What is Tax Reform? / by Todd Yarbrough

Year in year out the issue of tax reform remains at the top of most folks list of preferred legislation. Much is made about the inability of the current and former legislatures to enact what many believe are reforms necessary for fiscal health. How many politicians have promised to reform the tax code over the past 30 years? President Trump in fact has made tax reform a prominent part of his first year agenda. He is finding out how difficult tax reform is and why it hasn't occurred in more than 30 years. 

What I find especially interesting about the discussion over tax reform is how monotone it is. Despite the immense complexity of the tax code, most reforms put forward can barely be considered reforms. Take reducing the number of brackets for example. On the surface this may seem as a way to reduce the complexity of the tax, but it really doesn't do anything of real substance. If the U.S. moves from a 7 bracket income tax system to a 3 bracket one, what exactly makes more sense than did before? What is any more clear about the tax code than prior to such a minor change? Not much at all. Or how about the fact that many people seem to conflate lowering rates with simplifying the tax code? This is perhaps because politicians have joined these two issues at the hip in both rhetoric and proposed legislation. Regardless, lowering or even eliminating tax rates does very little to simplify a multi-thousand page tax code.

This is because most of the tax code complexity comes from the fact that there are many different ways for persons and businesses to make money. Given federal taxes are largely based on earned income, a tax code has to be malleable to the many ways we earn income. And the truth is a lot of the complexity in the tax code involves trying to keep tax rates low for persons and businesses by reducing the number of specific taxes an entity pays (take the avoidance of 'double taxation' for example). The tax code is full of carve outs and loop holes, reducing tax rates and making the tax code more complicated. The hard truth is that the tax code is so complicated because we made it that way. While some portions of the tax code are surely poorly thought out and inefficient, the vast majority serve real purposes. 

This helps to explain why the tax code has been so difficult to reform, politically speaking. Since most of the individual pieces of the tax code were designed to serve some purpose and because many of the purposes was to reduce the tax rate folks paid, then you can see why very little actually gets done to simplify the tax code. This also raises the question of whether you can ever have a simple tax code? Given that there are so many ways for folks to make money, and that specific parts of the tax code reflect both this and the goal of keeping rates low, what exactly would reform look like? What goals would reform have, beyond less complexity? And if reform occurs and significant changes are made to the tax code, how do we ensure that they don't simply lead to more complexity? 

To a tax economist such as myself, honest to goodness tax reform would occur across the following three considerations: 1) economic and revenue impact 2) progressiveness and equity and 3) complexity.  

The tax code needs to first and foremost confront what impact it has on the ability of the economy to grow and create jobs over the long run. At the same time, reform needs to ensure that tax revenue alterations generated by reform are fiscally responsible. Globally speaking, the U.S. tax burden is already low and quite business friendly. The ability for tax reform to enact pro-growth tax policies is limited by such low taxation. Further, reforming the tax code by lowering existing tax rates will likely lead to a reduction in the ability of the tax code to generate necessary tax revenue. In fact, most research suggests that revenues have already been weak, so furthering lowering rates has the potential to severely cripple revenue inflows. The only area where the U.S. has a comparatively high tax rate is the corporate income tax (CIT). Arguments in favor of lowering the CIT offer a mixed bag. Sure, there are tax havens that entice U.S. companies to park their profits overseas, but lowering our rates in an attempt to get this revenue back is 1) likely to fail and 2) would require rates that would reduce our ability to generate necessary tax revenues. Further, since most studies show that the majority of the CIT is paid by capital, and not labor, lowering the CIT would also reduce the progressiveness of the tax code. The U.S has recently been experiencing a general downturn in the number of new business start-ups, reflecting an overall downturn in entrepreneurship. Tax reform targeted at promoting small-businesses could be beneficial for three reasons: 1) increased competitiveness in industries with high market concentrations 2) wouldn't need to impact revenues much and 3) may cause some spill-over progressiveness. Overall, the U.S. tax code could and should be reformed to promote small-business entrepreneurship, but beyond this it would be difficult to make the tax code any more growth friendly without cutting the government's feet out from under itself fiscally. 

One area where the current U.S. tax code could use some significant reform is with respect to its progressiveness. The tax code is progressive with respect to statutory rates (the "sticker price" tax rate), but the aforementioned carve outs and loop holes actually make parts of U.S. tax policy regressive (and more complicated!). This is how Warren Buffet's secretary pays a higher effective tax rate than he reportedly does. Adding progressiveness to the tax code is easy in theory, but politically difficult. One could easily make the personal income tax more progressive by raising rates on the top brackets and lowering them on the low brackets, but the political power of the top income brackets makes such policy difficult to accomplish. One popular form of tax reform progressiveness would be to raise the tax rate on capital gains, since most folks who make substantial capital gains are at the top of the income scale. I am sympathetic to this argument, but more apt to suggest that our goal should be to get lower income folks earning capital gains. Perhaps then we could begin discussing a progressive capital gains bracket system. Alongside the consideration of progressiveness is equity. We hope to strive for a tax code that treats all income earners of a particular type the same. That is that persons and firms earning income in similar ways should be taxed similarly. It may be argued that adding considerably more progressiveness leads to an unequal tax code with those at the top paying a far larger proportion of their earned income to the government than lower income earners. There is both a moral and economic reason for a tax code to be progressive, potentially giving up some of its equity. Equity reforms should be focused on ensuring that carve outs and loop holes are being applied equally across persons and businesses, given the amount of preferred progressiveness. Given the immense income inequality in the U.S. at the moment, it doesn't seem readily necessary to be worried about whether rich folks are taxed at rate higher than poor folks, especially since they often are not and adding in such equity would most assuredly increase income inequality, all else equal. Overall, the U.S. tax code needs to be more progressive. With income inequality, education inequality, and access to avenues of success being severely biased towards high income earners, tax reform which adds progressiveness is likely pro-growth.

Lastly, we get to the complexity of the tax code. The U.S. tax code is both complex and confusing, but much of this complexity exists for precisely the same reasons that we now want to reform the tax code. In fact, a lot of past tax reforms show up as complexities in the current version of the code. I think if you were to ask a tax economist what they thought about how complex a tax code needs to be you'd here some non-answer about how the tax code should be as complex as we need it to efficiently produce the outcomes we wish it to. Basically, as has been true since there was a tax code, it is up to us how complex we want the tax code. As with anything in life, making the tax code less complex involves the potential for unintended and negative consequences. Simplification for simplification's sake is fool hardy and not in line with the spirit of true tax reform. But, reforms which accomplish both pro-growth and pro-progressiveness that also lead to a simpler tax code are difficult to locate and perhaps even harder to get passed. Overall, the tax code's complexity is a good political football that the parties can throw at each other, but should be a tertiary consideration behind growth and progressiveness concerns. 

I find much of the current national dialogue surrounding tax reform to be tiring and wholly missing the point. I'm not surprised this is the case, but cynical that it'll change anytime soon. Regardless, tax reform in earnest is a very important policy consideration that both parties are right to care about. It remains to be seen however if tax reform ever comes about, and if it does will it be any more than just tax cuts and bracket reductions? One could certainly hope. 

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Further reading:

http://www.taxpolicycenter.org/tags/tax-reform

https://www.brookings.edu/research/achieving-progressive-tax-reform-in-an-increasingly-global-economy/

https://www.cbpp.org/research/federal-tax/tax-reform-must-not-lose-revenues-and-should-increase-them