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Why Revenue-Neutral Tax Reform Would Be a Big Mistake

With the “fiscal cliff” budget deal behind us, congressional Republicans leaders say they’re done raising revenues.  They likely will push this year for “revenue-neutral” tax reform, meaning it would raise the same amount of revenue as the current tax code.

That, however, would be highly ill-advised; in inhibiting the further deficit reduction we need the negative effects of such a course would substantially outweigh any positive economic benefits from cutting tax rates and broadening the tax base.

Here’s why:

In the current political environment (which remains inhospitable to a new tax such as a carbon or a value-added tax), policymakers really have two opportunities to secure substantial revenue to help address deficits in a balanced way:  letting President Bush’s tax cuts for high-income taxpayers expire and curbing tax expenditures (deductions, exclusions, credits, preferential rates, and the like) — probably through tax reform.

The fiscal cliff deal secured about $600 billion from the upper-income Bush tax cuts.  That leaves tax expenditures.

Tax reform will likely exhaust the achievable savings in tax expenditures.  As a result, after tax reform, opportunities for significant revenue-raising will likely be gone for many years.  If tax reform is revenue-neutral, the total revenue raised for deficit reduction would be only about $600 billion.

And, having locked in permanent tax rates and secured the achievable tax-expenditure savings (and used them to fund other tax cuts), policymakers will have squandered the opportunity to raise significant additional revenue for deficit reduction.  Virtually all other deficit reduction would have to come from spending.

To be sure, the 1986 Tax Reform Act was revenue-neutral, but the story is very different now.  Given our long-term deficits, tax reform’s single most important goal should be to raise substantial revenue, in a progressive manner, as part of a balanced deficit reduction policy that also includes savings on the spending side.  Tax reform will be a large 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 much more modest.

Indeed, economic studies show that deficit reduction is substantially more important for long-term economic growth than tax reform.  And revenue-neutral tax reform would undercut efforts to achieve substantial further deficit reduction, not only because revenue-raising opportunities would be gone but also because reductions in spending would almost certainly be smaller.  The President and congressional Democrats will (with good reason) resist more sizeable spending cuts in the absence of additional revenue.

Thus, by squandering the opportunity to shrink deficits (by raising revenue and encouraging complementary spending cuts), revenue-neutral tax reform likely would yield adverse economic effects that substantially outweigh the more modest economic benefits of tax reform itself.

We’d like to see tax reform that both cleans up the tax code and raises substantial revenue.  But 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.