America's Fiscal Future Hinges on Tax Reform
Business + Economy

America's Fiscal Future Hinges on Tax Reform

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However the U.S. presidential election turns out, the trifecta of the Bush tax cut expiration, the debt limit ceiling on the horizon once again, and the congressionally mandated sequesters - cuts in domestic spending - will force the president and Congress to wrestle with fiscal issues, either in a lame-duck session after the election or in early 2013. The decisions they make will have profound impacts on America's fiscal future.

For many observers, the central question on the table is about entitlement programs: What will be done with them? Growth in entitlement spending associated with our aging population and its rising healthcare costs is the major factor in overall federal spending growth. But the capacity of near-term policy changes to have large impacts on that spending is less than many would suppose. The rising ratio of retirees to workers means that Social Security benefits at current levels will not be sustainable without some kind of tax increase. Sooner or later, revenue will have to rise or else outlays will have to be curtailed. While it is surely better to act sooner, the reality is that, out of necessity, action on entitlements is inevitable.

While almost everyone agrees on the desirability of containing federal healthcare spending, this is likely to be more difficult than we'd like to believe. Certainly, beneficiaries can bear more of the cost of their government insurance than others, and there are steps like malpractice reform and the further encouragement of preventive medicine that should be taken. Yet without intrusions into the private healthcare system that are unlikely to be politically acceptable, there are severe limits on what can be done.

Otherwise, the result will be unacceptable cuts in the availability of care for the clients of federal programs. Given all the uncertainties associated with new technologies, changing lifestyles, and ongoing changes in the private system, healthcare reform will and should be a continuing project.

But let's place healthcare aside for now. Less discussed in the context of major deficit reduction is tax reform. For a variety of reasons, 2013 should be the year when the tax code is overhauled in a substantial way.

First, the United States will need to mobilize more revenue. This year, the federal government will collect less than 16 percent of GDP in taxes - far below the post-World War Two average. The combination of an aging society, rising health care costs, debt service costs that will skyrocket whenever interest rates normalize, a still-dangerous world in which our allies' defense spending is falling even as that of potential adversaries rises rapidly, and a growing fraction of the population unable to hold steady work means that in all likelihood federal spending will need to be larger, not smaller, relative to GDP in the future.

Raising marginal corporate rates or increasing individual rates beyond their Clinton-era level raises serious issues about incentive effects or encouraging tax-shelter activities. Raising rates is, in any event, unlikely to be politically feasible. A much better strategy for raising necessary revenue would start from the premise adopted by the Simpson-Bowles bipartisan commission that tax expenditures are a form of government expenditure and presumptively should be cut back unless they can be justified.

Second, the current tax system is, in certain ways, manifestly unfair at a time of rising inequality. As is well recognized, America's rich have gotten richer, with the top 1 percent's income share rising from the 10 percent range to the 20 percent range over the last generation, while middle-class incomes have stagnated or worse. There is plenty of room for debate about the causes of rising inequality, and the extent to which reducing inequality should be a central objective of government policy and about the possible disincentive effects of excessively progressive taxes.

But there are fairly expensive aspects of the current tax system that favor the most fortunate - aspects that border on the indefensible. Recent political debates have pointed to loopholes that permit a few of the very fortunate to accumulate tens of millions of dollars in a tax-free IRA when almost everyone else is constrained by a $2,000 contribution limit. Can the observation that Ireland, Bermuda, and Luxembourg are three of the five jurisdictions where the U.S. corporate sector earned the most profits reflect anything other than rampant tax sheltering? Anyone who doubts this should ponder the fact that in 2007, U.S. corporate profits in Bermuda totaled 646 percent of Bermuda's GDP.

The treatment of profit incentives paid to investment operators who make no investment of their own money but simply receive the "carry" as they invest other people's money is another example of an inappropriate provision.

These examples and many others are not only significant because of revenue the government could recoup while also making the tax system fairer. They matter because they illustrate the power of special interests to shape fundamental aspects of economic policy. Reform could be an important step toward rebuilding citizens' confidence in the federal government, which is sorely lacking today.

Third, even while raising too little revenue and giving much away to various shelter efforts, the current tax system also manages to excessively burden economic activity. Corporate rates at the very high end of the world range encourage firms to manage their affairs so as to minimize reported U.S. profits using devices like transfer pricing, and to encourage the use of debt rather than equity finance. Employers who know that their workers face high tax rates work to find ways of providing compensation in the form of tax-free perquisites rather than money income. High marginal rates on individuals, along with a substantial capital gains differential, encourages individuals to spend time and effort that should be used more productively to engineer conversions of ordinary income into capital gains.

While the U.S. tax code is altered frequently, serious reform is no more than a once-in-a-generation happening. The last serious tax reform effort took place in 1986, meaning we are overdue. The Simpson-Bowles proposal for eliminating all tax expenditures and radically reducing tax rates provides an excellent starting point for a debate the country should have.

The delicate question is: How should Washington prepare for serious tax reform during what is likely to be a unique window of opportunity in late 2012 and 2013? The timing is essential, both because of all of the deficit reduction activity, but also because spending-side reforms will have a much more difficult time moving forward if revenue is not addressed as well.

It is tempting to say presidential candidates should put forward their tax reform proposals in detail and allow voters to choose. However, this is unlikely to work. Indeed, the more tax issues are discussed during the campaign, the more the candidates will be driven to make pledges about things they will never do - pledges that might make tax reform that much more difficult.

Here is an alternative: Leaders in both parties should commit themselves to the goal of tax reform for growth, fairness and deficit reduction. They should acknowledge that every tax expenditure or special break has to be on the table. They should have their staffs compile a large inventory of options. The relevant congressional committees should take testimony from experts of all persuasions. And then, right after the election, the negotiations should begin. Nothing that is likely to be done during the next four years will be more important.