What Should Tax Reforms Do?

Linda Sugin in The New York Times, January 23, 2013

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Raising taxes on wealthy Americans, as was agreed upon by Congress earlier this month, won’t be enough to deal with the nation’s budget deficit. Some would argue that we also need to raise taxes on everyone. At the very least, a broader conversation about this country’s tax policy is necessary, and that means asking a simple question: What should tax reform do?

MICHAEL J. GRAETZ: What our nation needs is a new and better tax system, one that is far simpler, fair and more conducive to economic growth. We should combine a tax on sales of goods and services with an income tax on higher-income people to be at least as progressive and raise at least as much revenue as current law.

The Tax Policy Center estimates that enacting a 12.3 percent tax on sales of goods and services could fund a $100,000 exemption from the income tax, removing more than 150 million Americans from the income tax rolls. Making this system revenue neutral, with a distribution of the tax burden similar to that of current law, could be accomplished with an income tax rate of 16 percent on income between $100,000 and $200,000 and 25.5 percent on incomes above $200,000, a 15 percent corporate tax rate, along with a debit card that exempts from the consumption tax a specified amount of purchases and payroll tax offsets that together will protect low and moderate income families from a tax increase. After the fiscal cliff legislation, a third income tax rate of about 30 percent may be needed for families with income above $350,000 or $400,000. Small businesses with up to $500,000 or even $1 million or less of sales could be exempted from having to collect the consumption tax.

While businesses and the Internal Revenue Service are gearing up to implement a consumption tax, Americans would accelerate their purchases of large ticket items, like cars and large appliances, providing a short-term boost to our economy.

Such a tax reform would make the United States more attractive for savings, investment and economic growth. The vast majority of Americans would never again have to deal with the I.R.S. International tax planning by multinational corporations would no longer pay. And taxing imports while exempting exports would yield hundreds of billions for the U.S. Treasury from sales of products manufactured abroad.

A dramatic reform that uses a goods and services tax to reduce our nation’s reliance on income taxation is the only path forward that will enhance economic growth without abandoning tax equity.

LINDA SUGIN: We need to simplify the Internal Revenue Code by taxing income from work and investments equally, and by making tax burdens more transparent by repealing the alternative minimum tax and stealth phaseouts. Taxes will need to eventually rise to address our long-term fiscal needs, and fairness requires that the burden be increased on those who can afford to pay more.

Some people are nostalgic for the Tax Reform Act of 1986, and its mantra of lowering rates and broadening the tax base. But it isn’t 1986 anymore, and eliminating loopholes is not the answer. In 1986, we paid for individual tax reform with a corporate tax hike, an option nobody seems to want today. Many tax preferences now are income support for low-income taxpayers, rather than shelters for high-income taxpayers. There aren’t enough loopholes to raise much revenue without slashing preferences dear to millions of Americans.

Repealing tax preferences like the home mortgage interest deduction, the charitable deduction, and the deduction for state and local taxes would impose losses on middle and lower-income individuals. High-income taxpayers claim the lion’s share of these deductions on their returns, but they might not be the ones who would suffer most on their repeal. Congress never intended for taxpayers who claim the charitable deduction to be the beneficiaries of it. The policy behind the charitable deduction is an incentive for charitable giving, and individuals increase their charitable giving because of it. The beneficiaries of the deduction are charities and charitable beneficiaries; donors are just conduits for spending by the government on charities. Reducing the deduction reduces that government subsidy.

Repealing some tax benefits may harm people who never enjoyed a real economic benefit from the provision. Today’s homeowners probably paid more for their houses than they would have if the home mortgage interest deduction never existed. The deduction contributed to inflated housing prices. If repealing the deduction causes a drop in housing prices, today’s homeowners – even those without mortgages -- may feel the pinch of repeal even though they never really profited from it.

ALAN D. VIARD: In the short run, reform efforts are likely to focus on improving the income tax. We should curb ill-designed tax breaks, like those for expensive homes and Cadillac health insurance plans, and reform business taxes.

In the long run, we should ease the tax burden on saving and investment by moving toward some form of consumption taxation. But complete replacement of the income tax with a sales tax or value-added tax is not the way to go – that would unacceptably shift the tax burden to those who are worse off.

A somewhat better approach would replace part, but not all, of the income tax with a value-added tax. Many countries have done this and we may eventually follow suit, but it’s not an ideal approach. Even with a progressive income tax still in place, the value-added tax's regressivity is problematic. And, giving the government another revenue source may spur spending.

The best approach would completely replace the income tax with a progressive consumption tax. We can do this by adopting a personal expenditure tax, which requires taxpayers to file returns on what they compute their consumer spending by subtracting saving from income. Spending above an exemption amount is taxed at graduated rates, with higher brackets for those with higher spending. Or, we can adopt a Bradford X tax, which splits consumption into two pieces, wages and business cash flow, and taxes them separately. Workers are taxed on wages at graduated rates, above an exemption amount, and businesses are taxed on cash flow at a flat rate, equal to the highest wage tax rate. Under either system, tax credits can be paid in cash to poorer households.

Thinking outside the box and embracing progressive consumption taxation offers a way to promote both tax fairness and economic growth.

ALAN J. AUERBACH: The United States needs tax reform, to help us deal with looming budget challenges and the evolving economic environment. Here are four improvements to our tax system that promote economic growth, are equitable, and would generate the level of revenue we need:

1. Cut tax expenditures -- tax credits, deductions, exclusions and exemptions -- before raising tax rates. Although increasing tax rates can increase revenue, so can broadening the tax base; and broadening the tax base should damage the economy less than increasing rates, by improving the allocation of our economy’s resources. Many existing tax breaks are hard to justify, particularly when large cuts in direct spending programs seem unavoidable.

2. Reform capital gains taxation. Raising the capital gains tax rate to 20 percent, as we have just done, provides additional revenue in a progressive manner. But because the capital gains tax is relatively easy to avoid, there is a limit to how far we can go, especially if we do not change the way the tax operates. Our practice of forgiving capital gains taxes at death and when gifts of appreciated property are made fosters tax avoidance; reforming these and other loopholes is a smarter way to increase capital gains tax revenues.

3. Adopt a modern corporate tax. A declining share of U.S. business faces the corporate income tax; an increasing share of business that does face the corporate income tax is done by multinational corporations. We should broaden the coverage of the corporate tax while modifying its structure to enhance the global competitiveness of U.S. producers.

4. Add consumption taxes. We are the only leading economy without a national broad-based consumption tax such as the value-added tax. Even with comprehensive tax reform, and especially without it, we will likely need the additional revenue that a value-added tax can provide.