Tax Reform That Works: Building a Solid Fiscal Foundation with a VAT

Tax reform is like the weather – everyone talks about it, but no one ever does anything about it. But unlike inclement weather, the problems of the tax system don’t go away; they continue to fester and compound. Today there are a number of unpleasant trends in the federal tax system that are crying out for attention:

• Taxes are too low to finance the level of government people appear to demand. Federal revenues are just 15.8 percent of GDP. They have averaged 18.5 percent of GDP in the postwar era, but only reached that level once in the last 10 years; every other year revenues have been well below that level, contributing heavily to the budget deficit and growth of the national debt.

• The tax code is getting harder and harder to understand and administer and desperately needs radical simplification. Yet Americans show no appetite for giving up cherished deductions and credits that clutter the tax code, overlap and duplicate each other, and often encourage inefficient and wasteful economic activities.

• It is widely believed that the tax code, especially on the corporate side, is a drag on economic growth. While the idea that tax reform is essential to jumpstart growth is unrealistic, there is no question that there are potential reforms that would raise the long-term trend rate of growth if implemented properly.

People often point to the Tax Reform Act of 1986 (TRA 86) as an example to follow. It eliminated various tax preferences and lowered statutory tax rates. While in principle this would be worth doing again, there are a number of obstacles, both political and substantive, that make a simple reprise of TRA 86 unrealistic.

First, the Tax Reform Act of 1986 was the culmination of almost two decades of efforts to reform the tax system that previously produced budgets laden with tax expenditures and included the tax reform acts of 1969 and 1976. In many ways, there was an infrastructure in place at that time regarding knowledge of the tax system and a consensus on at least the general outlines of reform that does not exist today.

Second, in advance of the 1986 effort there were two important congressional tax reform proposals – a Democratic bill cosponsored by Sen. Bill Bradley of New Jersey and Rep. Dick Gephardt of Missouri, and a Republican plan cosponsored by Rep. Jack Kemp of New York and Sen. Bob Kasten of Wisconsin – which showed enough similarity that both sides recognized the potential for a bipartisan tax reform effort. Nothing remotely the same exists today, with the two parties deeply polarized on tax policy.

Finally, the ultimate impact of TRA 86 was disappointing, both politically and economically. As early as 1990, critical aspects of it were already unraveling: in particular, the top rate was raised without restoring tax preferences that were eliminated as part of a package deal, and the agreement to tax capital gains at the same rate as ordinary income was broken. Subsequent analysis of the real world economic effects of tax reform showed surprisingly little impact despite widespread expectations that the 1986 act would have large effects. The paucity of meaningful impact suggests that extravagant claims for how tax reform is all that is needed to jumpstart growth should be taken with many grains of salt.

Earlier tax reform efforts in the 1960s and 1970s were driven largely by liberals wishing to make the tax code more progressive by ending tax loopholes for the rich. This effort was joined in the 1980s by conservatives anxious to cut statutory tax rates, which they believed to be the key to growth, and they were willing to pay for rate reductions with base-broadening. Critically, the budget deficits of that decade imposed a hard constraint on tax reform: rate cuts had to be honestly paid for with real reforms that raised revenues to guarantee a revenue-neutral package.

Additionally, all previous tax reform efforts were strongly supported by the Treasury Department, which was really the central driver. The 1969 and 1976 tax reforms were essentially drafted by Treasury and the 1986 reform grew out of a three-volume report drafted by Treasury economists. However, since the 1990s, under both Republican and Democratic administrations, Treasury has been marginalized in terms of tax policy, with Congress taking the lead role. As a consequence, tax legislation has become increasingly unfocused, with tax bills being little more than random collections of various tax provisions that often overlap with existing law and may even conflict with each other. Restoring Treasury’s central role in tax policy is a necessary precondition for meaningful tax reform.

Another precondition is strong support by the president. Congress is too divided and heterogeneous to do tax reform by itself. Under the Constitution, tax bills must originate in the House of Representatives and then, if successful, the process must start all over again in the Senate. The president must be actively engaged to make sure they don’t go off in different directions, that the integrity of the effort is maintained, that unintentional subsidies or penalties aren’t inadvertently inserted, and to help overcome resistance through lobbying and political pressure.

Presently, the tax reform effort is in its infancy, with no strong leadership, no framework with the potential for bipartisan support, or even a consensus among tax experts on where to begin.