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Revenue-Neutral Tax Reform: The Road to Nowhere on Deficit Reduction

Congressional Republicans reportedly may insist upon revenue-neutral tax reform as part of their price for agreeing to raise the debt limit later this year.  Such a course, however, would effectively block further progress in reducing long-term deficits.  As a result, its negative effects would likely substantially outweigh any positive economic benefits from tax reform.

Here’s why:

After enactment of the fiscal-cliff legislation at the start of this year, further increases in tax rates appear to be off the table.  And the current political environment remains deeply hostile to a new tax such as a carbon or a value-added tax.  The only realistic way to secure significant further revenue to help address long-term deficits is by curbing tax expenditures (deductions, exclusions, credits, preferential rates, and the like), likely through a tax reform process.

Curbing tax expenditures is difficult politically, and tax reform will likely exhaust the achievable savings in that area.  Thus, once tax reform is enacted, opportunities for significant revenue-raising will likely be gone for many years.

This is the danger of revenue-neutral tax reform:  having secured the achievable tax-expenditure savings and used them to fund other tax rate cuts, policymakers will have squandered the opportunity to raise the significant additional revenue needed for deficit reduction.

Thus, if policymakers sought more deficit reduction, virtually all of it would have to come from further spending cuts.

But Congress has already cut funding for discretionary programs by $1.5 trillion over ten years (not counting sequestration), primarily through the 2011 Budget Control Act, which will bring non-defense discretionary spending to its lowest level on record as a share of the economy.  If the sequestration budget cuts remain in effect, they will shrink discretionary funding even further.

As for entitlement programs like Social Security and Medicare, the President and congressional Democrats will strenuously resist — rightly, in our view — substantial cuts in the absence of additional revenue from curbing unproductive or low-priority tax breaks.

If revenue-neutral tax reform takes a further revenue contribution to deficit reduction off the table, it will likely take any prospect for a deficit-reduction agreement off the table as well.

And ironically, Republicans will have held the debt ceiling hostage to produce a result that blocks further progress on long-term deficits and debt.

Proponents of revenue-neutral tax reform sometimes cite the 1986 Tax Reform Act as a model, but the situation is very different today.  Given our long-term deficits, tax reform’s single most important goal should be to raise significant revenue, in a progressive manner, as part of a balanced deficit-reduction policy that also includes savings on the spending side.  Tax reform will consequently be a step backward unless it raises significant revenue.

Many assume that tax reform that lowers rates and broadens the base will yield substantial economic benefits.  But the literature in the field indicates that the economic benefits of revenue-neutral tax reform are likely to be modest.  Economic studies indicate that deficit reduction is considerably more important for long-term economic growth than tax reform.

In short, by squandering the opportunity to reach an agreement to reduce long-term deficits, revenue-neutral tax reform would likely yield adverse economic effects that far outweigh the more modest economic benefits of tax reform.

Tax reform should both clean up the tax code and raise substantial revenue, and policymakers should not undertake tax reform that does the former without the latter.  At this juncture, no tax reform at all would be a sounder and more prudent policy than tax reform that is revenue-neutral and thereby undermines deficit reduction.