Beware the Tax Reform Trap

Howard Gleckman of the Urban-Brookings Tax Policy Center has a mostly positive take on former Congressional Budget Office Director Douglas Holtz-Eakin’s proposed four-step path to tax reform.  Those steps (as Gleckman describes them) are, in order:

1. Recognize that the U.S. will have a progressive tax code.
2. Agree on a top rate.
3. Agree on how much revenue you want to raise.
4. Eliminate or scale back the tax preferences you need to accomplish the first three.

This approach — setting a specific (presumably low) top rate before agreeing either on how much revenue to raise for deficit reduction or on any specific tax preferences to end or scale back — is a prime example of what I call the “tax reform trap.”  It could lead to “tax reform” that actually increases both deficits and inequality.

I’ll explore this issue in an upcoming paper, but here’s the short version.

The Holtz-Eakin path reflects the “lower the rates, broaden the base” mantra for tax reform.  All else being equal, that mantra is economically sound.  But all else isn’t equal.  We face enormous long-term deficits that will require wrenching policy choices.  In addition, income inequality has grown to historic levels in recent decades.

So, this isn’t 1986, when revenue-neutral tax reform was a plus.  In fact, it would be counterproductive today.  It would take the two main ways to secure a revenue contribution to deficit reduction — letting some of the tax rate cuts scheduled to expire at the end of this year actually end, and reducing tax preferences — off the table without producing any deficit reduction.

Moreover, without a revenue contribution to deficit reduction, Democratic policymakers will understandably resist spending cuts.  The likely result: much higher future deficits and slower economic growth.

Indeed, given the nation’s current circumstances, the single most important goal of tax policy should be to raise enough revenue (in a progressive way) to contribute to a balanced deficit-reduction policy.

The Holtz-Eakin four-step plan doesn’t get you there; it would likely be an impediment instead.  It would first lock in a permanent new top rate, presumably at a low level, which would be both expensive and regressive.  Only then would policymakers set a revenue target.  And, they would do so with no specifics on which tax preferences to close or by how much.

When policymakers finally reached Holtz-Eakin’s step #4 and saw what they would have to do to the big and popular tax preferences — the mortgage interest deduction, the charitable deduction, 401(k) preferences, and the like — to hit their revenue target (given the rates they had set in step #1), there’s a very good chance they would balk at cuts of that depth and scope.  The revenue target would then give way.

That’s why the tax reform effort should start only with a specific revenue target.  Where the rates are set and how much (if at all) they are reduced should turn on how much policymakers are willing to broaden the base.  Given the huge potential for tension between the revenue target and the top rate, one must have primacy over the other; if one cares seriously about balanced deficit reduction, it must be the revenue number.

Some recent proposals, such as that from House Budget Committee Chairman Paul Ryan, go sharply in the opposite direction.  They call for extending all of President Bush’s tax rate cuts and adding huge new marginal rate cuts on top.  Ryan and other proponents say they would offset the cost of the new rate cuts by curbing tax preferences, but they offer no specifics.  Politically speaking, as various tax experts have noted, policymakers would find it virtually impossible to enact enough cuts in tax preferences to come anywhere close to offsetting the cost of Ryan’s drastic rate cuts.

Here’s an alternative four-point path to tax reform that doesn’t compromise deficit reduction:

1. Let the Bush tax cuts aimed at households making over $250,000 expire on schedule, locking in nearly $1 trillion in deficit reduction over ten years.
2. Seek agreement on how much additional revenue to provide, alongside significant spending cuts, as part of a balanced deficit-reduction package.
3. Seek agreement on the specific tax-policy changes needed to raise this revenue while maintaining or improving tax progressivity.
4. Consider reducing tax rates below their scheduled levels under current law only if policymakers can generate enough revenue from cutting tax preferences to meet their revenue target without gimmicks and in a way that will last.