Congress needs to engage in some real tax reform

Contributing WriterJanuary 3, 2013 

This week we avoided that plunge over the fiscal cliff. Not only did Democrats and Republicans reach a consensus that taxes must increase, but in a final dramatic hour they even agreed on the specifics.

But it’s not yet time to breathe easy, as the parachute we’re on is only half opened. The tax code changes that Congress agreed to are meager and a far cry from the true tax reform we need.

Recall that our “fiscal cliff” dilemma was created to give Congress a hard deadline for getting our fiscal house in order. But ironically, the deadline caused both Democrats and Republicans to focus exclusively on the deadline itself and its repercussions, rather than on our fiscal house.

The Democrats’ plan, a version of which Congress just passed, consisted almost exclusively of raising the richest citizens’ marginal tax rates. This bill should net the U.S. treasury around $100 billion per year – a good start but not nearly enough to begin meeting the objective of long-term fiscal stability. Both Democrats and Republicans know this, and they’ll soon be back to the drawing board.

The Republicans’ preferred approach to tax reform is to limit one type of “loophole” in the tax code, called itemized deductions, without touching marginal tax rates. In theory, limiting loopholes is a good idea, but the Republicans’ approach to it is not.

Capping itemized deductions at $17,000 – which is the strictest cap any Republican has yet to advance – would only raise about $80 billion per year. If you exempted charitable contributions from this cap (a political no-brainer), additional tax revenue would fall to about $40 billion per year.

In other words, when it comes to tax reform, the Republicans don’t seem to have anything serious to offer.

What would be refreshing is if political leaders would describe in detail what lies behind our tax code’s “loopholes.” The term conjures up shady practices and tax cheats. If so, why not get rid of them all?

The reason we don’t get rid of our tax system’s “loopholes” is the same one that explains why, during his presidential campaign, Mitt Romney refused to identify even a single one he would eliminate: They are popular. Instead, he – and now the Republicans – only suggest capping them.

If these “loopholes” were like calories and the federal government an overweight patient, it might make sense to simply and indiscriminately limit them. But that isn’t the case. They consist of varied provisions with wide-ranging justifications.

There are, for instance, those provisions that allow some (but not all) to escape taxes on income used for particular purposes, such as paying off a mortgage. There are others that allow some income (but not all) made off of savings to be taxed at a lower rate than is income earned in other ways.

Finally, there are fringe benefits – heath care and retirement benefits primarily – which are used to compensate employees but unlike wages are not taxed.

These varied loopholes are not identical in terms of their justification and impact. Many make good sense. Many more do not, but have become like entitlements that politicians fear touching, let alone simply naming.

Together these “loopholes” cost us $1 trillion in lost federal revenue each year. Fringe benefits account for about a third of this total. What’s more, in terms of employee compensation, fringe benefits are both growing in importance and becoming more unequal.

The mortgage deduction winds up providing substantial subsidies to people investing in real estate. The recent financial crisis was partly a result of citizens’ imbalanced investment choices. Should federal tax policy continue to encourage these investments over others?

The income of the very wealthy disproportionately comes from capital gains and dividends, for which they are lightly taxed. The rhetoric behind this provision, mostly having to do with economic growth, does not match up with the evidence.

Rather than jump-starting a debate over fundamental tax reform and making the case why we all need to pay more in taxes, the fiscal cliff focused us on an artificial deadline and the consequences of not acting before it. In this sense it contributed to, rather than redressed, long-standing and structural problems in how we fund our federal government.

Here’s hoping the New Year brings with it a more honest look at the unsatisfactory state of federal tax policy.

Katie Baird is an associate professor of economics at the University of Washington Tacoma. Email her at kebaird@uw.edu.

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