Can Tax Reform Save the U.S. Economy?

Abstract

The Bowles-Simpson tax reforms make sense, but nothing about tax reform is politically easy.

Published in International Economy, Winter 2012: pp 49-50

Were it not for the growth in spending on Medicare, Medicaid, and Social Security, the United States wouldn't have much of a budget problem. The two biggest programs—Social Security and Medicare—are retirement programs that are extremely popular politically. Both need to be reformed, but they cannot be cut abruptly and they cannot be cut drastically. Consequently, it's hard to avoid concluding that some revenue increases will be needed to solve our fiscal problems.

Once that need is accepted, we have to ask, "What kind of revenue increases?" The least desirable approach would raise income tax rates in the current system without fixing its complications, inefficiencies, and inequities. If raising rates is rejected, we must either create a new tax— such as a value-added tax or an energy tax—or design a significant, revenue-raising tax reform.

A VAT or an energy tax is probably a nonstarter politically. Republicans see a new tax as a money machine that would finance a much larger government. Democrats worry about the complexity of making such taxes sufficiently progressive

The Bowles-Simpson presidential fiscal commission showed that there are income tax reforms that can raise revenues progressively and efficiently. In one option, they got rid of a host of special tax provisions while limiting, but not eliminating, some of the most politically sensitive, such as the charitable and mortgage-interest deductions. That allowed them to lower the top rate for individuals to 28 percent while still raising $80 billion more in 2015. With three rates—12.7 percent, 21 percent, and 28 percent—the top 0.1 percent of the income distribution lost 11.8 percent of its after-tax income and the top 1 percent lost 7.8 percent. The middle three quintiles lost less than 2 percent.

Erskine Bowles and Alan Simpson achieved a high degree of progressivity by taxing capital gains and dividends at ordinary income tax rates. That imposes a very high double tax on corporate profits. A more radical option would limit the double tax by integrating the corporate and individual tax systems. An even more radical change would move toward a progressive consumption tax. Capital gains and dividends wouldn't be taxed if reinvested, but would be hit if used to finance consumption.

None of this discussion implies that radical tax reform is easy. The revenue-neutral reforms of 1986 were anything but. A revenue-raising reform greatly increases the ratio of losers to winners. Accomplishing reform seems easy only when compared to persuading Americans to accept a VAT or new energy tax.

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