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Avoiding the Tax Reform Trap

June 8, 2012 at 2:12 PM

Tax reform, an issue that’s receiving growing attention in Washington, holds promise.  But as we explain in a new paper we released today, reform may also bring serious risks:

Policymakers are increasingly discussing the need for tax reform, with a number of them calling for large cuts in tax rates — to levels well below the Bush tax rates — as a core element of reform.  They contend that sweeping but unspecified cuts in tax expenditures (credits, deductions, and other tax preferences) will offset the cost of deep cuts in tax rates and, depending on the proposal, possibly generate some revenue to reduce deficits.  Many who favor this approach go a step further and call for policymakers to commit to specific cuts in tax rates before they agree on any specific tax expenditures to reduce.

Such approaches pose big risks.  They could produce tax “reform” that increases both deficits and inequality because while cutting “tax expenditures” sounds appealing in the abstract, cutting specific tax expenditures enough to offset the costs of substantial new rate cuts and contribute meaningfully to deficit reduction would likely prove difficult, if not impossible, to achieve.  Indeed, the difficulty of cutting popular tax expenditures — from the mortgage interest deduction to 401(k) tax preferences to the deduction for charitable contributions to the exclusion for employer-sponsored health insurance — is why those who urge policymakers to commit upfront to specific, large rate cuts rarely specify any tax expenditures to cut.  In fact, they often highlight tax expenditures that they would refuse to touch, such as the preferential tax rate for capital gains. …

In essence, policymakers must not to let tax reform become a trap.  The goal of lowering rates and broadening the base, if not pursued carefully and cautiously, could make it much harder, if not impossible, to achieve a balanced deficit-reduction plan.  It also could lead to tax changes that reduce the progressivity of the tax code and thereby exacerbate income inequality, which is already very high.

Policymakers can avoid such a trap, and make tax reform an important positive force, by setting as the most important tax-reform goal the raising of substantial new revenue for deficit reduction and doing so in ways that maintain or improve the tax code’s progressivity.

Click here to read the full report.


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