"Fixing" the Tax Code: Key Principles for Successful Reform
"Fixing" the Tax Code: Key Principles for Successful Reform
The most basic goal of tax policy is to raise enough revenue to meet the government’s spending requirements with the least impact on market behavior. The United States’ tax code has long failed to meet this aim: by severely distorting market decisions and the allocation of resources, it impedes both potential economic growth and potential tax revenue.
While there is widespread agreement on the need for tax reform, there is no consensus—either between or within parties—on specific elements of reform. To move the debate forward, policy makers need to know the goals of successful tax reform and what steps to take to achieve those goals.
What Are the Goals of Tax Reform?
Clearly, the nation’s increasingly dire economic and fiscal situation has increased the motivation—and the urgency—to reform the federal revenue system, along with the federal government’s other unsustainable institutions and practices. But what would an ‘ideal’ tax code look like?
Luckily, policy makers need not fly blind when it comes to defining the principles and goals key to a successful revenue system. Academic research suggests that a successful revenue system should be:
Simple. The complexity of the tax system makes it difficult and costly to comply with; it also makes it easy to scam. Congress should make the tax code as simple and transparent as possible so as to increase compliance and reduce compliance costs.
Equitable. Policies intended to benefit or penalize select individuals and groups riddle the tax code; these policies also result in immeasurable unintended consequences. Fairness is subjective, but “tax fairness” would at least reduce the number of provisions in the tax code that favor one group or economic activity over another.
Efficient. Because the tax code alters market decisions in areas such as work, saving, investment, and job creation, it impedes economic growth and reduces potential tax revenue. An efficient tax system must provide sufficient revenue to fund the government’s essential services with minimal impact on taxpayer behavior.
Predictable. The negative effects of the current tax code result not just from what it does today, but also from what it may do in the future. Such uncertainty deters economic growth. An environment conducive to growth (and thus, increased revenues as a result of a larger economy) requires a tax code that provides both near- and longterm predictability.
What Reforms Are Most Likely to Advance These Goals?
There is broad consensus across academic research as to which key policies are most likely to promote solid, sustainable economic growth and revenues—and which policies are most likely to fail.
Lower Rates. Exhaustive economic research repeatedly proves this most basic effect: the more you tax capital or labor, the less you get. It also makes clear that incentives matter. Successful reform will lower current individual and corporate tax rates.
• “Both macroeconomic and microeconomic perspectives suggest that [higher] taxes slow economic growth, thereby limiting the scope for revenue gains.” Jeffrey Miron, Harvard University, "The Negative Consequences of Government Expenditure,” Mercatus Working Paper, September 2010.
• There is a negative tax multiplier of -1.1; taking money out of the economy through taxation costs the economy more than the actual dollar amount taken out. Robert Barro, Harvard University, and Charles Redlick, “Macroeconomic Effects from Government Purchases and Taxes,” Mercatus Working Paper, July 2010.
• Consequences of raising taxes on economic growth: “a tax increase of 1 percent of GDP reduces output over the next three years by nearly three percent.” Christina Romer, Former Chair, Council of Economic Advisers (2009–2010) and David Romer, University of California, Berkley,“The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” American Economic Review, June 2010.
• The United States’ corporate tax rate is among the highest in the industrialized world; this increases business’ flight to lower-tax countries, taking their jobs, money, and tax dollars with them. To regain competitiveness, reduce the U.S. corporate tax rate to at-or-below the 25% average rate of other OECD nations. Jason Fichtner and Nick Tuszynski, “Corporate Tax Reform: Why the United States Needs to Restructure and Reduce its Corporate Income Tax,” Mercatus Working Paper, Forthcoming.
• Similarly, further increasing the nation’s corporate tax rate would result in some combination of lower wages, fewer jobs, higher prices for consumers, and lower returns on investment. Fichtner and Tuszynski, forthcoming.
• “[D]omestic labor bears slightly more than 70 percent of the burden of the corporate income tax.” William Randolph, International Burdens of the Corporate Income Tax, Congressional Budget Office Working Paper, August 2006.
• Combining lower marginal rates with reduced government spending is likely to foster economic growth. Andreas Bergh, Lund University and Magnus Henrekson, Research Institute of Industrial Economics, “Government Size and Growth: A Survey and Interpretation of the Evidence,” January 2011.
• High tax rates encourage avoidance and evasion. Martin Feldstein, Harvard University, “The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act,” The Journal of Political Economy, June 1995.
• Historically, raising taxes increases Congress’ incentive to spend and decreases its incentive to cut. Barro and Redlick (2010).
• Other high-quality, empirical studies on the impact of tax rates on growth: Romero-Avila and Strauch (2008); Bergh and Karlsson (2010); Mountford and Uhlig (2008); Alesina and Ardagna (2009); Blanchard and Perotti (2002); Giertz (2006); Rogerson (2006); and Davis and Henrekson (2004).
Broaden Base, Eliminate Loopholes. One of the keys to successful fiscal reform is to move away from a spending system that depends upon an easily manipulated income tax system. Tax reform should lower rates, broaden the tax base, and eliminate loopholes; this will increase stability, and lead to greater economic growth, added employment, and perhaps even increased revenues. Barro and Redlick (2010); Fichtner and Jacob Feldman, “Lessons from the '86 Tax Reform,” Mercatus Working Paper, April 2011.
• Over the past 30 years, a rising percentage of citizens pay little or no federal taxes; this means that for these people the tax-price of government services is zero, resulting in a greater demand for government services, greater entitlement spending, and higher debt. Bruce Yandle, Clemson University, and Jody Lipford, Presbyterian College, “The Relationship between Tax-payers and Tax-spenders: Does a Zero Tax-Price Matter?” Mercatus Working Paper, August 2011.
• As the president’s Fiscal Commission recommended, tax rates should be flattened and the tax base broadened so that more citizens will feel the costs of spending and support actions to stop the cycle of excessive government spending and debt. Yandle and Lipford (2011).
• Spending through the tax code masks the true size of government, and “can lead to higher taxes, larger government, and an inefficient mix of spending…” Leonard Burman, Syracuse University Center for Policy Research, and Marvin Phaup, George Washington University, “Tax Expenditures, the Size and Efficiency of Government, and Implications for Budget Reform,” August 2011.
• Loopholes severely distort market behavior, influencing behavior based on tax preferences rather than the best and most productive economic decisions. “These preferences narrow the tax base, reduce revenues, distort economic activity, complicate the tax system, force tax rates higher than they would otherwise be, and are often unfair.” Donald Marron, Urban-Brookings Tax