000 for joint filers).

What Tax Reform Should Really Accomplish

So, misconceptions about behavioral responses to lower tax rates have vastly overhyped the benefit of revenue-neutral tax reform, and 1986-style tax reform is a flawed template running contrary to modern economic theory and research. But the opportunity cost of revenue neutrality and political allure of distributional neutrality also imprudently disregard economic context.

The dual challenges of addressing long-term fiscal sustainability and marked income inequality growth necessitate that reforms raise more revenue and restore diminished progressivity of the tax code, rendering 1986-style reform unviable. Short of reneging on the nation’s commitments to ensuring health care for the elderly, poor, and disabled, Congress must realistically raise substantially more revenue than projected under current policy — an outlook largely shaped by the Bush-era tax cuts and essentially unchanged by the lame-duck budget deal. Beyond improving the fiscal outlook, higher top marginal tax rates and a more progressive tax code would push back against pre-tax and post-tax income inequality growth, respectively.

The debate over revenue targets remains so contentious that it may preclude a modern comprehensive tax overhaul. But should it advance, Washington’s overarching tax reform blueprint would only lock in inadequate revenue levels and exacerbate inequality while failing to spur recovery or substantially accelerate long-run economic growth.