Jared Bernstein: The Tax Reform Trap

A couple of my CBPP colleagues have written an important paper -- a warning, really -- on tax reform. Chuck Marr and Chye-Ching Huang describe a trap that almost every tax reform effort I've heard about in recent months risks falling into. It's critical that we wrap our heads around this, because major tax reforms are rare and if one is coming -- and it might well be -- we can't afford to blow it.

This is their warning:

-the mantra of all tax reform initiatives these days is "lower the rates, broaden the base" where the latter means ending certain tax expenditures (a wide variety of tax breaks and credits ranging from the Earned Income Credit -- a wage subsidy for low wage workers -- to the reduced rate on capital gains).

-but most of the actual reform proposals -- like those of Rep Paul Ryan, Gov Romney, or the Bowles-Simpson commission -- cut rates first, with an agreement to find the base broadeners later (Bowles-Simpson, to be fair, included "illustrative" cuts, but the members of the commission were unable to reach agreement on them).

Therefore, TAX REFORM THAT LOWERS RATES WITHOUT FIRST LOCKING IN HIGHER REVENUES WILL VERY LIKELY FAIL TO RAISE THOSE REVENUES. The sequencing of tax reform therefore must be:

1) choose a revenue target, one that reliably reduces the deficit once the economy is back on track;
2) figure out the rates and base needed to hit that target;
3) ensure that a) a majority of policy makers accept the base broadeners and b) the changes do not make the code less progressive;
4) only then, once progressive base-broadeners and a deficit-reducing revenue targets are locked in, should lower rates be considered. If the lower rates violate any of the prior conditions, they must be rejected.

Reading through Chuck and CC's paper, I cannot over-emphasize the importance of this sequencing. In a way, it's as simple as spinach first, then dessert. But once you open your eyes to this problem, you see it everywhere. Even the White House, folks who clearly understand the need for new revenues, gets it wrong.

I wrote a variation of this earlier, under the rubric of the D.C. Dodge. But my colleagues add a lot more meat to these bones. A few of their other key points:

-many of the "lower rates, broaden base" plans claim to be revenue neutral. Um...neutrality is not the correct goal when we need net new revs;

-across the board rate cuts, ala Gov Romney's plan, are regressive, delivering larger tax cuts to those at the top of the income scale (see CM/CCH's figure 2);

-base broadening through cuts in tax expenditures is WAY harder than you'd think from hearing policy makers blithely invoke it:

...curtailing tax expenditures, especially if that must produce deficit reduction and offset the cost of large and regressive reductions in tax rates, is far harder than many proponents suggest. First, there are immense political and other obstacles to raising very large amounts of revenue through tax expenditure reform. Second, cutting tax rates reduces the revenue gains from base broadening [because lower rates mean smaller deductions; thus, ending those deductions raises less rev]. And third, it's even harder to overhaul tax expenditures in a way that simultaneously offsets the cost of rate cuts, raises significant additional revenue for deficit reduction, and maintains or improves the progressivity of the tax code -- especially if proponent insist on maintaining the preferential rate for capital gains.

Chuck and CC conclude that tax reform, done badly with the wrong sequencing, could end up exacerbating both inequality and the budget deficit. And if you've spent any of your time in this debate in D.C. in recent years, you know that the likelihood of getting caught in the very trap they elaborate here is great.

So read this and be forewarned. We've got enough problems without getting our fiscal legs caught in a trap.

This post originally appeared at Jared Bernstein's On The Economy blog.

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Follow Jared Bernstein on Twitter: www.twitter.com/@econjared

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