The U.S. as much as any other part of the developed world needs a simple, just, incentive oriented tax and social contribution system. Basically, this is a 20% VAT, a 20% flat income tax with a generous subsistence minimum (to differ from country to country) and a 20% corporate income tax. This should be complemented with emission certificates to protect the environment. If the latter are too complicated to introduce, a gasoline tax (plus equivalent for other fossil energies) of two USD per gallon would make the planet tick – in this case the VAT should be reduced to 16%.

What can/should the Obama administration do with tax reform?

To begin with, tax reform--like campaign finance reform or labor law reform-- means very different things to different people.  I want federal taxes to be lower.  The modern Democrat party wants them higher.  Calling a tax hike, "reform" doesn't make it reform.

What will Obama/Reid and Pelosi do?  They will try to jam higher taxes through under the false flag of reform.  Will the promise not to raise taxes on 95% of Americans hold them back?  Don't make me gag.  It was only sixteen days into the administration that Obama signed his first tax hike: a tax increase on tobacco consumers, all, except him, earn less than $250,000.  Obama and the Democrats have already raised taxes directly on 20 or 25% of Americans below his now phony $250,000 cap.

The administration and Congress will try and say they are going after "tax cheats"...Obama praised Rangel, Democrat leader of the Ways and Means committee who is second only to Obama's treasury secretary as the most famous tax cheat in modern America.  This administration doesn't fight tax cheats: they promote them.  They have no moral standing in that zone.

And yes. They want to impose a VAT--that will hasten the destruction of American exceptionalism and move us closer to looking just like the slow growing, European welfare states.  And yes, it will be a massive tax hike on average citizens.  What? You thought Obama cared about that?  Hah.

Collapse

There are several problems that a reform commission deals with right off the bat.<br><br>

• politically, the staff of Ways and Means and Finance haven't been involved.  That makes the exercise little more than a waste of time and money
• creating a new VAT would be a disaster.  Very soon, there would be European levels of VAT rates (20 percent or so), with carve outs, etc.  And since a tax-inclusive system is opaque, people wouldn't feel the pain of a tax increase
• depending who you ask, there's somewhere between one-third to four-tenths of families don't have an income tax liability.  that makes it very difficult to do 1986-style reform
• increasingly, many tax benefits now take the form of outlays, not revenue reductions.  increasing these outlays and paying for them with revenue raisers is a Taxpayer Protection Pledge violation
• the scorekeepers at JCT and OTA won't take into effect the macroeconomic changes resulting from lower tax rates and more neutral treatment of savings and investment.  so, you have to "pay for" some tax cuts which will in fact have a partial, full, or more than full revenue feedback effect
• the Left requires that the distribution be the same as now or more progressive.  they never seem to acknowledge that the lower marginal tax rates of the past thirty years have been coincident with much greater distributional progressivity
• the Left won't want to sever the link between FICA and the middle class entitlements.  so, you can't draw that in as a part of comprehensive tax reform, which is vital if you're going to get the lower third of households back into the equation
• Many taxpayers don't feel the pain of complexity anymore because of e-filing, which is now a majority of all tax returns filed

There is only one sane conclusion given all these limitations: don't do comprehensive reform.  It simply isn't ripe right now.  Instead, focus on the biggest problems facing economic growth:

• Our corporate marginal rate is tied for the highest in the developed world.  This affects investment decisions at the margin, no matter what the fairly uninteresting average corporate rate is.  25 should be the maximum corporate rate, and the revenue feedback effects would probably pay for itself
• Almost as bad, we have a bizarre corporate system of worldwide taxation combined with deferral.  Better to simply transition to a territorial structure.  The repatriation experiment of 2005 shows that this does in fact pay for itself
• The corporate capital gains rate is 35 percent.  That could be matched to the personal rate of 15, which would unlock all sorts of corporate assets which never would have been sold otherwise.  Again, this pays for itself
• On the personal side, we need some certainty on the big things.  Let's lock in the top rate at 35, and the capital gains and dividends rate at 15.  Everything else can be moved around provided there's not a net tax hike.  Using the magic Obama "present policy" baseline, this also pays for itself
• With the death tax, just match it to capital gains and give a generous exemption.  Since the death tax causes more tax losses in avoidance than it collects in revenue, this also pays for itself in any real-world calculation
• There's some cleanup that can happen that almost no one would object to.  Examples include combining the Hope and Lifetime Learning Credits, integrating the EITC and the additional CTC, etc.  The result would be a less redundant and more easily-understood tax code

Collapse

John Maggs, our web ringmaster, couldn’t have said it better. Tax reform efforts are "handcuffed!"   Our current U.S. tax system, whose fundamental structure dates back to the 19th century buggy whip era, cannot sustain the current political and economic demands of 21st Century America and a global economy.  
 
As I write, three of my earlier blog colleagues that have responded thus far have made compelling arguments that support my contention.
 
Professor Frankel, I understand your rationale for taxing energy consumption to address environmental externalities but why limit yourself to those inefficiencies? Wouldn’t it be wiser to urge a broad-based consumption tax to deal with your concerns?  You’re a distinguished professor for capital formation. If we are to have long-term economic growth, don’t we need more savings and investment? Don’t we need a tax system that isn’t intrinsically biased against savings and investment? Don’t we need tax reform that  eliminates us as the odd duck in the global marketplace?  The U.S. remains one of the few countries in the world that doesn’t have a national consumption tax in its fiscal structure.
 
Bill Gale and I were on opposite sides of the tax debate now almost a decade ago as invited witnesses before the Senate Finance Committee.  Bill argued for a progressive income tax and I for a U.S. consumption tax.  I’m delighted that he now favors a VAT although I fear he does so in the context of a new tax—perhaps as an easy revenue source for larger government. I am worried about it being “money machine” but will take some chances today since the alternative, the current structure is so deficient. Having said that,  I would like a U.S. consumption tax; I don’t want to import a foreign one. Its called “Plan X.”  Call me and depending who you are, I will spill the beans.  It needs to address the unusual culture and history of America and be  primarily a replacement for the income tax to address the political demands that it cannot meet [the AMT for example] and the economic demands on it. For example, we tax investment on new machinery and equipment more harshly than many of our global competitors.  And as Bill says, we often tax savings and investment in a haphazard and complex manner, taxing some forms of capital income more than once—thus undermining the capital growth capacity of the U.S.
 
And J.D. Foster, thanks for reminding us about the history, the false promises and the potential shortcomings of a presidential commissions on fundamental tax reform.  I agree with you about the results of the Breaux-Mack commission under President  George Bush, which was too hampered by constraints to develop a proposal worth enacting.  I can recall at least a half-dozen earlier attempts that ended up in similar fashion.  
 
I applaud the President for understanding that our tax system is broken.  I worry that the commission’s possibilities are handcuffed, but I strongly warn that when all of the brush fires are put aside, the current financial and economic challenges and policy debates, that the government needs to be financed.  Our current structure cannot do so.  We will eventually come out of the current recession but we then enter the global economy with at least one hand tied behind our back in our ability for long and sustained economic growth.

Collapse

The state of the debate on tax reform suffers not only from political constraint, as the question here suggests, but also from intellectual constraint.  For perhaps the most widely held view of tax reform is that greater simplicity should be a key outcome of any reform. Both the question posed here (“other than the general goals of broadening the base and lowering rates, what should the commission focus on?), and Bill Gale’s response (“The sina qua non of meaningful tax reform is to clean out and rationalize the exclusions, exemptions, deductions, and credits in the tax system), reflect this tenet.  

The holy grail of simplicity stems directly from the underlying principle of the neoclassical economics doctrine which holds that any tax distorts prices from what the “market” would naturally produce and therefore leads to economic welfare losses.   Therefore, the best tax reform, according to this view, is one that eliminates most deductions and exemptions and using the savings to pay for a lower statutory tax rate. 

But there is an alternative view, grounded in what could be termed “innovation economics.”   (see www.innovationeconomics.org)  Under this doctrine, the goal of economic policy generally and tax policy specifically, is not to drive efficient allocation of scarce goods and services by reducing distortions, but rather to drive the creation of new goods and services and increased productivity through robust and conscious innovation policies.  

This has two big implications for any tax reform efforts. First, any effort should start by distinguishing between corporate taxes from personal taxes.  Despite what the neo-classical consensus holds, there is little or no evidence that modestly higher marginal rates on personal income have any negative effect on growth. However, higher effective corporate tax rates can reduce innovation, productivity growth, and national economic competitiveness.

Second, it means that corporate tax reform should significantly strengthen, not weaken, incentives for firms to invest in activities that spur productivity and innovation.  More than two decades of economics research has shown that R&D generally, and the R&D tax credit specifically, play a key role in innovation. As a result, tax reform should significantly expand the R&D tax credit.  The Obama administration’s proposal to make it permanent is a good, but inadequate, step as it essentially reinforces the status quo of the last 25 years in which Congress extends the credit every few years.  Rather, we need to significantly expand the credit (in part to catch up to other nations that have put in place much more generous credits), and also broaden it into a knowledge tax credit to enable companies to receive a credit for investments in not just product R&D, but also process R&D and employee skills training.  The corporate tax code should also affirmatively spur investment in new equipment, particularly in information technology (hardware and software) that has been shown to be the main driver of productivity growth.  This means letting firms expense investments in the first year (or an investment tax credit).    

Third, as Jeffrey Frankel notes, adding a tax on environmental externalities, particularly CO2, can help not only raise revenues but also modestly incent the development and adoption of cleaner technologies.  

To be sure, taking these steps goes in the opposite direction of simplicity. But the benefits to economy (and the environment) would vastly outweigh any losses to allocation efficiency.

Collapse

If tax reform were really freed from political handcuffs, then the most important place to get more revenue is taxes on environmental externalities.   An overwhelming majority of economists agree with this proposition -- for example the members of the Pigou Club dreamed up by Greg Mankiw (who was chair of President Bush's Council of Economic Adivsers).

Most compatible with efforts on global climate change would be a cap-and-trade program on emissions of CO2, with the permits auctioned off (except for some limited free distribution in the short run to adversely impacted industries).   But I would be equally happy with a carbon tax, or BTU tax, or even a simple gasolene tax.   My prefered place to use the revenues from such energy taxes would probably be eliminating taxes on lower income workers (including the payroll tax) and permanently fixing the AMT for the middle class.   I wouldn't mind reducing corporate income taxes too. 

Of course, discussion of energy taxes has always been political suicide.  But here are several twists that could potentially increase the ability of the electorate to swallow them politically:

1) Although announced in the near future (thereby sending desirable allocational signals), the energy taxes would not go into effect until the economy fully recovers from the current recession (thereby avoiding an abortion of the recovery).

2) Such measures could be on stand-by, to be enacted in the event of a major unforturnate geopolitical setback in the Middle East (e.g., military conflict with Iran, or a militiant takeover of Saudi Arabia) or a tragic terrorist event (along the lines of September 11), which would galvanize public opinion to do something sensible for the first time about the extent of US dependence on oil imports.

3) A tax on, e.g, gasolene, could be designed to put a floor under the current price.  The status quo always generates less political resistance than a tax that raises the price.

4) The revenue from the first penny per gallon could be earmarked to fund the deficit in social security benefits of those retiring in 2027, for example.  They were born in 1962, and know who they are.  The revenue from the second penny could be used to finance the benefits of those retiring in 2028, and so on.  (Numbers are illustrative.  I haven't done the actual calculations.)     The result would be to create a constituency for keeping the tax in place, namely those whose retirement benefits are funded with the proceeds.

JF

Collapse

The state of politicians' discussion on taxes in this country is downright embarassing and increasingly dangerous.  One side says "no new taxes."  The other side says "no new taxes on the bottom 95 percent."  The way these two positions relate to tax reform is best captured by the phrase "you can't get there from here."

Tax reform involves improving the efficiency, equity, simplicity, and revenue adequacy of the tax system.  Any effort to establish adequate revenue is going to require an increase in revenues – most likely through the creation of a new tax like a VAT.  Any effort to improve the efficiency, equity, and simplicity of the system is going to involve structural reforms that will help some taxpayers and hurt others.  None of these are options are even on the table to be discussed if the debate is between "no new taxes" and "no new taxes for the bottom 95%."

The sina qua non of meaningful tax reform is to clean out and rationalize the exclusions, exemptions, deductions, and credits in the tax system. A broader base treats various activities on a more equitable basis, makes the tax system simpler and more efficient, and allows for lower rates in order to achieve a given revenue target.  Chief candidates here include limiting itemizing deductions or converting them to credits and scouring corporate tax expenditures, especially industry-related measures.  The tax code treats saving and investment in a haphazard and complex manner, taxing some forms of capital income twice, some once, and some not at all.  Restructuring this part of the code to provide more consistent treatment across all forms of capital income and different organizational structures would be beneficial.  In addition, the only way we are going to come close to raising needed revenue is to impose a new tax – preferably a VAT – that can raise between 5 and 10% of GDP.

Taxes can also help address the nation's long-term challenges related to energy production and consumption. Government must make it more expensive to use and emit carbon by either a direct tax on carbon emissions or a "cap and trade" system, with the government selling "permits to pollute." The two approaches are economically equivalent and would produce wide-ranging benefits: the societal cost of producing and consuming carbon would be included in the price of goods like gasoline and electricity; energy security would rise; environmental damage would decline; and federal revenues would increase.  A carbon tax or a "cap-and-trade" system would provide significant incentives for development of alternative energy sources and would render unnecessary the existing panoply of targeted energy subsidies. A carbon tax could replace existing, less efficient taxes, or serve as a new revenue source.

Taxes can also help address health care reform. The most significant tax issue is the deduction for employer-provided health insurance premiums. Allowing such a large part of employee compensation to be deductible drives up the cost of health care, leads to gold-plated health insurance policies, gives a larger benefit to high-income taxpayers, and leads to billions of lost tax revenue every year, while disadvantaging families without employer-based coverage. Reform should convert the deduction into a fixed, refundable credit for individual workers or eliminate the tax benefit completely.  This policy will only work, though, if well-functioning non-employer group insurance markets are developed first.  The policy would also make it more likely that consumers paid the costs of their health care on the margin, which would help reduce expenditures and encourage consumers to choose the most productive expenditures.

Every year the U.S. tax system becomes more complex.   Making simplification is priority in tax reform is necessary because without such an action, the code will continue to become more complex.  Likewise, an intelligent reform plan would equip the IRS with the resources to enforce and administer the tax system as well as strict safeguards to ensure that abuse does not occur.  Chief candidates here include repealing the AMT, consolidating saving incentives, consolidating education incentives, consolidating family subsidies, taxing dividends and capital gains at ordinary income tax rates (provided the top rates come down).

In short, a better tax system could address a host of social and economic ills.  It would certainly not be painless, but in economics the right question is always "compared to what." And, compared to doing nothing, serious tax reform that raises revenues and restructures taxes to be more efficient, equitable, and simple would be an enormous improvement over the existing system.

Collapse

Americans were once again reminded during the recent tax filing system that the income tax is a functional disaster.  It functions, but it’s still a disaster.  And so the President’s creation of an independent commission to work on tax reform should be encouraging.  It should be, but it isn’t.  Not yet. 

President Bush had his tax reform commission under Senators Breaux and Mack.  Their mandate was broad.  They did excellent work.  It came to naught.  President Obama has already handcuffed his tax reform panel by constraining them to work within the confines of current policy.  It’s not entirely clear what he means by “current policy” in this regard.  Does he mean the distribution of the tax burden across levels of income, across industries, across generations, across factors of production?  What we know from past experience, including that of the Breaux-Mack effort, is that the more constraints you place on the design of the tax base, the harder it is to develop a proposal worth enacting.

Does the President mean to keep the current level of taxation?  His budget indicates a preference for massive tax hikes.  Is the tax reform commission to consider these as current policy, or perhaps it is really just a smoke screen for even more severe tax hikes? 

For all these misgivings, I hope the President is serious about serious tax reform.  If he is, then he’ll allay any concerns about this being a tax hiking smoke screen, and he’ll relax the handcuffs so his tax reform panel can build on the work of the Breaux-Mack commission and develop compelling ideas to make our tax system more pro-growth and simpler.  

Collapse