Moving Forward with Bipartisan Tax Policy

February 12, 2009

Download Working Paper No. 5

Working Paper No. 5

Introduction

U.S. tax policy is urgently in need of reform. Our tax system is overly complex and has failed to keep pace with changing economic conditions. The current economic crisis has led to an escalating budgetary shortfall, which will exacerbate the already significant fiscal challenges facing the country. Moreover, looming changes written into the tax law will require Congress to make major decisions regarding the tax code. On December 31, 2010, most of the tax cuts passed in 2001 and 2003 (“the Bush tax cuts”) will expire. In the meantime, the Alternative Minimum Tax will fall on tens of millions more American families. And the federal estate tax is scheduled to disappear completely in 2010 before reappearing in 2011. If these changes were permitted to take effect, which is unlikely, they would lead to sudden and significant changes in effective tax rates, after-tax wages, returns to capital, and the distribution of the tax burden. Congress needs to act, not simply to move towards a more stable tax system but to create a tax system adequate to the demands of the twenty-first-century economy.

Under current law, the tax system is also set to raise more revenue. Since the end of World War II, federal revenues have averaged roughly 18 percent of GDP. They are expected to fall to 17.5 percent of GDP for fiscal year 2010 (in large part due to the current economic weakness) and then rise to 19.5 percent in fiscal year 2012, the year after the Bush tax cuts expire, and to 20.2 percent by 2018. These increases may be welcome to some because they will bring revenues more in line with federal spending, which has averaged 21 percent of GDP over the past 25 years. Others will argue that spending should be reduced to match the historical revenue average.

Regardless of whether the tax cuts are extended, the gap between spending and revenues is projected to increase dramatically in the coming decades due to the effects of an aging population and rising per capita health care costs. Whatever disagreements there may be between those on the right and those on the left about the appropriate size of the federal government, the “correct” level of revenues is that which adequately covers the cost of government spending programs-if not year by year, then over the longer run. The unavoidable economic costs of raising revenue can and should be minimized by creating a tax structure that tries to minimize inefficiencies.

There is also a difference of opinion along the political spectrum over how progressive the tax code should be. Currently, the top 20 percent of earners pay nearly 75 percent of all federal taxes, while the lowest 20 percent pay only 0.4 percent. Many left-leaning observers think the tax code should be more progressive-particularly in light of growing income inequality in the United States. Others on the right argue that there is already a tremendous amount of redistribution in both the tax and spending sides of the budget and that the negative incentives and distorting effects resulting from additional levels of progressivity could have a harmful effect on the economy and on living standards.

Federal policymakers face a choice: they can either continue to operate in a “reactive” mode, proposing tax legislation haphazardly, resorting to temporary fixes, and acting hastily when tax legislation is due to expire, or they can take a “proactive” stance, instituting farsighted reforms that will lead to an efficient and fair tax system for the long term.

Although the authors of this paper have divergent viewpoints as to the appropriate role and size of government, we agree that the current tax system is inadequate: it raises revenue inefficiently and is not well equipped to handle the challenges of the twenty-first century economy. We agree that the federal government should take the following steps:

  • Create a more transparent and straightforward tax code
  • Promote saving by shifting toward a progressive consumption tax
  • Rethink tax expenditures
  • Update U.S. business income taxes
  • Implement an environmentally motivated tax policy

We believe that a productive discussion of tax reform must start where tax and budget policy considerations intersect. We agree on a number of changes that should be made to the tax code to improve its efficiency and transparency. And, most importantly, we believe tax reform has to be undertaken on a bipartisan basis if it is to be politically acceptable, economically sensible, and long lasting.


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