Tax Cuts or Tax Reform for 2006?

Are more tax cuts on the way in 2006 from Washington? An article today from USA Today suggests that support from Republicans for tax cuts during this midterm election year is diminishing.

The problems Republicans are having passing a relatively small set of tax cuts this year point to bigger trouble for President Bush: His tax-cutting agenda is in jeopardy, lawmakers and lobbyists say, dimming prospects for extending the big tax cuts passed in 2001 and 2003.

Republicans say rising federal budget deficits and the costs of Iraq, Afghanistan and Hurricane Katrina make it harder to argue for tax cuts. Though this year’s package probably will pass, Bush’s signature domestic policy goal faces hard times ahead.

“As deficits increase, it puts more pressure on most members to question how much further we go in terms of cutting taxes,” says Rep. Jim McCrery, R-La., a leading candidate to become the next chairman of the House’s tax-writing Ways and Means Committee. “We are going to have to … get spending much better under control before we can continue to cut taxes to the extent that many would like to.”

However, the best line of the article appears near the bottom:

Some tax cuts passed in 2001, such as those that benefit married couples and parents, have less economic impact, says Douglas Holtz-Eakin, former director of the Congressional Budget Office.

” ‘Make the tax cuts permanent’ has always struck me as too sweeping a mantra,” he says. “Make the good parts of the tax cuts permanent.” (Full Story)

Holtz-Eakin is correct. Passing any and every tax cut available is not necessarily the best tax policy. Rather, the best tax policy would be to reform the entire federal tax system in a way that would broaden the federal tax base by treating income from all sources equally and allowing lower across-the-board tax rates – assuming we retain an income tax and don’t move to a consumption-style tax system.

While many lawmakers in Washington consider every tax deduction or credit they enact to be a tax cut, this practice of treating one economic activity differently than another with respect to the tax system often leads to huge distortions in the marketplace. These “targeted tax cuts”, typically enacted for targeted political reasons are generally not the best method to promote economic growth and are in practice end up serving as little more than central economic planning of the U.S. economy.

Two crucial points need to be made: (1) enacting targeted tax preferences is not the same as enacting base-broadening tax reform; and (2) not all tax cuts are created equally. Some tax reductions are economically better than others.

For more on reforming the federal income tax system, check out the Tax Foundation section on tax reform.