The Economic Costs of Tax Policy Uncertainty: Implications for Fundamental Tax Reform

Summary:

For myriad institutional and political reasons, the U.S. faces tremendous tax-policy uncertainty in both the near and long term. While good tax policy is always preferred to bad, economic literature increasingly finds that policy uncertainty itself has negative implications for the economy, reducing investment, consumption, employment and growth, and possibly prolonging a weak recovery. 

A new Mercatus study suggests an additional, largely unexamined cost of the United States’ tax-policy uncertainty: “unproductive” or “destructive” entrepreneurship—the diversion of resources away from economically productive activities to the unproductive activity of lobbying for preferential tax-policy treatment. 

The Economic Costs of Tax Policy Uncertainty reviews existing academic research on the causes and economic effects of tax-policy uncertainty, examines the relationship between tax-policy uncertainty and increased rent-seeking (such as lobbying and political action committee spending) and considers what these findings imply for fundamental tax reform.  

To read the study in its entirety and learn more about its authors, please click here

Key Points:

Economic Implications of Temporary Tax Policy

Tax-policy uncertainty has been shown to negatively impact a variety of factors relating to economic growth, including investment, consumption, and employment. 

The study’s findings suggest tax-policy uncertainty also leads to an increase in rent-seeking. 

  • Because policy uncertainty means the government is open to policy change, it encourages interested parties to spend more money on government lobbying efforts to secure preferential policy treatment. 
  • This diverts resources away from economically productive activities and toward the non-economically productive activity of rent-seeking, thus harming economic growth.
  • This cycle works both ways: tax-policy uncertainty increases rent-seeking; rent-seeking drives constant changes to the tax code, fueling uncertainty.
    • Tax-policy uncertainty—and the rent-seeking and tax loopholes it spurs—shrinks the tax base and reduces revenues. This increases borrowing and debt, which threatens higher tax rates that would further hamper economic growth.

Causes of Tax-Policy Uncertainty

The Budget Process. In recent decades, Congress has passed a series of budget control acts intended to impose discipline on the budget process. These acts have had the unintended consequence of encouraging policy phase-ins, phase-outs, and expiration dates. This gaming of budget rules results in official estimates of budgetary impact that are unrealistically favorable, in addition to an unstable and uncertain policy environment. Over the short term, this uncertainty is reflected by the “fiscal cliff.” Over the long term, uncertainty stems from a tax system that is expected to bring in far less revenue than Congress has committed to spend. 

  • The Congressional Budget Office’s (CBO) process for assessing the budget implications of proposed legislation—as set by the 1974 Congressional Budget Act and subsequent amendments—is regularly gamed by legislators who produce bills designed to receive unrealistically favorable analysis (or a smaller effect on the deficit than is likely to actually materialize).

No Lobby for Economic Efficiency. A key challenge to establishing and maintaining a predictable tax code (one with few special-interest loopholes) stems partly from the fact that economic efficiency does not have a well-organized or focused interest group to represent it. This is because while economic efficiency produces great benefits, these benefits are widely dispersed, making organized lobbying more difficult. 

  • In contrast, carve-outs that make the tax system more inefficient, complex, and inequitable often confer concentrated benefits on a relatively small group. While the costs of such measures generally far outweigh the benefits, the beneficiaries are more concentrated and the benefit-per-beneficiary is often much larger. These measures lend themselves to increased special-interest lobbying.

Lessons from History: TRA 86

The federal government’s most recent fundamental tax reform effort—the Tax Reform Act of 1986—closed loopholes, broadened the tax base, and lowered rates. Studies have shown that it greatly reduced economic inefficiencies, and some argue it laid the foundation for the United States’ strong economy during the remainder of the 1980s and in the 1990s. 

  • But in the 20 years following TRA 86, Congress amended the tax code approximately 15,000 times—that’s more than twice a day, including weekends!
  • A major shortcoming of TRA 86 was that the new tax system remained malleable, leaving open some of the largest and most politically sensitive tax loopholes—such as the mortgage interest deduction and the exclusion of employer-provided health insurance. As soon as many of the other loopholes were closed, lobbyists and Congress were hard at work to reopen them. 
  • Economists Alan Auerbach (Berkeley) and Joel Slemrod (Michigan) concluded in their review of TRA 86: 

“Even the simplification potential of radical tax reform depends on how enduring a simple, broad-based tax can be, in the face of constant political pressure to reintroduce special ‘ encouragements’ or to redistribute the tax burden.” 

Enduring Fundamental Tax Reform 

Create a code that is simple, equitable, efficient—and predictable—requires diminishing the opportunities for rent-seeking. 

  • Budget Process Reform. Reforms could include requiring CBO and JCT to score proposed legislation over the next decade both as written and as fully phased-in; the score that is less favorable would be operative. 
  • Restricted Deductions. 
    • A no- or low-loophole tax code could take the form of a flat tax with limited exclusions enforced by a constitutional amendment (as suggested by Milton Friedman), possibly requiring supermajorities to pass laws pertaining to tax expenditures.
    • Other studied reform options include setting a fixed and enforceable limit for tax deductions. 
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