Obama May Tackle the 800 Pound Gorilla—Tax Reform
Business + Economy

Obama May Tackle the 800 Pound Gorilla—Tax Reform

President Obama’s decision to embrace tax reform signals the start of a long and contentious debate over a cumbersome, loophole-ridden and globally uncompetitive U.S. tax code that leaves the nation with huge structural deficits even when unemployment is low.

While enacting a major overhaul of the federal tax code in the next two years would be daunting, the president signaled that he may include elements of tax reform in the budget he will propose to Congress next February. At the press conference last week where he lashed out at liberals in Congress who are balking at voting for the tax-cutting stimulus plan hammered out with Republican leaders at the White House, Obama said, “I don’t think anybody thinks the tax code right now is fair or efficient.”

Obama followed up by ordering Treasury Secretary Timothy Geithner to review the options and repeated his intent to pursue reform in an exclusive interview to National Public Radio on Thursday. “The general concept of simplifying — eliminating loopholes, eliminating deductions, eliminating exemptions in certain categories — might make sense if, in exchange, people's rates are lower,” he said. “That may end up being a more efficient way of doing business.”

That approach mirrors proposals contained in the report issued early this month by the National Commission on Fiscal Responsibility and Reform, which won votes from some Republicans and Democrats on the panel. But there are huge political challenges that must be surmounted before Congress overhauls the tax code.

Reform inevitably involves raising taxes on some people and businesses while lowering them for others. Eliminating common deductions like payments made on home mortgage interest and the exclusion of health insurance benefits from taxation would change the rules of the game for major sectors of the U.S. economy, whose firms individually and collectively deploy small armies of lobbyists in Washington to defend their interests.

Reform also pits deficit hawks, who want to use the tax changes to raise additional revenue and reduce the deficit, against conservative Republicans,  who usually can be counted on to oppose any tax plan that doesn’t “starve the beast,” a phrase first uttered by President Ronald Reagan in 1981 to describe a tax-slashing plan that he hoped would limit the size of government by reducing tax collections.

On the other side of the political spectrum, liberals fear reform because they see it as a backdoor strategy for undermining social programs that benefit the poor and middle class and entitlement programs that help everyone, like Medicare and Social Security.

Leaders from both political parties say they are willing to discuss tax reform. For instance, Rep. Dave Camp, R-Mich., the  incoming chairman of the House Ways and Means Committee, told the Tax Council in mid-November that “tax reform is an important part of deficit reduction because while an efficient tax code can ensure the government has the money it needs with as little drag on the economy as possible, a broken tax code that impedes growth will fail to generate sufficient revenues even if spending is cut dramatically.”

But the political calendar isn’t hospitable to a serious effort over the next two years. The president’s initial embrace of reform took place at a press conference where he was defending the deal he and congressional GOP leaders negotiated that would insert a raft of new tax breaks into the code. The tentative agreement, which awaits congressional action, angered liberals by rewarding wealthy taxpayers, and frustrated deficit hawks by adding nearly $900 billion to the nation’s long-term budget outlook.

 With those tax breaks due to expire in two years, the table is set for a repeat of this year’s debate over the Bush-era tax cuts – but next time Obama will be in the midst of a presidential election campaign. “The conventional wisdom is that tax reform can only happen in the second term of a popular president,” said Martin Sullivan, a contributing editor at Tax Notes who previously helped craft the nation’s tax policy while on Capitol Hill, at the Treasury Department and as a corporate tax lobbyist. “It would certainly be difficult under current conditions, where there is so much partisanship.”

The goal of tax reform is to eliminate loopholes, broaden the tax base, and lower overall rates.  This goal has only been achieved once in the past half century. The 1986 tax reform law, signed by Reagan, is considered a model for tax reformers, since it lowered rates by eliminating corporate tax loopholes, many of which had been opened up when he first came into office.

In fact, Reagan signed three major tax increases after the massive 1981 tax cut – raising corporate, fuel and Social Security taxes. There was also a raft of smaller tax increases during his eight years in office.  Those set the stage for the 1986 law, which achieved lower rates but was close to revenue neutral.

The law, which was championed by centrists from both political parties, including Democratic Sen. Bill Bradley and Republican Sen. Bob Packwood, lowered rates by closing numerous corporate loopholes. That angered large parts of the business community while winning plaudits on the left.

“I thought it was a good thing,” recalled Robert McIntyre, executive director of Citizens for Tax Justice, a liberal advocacy group. “The complaint of my colleagues at the time was, why should we lower rates while closing loopholes. I said we could raise the rates later on to raise revenue [which happened under President Bill Clinton in 1993]. I won a few bets on that,” he said.

But the huge budget deficit confronting the nation over the next decade makes a revenue neutral tax reform bill undesirable. “The broader question is how we can talk about tax reform while fixing the budget,” said Donald Marron, director of the Urban-Brookings Tax Policy Center.

He remains mildly optimistic that something can get done in the next two years. “American history shows that leadership by elected officials, particularly the president, can cause things to happen,” he said.