The Conventional Wisdom of Tax Reform

By James Kwak

In the Times this weekend, David Leonhardt has a generally good overview of the tax policy showdown that is scheduled for later this year, as the Bush tax cuts approach expiration on January 1. He outlines several of the central issues we face: “hypothetical solutions are a lot more popular than actual ones”; everyone says she wants tax reform, but the tax expenditures that would have to be eliminated are very popular; and any significant deficit solution will directly affect vast numbers of Americans.

I have a few differences with Leonhardt, however. First, after his colleagues David Brooks and James Stewart, he seems to have fallen briefly under the spell of Paul Ryan: “Mr. Ryan’s plan would cut the top rate to 25 percent, from 35 percent, and still leave overall tax collection roughly where it has been, by eliminating tax breaks.”

Paul Ryan has no tax reform plan. His bizarrely much-heralded “plan” is to cut tax rates to specific levels (25%, at the top end) and “broaden the tax base to keep revenue as a share of the economy at levels sufficient to fund critical missions that rightly belong in the domain of the federal government.” Nowhere does he say how he would broaden the tax base. This is a statement of an objective, not a plan.

As Leonhardt says, “What’s missing from these plans is any detail on which tax breaks would be eliminated”—which means they should be taken as political gambits, not as tax reform plans. A plan, like Domenici-Rivlin or chapter 7 of White House Burning, has to say what you would actually do, and Ryan fails that simple test.

More importantly, Leonhardt propagates a misleading framing of tax reform:

“The notion of tax reform also has widespread support from economists, liberal and conservative. As they define it, reform would reduce marginal tax rates while eliminating or reducing various tax breaks.”

There’s no definitional reason why tax reform has to reduce marginal rates. You could simplify the tax code and eliminate loopholes, reducing both administrative and compliance costs and economic distortions, without touching marginal rates. Sure, this would increase revenues. But it seems pretty obvious to me, as it would to a third grader, that if the problem is the budget deficit, then you want to increase revenues.

It’s also obvious to Daniel Shaviro, a leading tax professor who has been writing about deficits and tax reform for well over a decade.  From the abstract:

“First, if tax expenditures are properly viewed as spending through the tax code, a revenue neutrality norm in which the budgetary gain from their repeal ostensibly needs to be offset by rate cuts is intellectually incoherent. Second, the long-term U.S. fiscal gap makes rate-cutting, in particular for individuals, potentially imprudent. Third, if one wants to address rising high-end income concentration in the United States since 1986, the option of raising, rather than reducing, the top marginal income tax rates may need to be squarely considered.”

You may disagree with the third point, but the first two seem pretty irrefutable to me.

So why do people inside the Beltway reflexively equate tax reform with lower rates? It’s a political question, not a substantive policy one. Everyone knows that you can’t get any Republican votes for any bill that increases tax revenues. Ergo, there are only two ways tax reform could pass: either you make it revenue neutral—in which case you should admit that it will have no impact on the deficit—or you wait for (and campaign for) a Democratic sweep. Since doing the latter is “partisan” by definition, most wannabe centrists settle for the former. But it is certainly not correct to say that “liberal” economists define tax reform as rate reduction.

The other problem with revenue-neutral tax reform is that it presumes that the overall tax level set by the Bush tax cuts—lowered from the 1997 budget bill, itself lowered from the 1993 budget bill—is the right one. Revenue-neutral tax reform would make permanent a set of huge tax cuts that were passed (a) when the budget was almost in balance, (b) before the huge expense of the Iraq War, and (c) before the financial crisis and ensuing recession. Those tax cuts are due to expire precisely because the Bush administration could not find sixty votes in the Senate for them, and had to use reconciliation. If we’re going to aim for revenue neutrality—even though, as Shaviro points out, the concept doesn’t make sense because of the tax expenditure phenomenon—there’s no compelling reason why current tax rates should be the baseline rather than current tax law, in which we revert to 1997 rates on January 1.

The problem is that the conventional wisdom inside the Beltway is that tax reform means rate reductions to achieve revenue neutrality at Bush levels. If people believe that, Grover Norquist has already won.

14 responses to “The Conventional Wisdom of Tax Reform

  1. The real point here is that 2/3’s of all U.S. corporations pay NO income taxes at all! GE hasn’t paid anything in years. (Note who heads the President’s Jobs Panel!) Nor has Wells Fargo. The list goes on and on, but the math remains the same,e.g, 35% (or whatever) X $0 = Nothing, nadda, nix………..You can change the 35% to anything you want and the answer still comes out the same way. And the only solution is tax reform! And good luck with that!!

  2. Bought the book today. Thanks for all your great work.

  3. Arguing corporate tax rates is simply an effete meme, since those making the argument of lowering rates have KNOWLEDGE (or are in a position to KNOW) of the very low percentage of corporations paying
    income taxes, anywhere proximate to its’ robust income statements.

    Get someone good at “generating” NOL’s, and you can even find a path to refund NIRVANA.

    So, this entire argument (Paul Ryan and his ilk) consists mainly of smoke and horse manure, not necessarily in any particular order.

    Corporate tax rate Memeology: this is akin to network “news”…..memes repeated so often without basis in fact, that the majority of viewers consider the information valid and true.

    Nothing is further from the truth. Memes only obscure, and dumb-down the mentally shackled.

    Imagine YOU earned a GAZILLION BUCKS $$$$ and not only didn’t you register any tax liability, you somehow managed a big fat refund, on account of a LOSS. IS the multiverse this absurd?

    Someone on another post said good luck at tax reform…true that.

    But that’s what needed, especially at the corporate level, unless your real objective is not to tax the income of these entities.

    But, why not, they are people, aren’t they, per SCOTUS?

    James, keep up the good work, old boy. But I hope you are very much mistaken the *cretin* Norquist has already won.

  4. From 1945 to 1980 income taxes averaged near 12% of GDP. Reagan reduced marginal tax rates so much that they fell close to 9%. Clinton increase them back to 12%; and Bush/Obama reduced them again to 9 %(and below). However, on budget expenses have remained 12%(+/-1%)) of normalized GDP throughout. The deficit in income taxes has been financed by borrowing, largely from the Social Security trust fund. But, not only can we no longer continue to borrow from the trust funds, we have to start paying money back as beneficiaries start relying on the trust funds. In the short term, we have to raise income taxes to 12%, simply to cover on budget expenses. In the long term, income taxes must rise above 12% in order to pay back the trust funds

  5. Jones the Reprobate

    “There’s no definitional reason why tax reform has to reduce marginal rates. You could simplify the tax code and eliminate loopholes, reducing both administrative and compliance costs and economic distortions, without touching marginal rates. Sure, this would increase revenues. But it seems pretty obvious to me, as it would to a third grader, that if the problem is the budget deficit, then you want to increase revenues.”

    Absolutely right!

    It’s what I learned in Public Finance 4 decades ago. The government will raise taxes to meet its spending needs – and the spending needs never go down. Of course the new part of the equation is borrowing from China. When that declines then taxes will rise to meet that debt service. (Don’t be lulled to sleep by historically low interest rates.)

    I fear for the well being of my grandchildren if the present course continues. I wish Mr. Kwak would express why I should not worry about the future, but I think he either can’t or believes, like Keynes, that I’ll be dead anyway so, what, me worry?. His solution is to stay the course – everything will be all right. Countries never go bankrupt because they have the taxing power….

    Oh, and by the way, I have no truck with Norquist, But I see no value in today’s progressivism, which is, in fact, profoundly reactionary. Let’s just continue with the principles of the New Deal; everything will be all right. What’s worked for the last 80 years will continue to serve us; stay the course, keep the faith. What, me worry?

  6. Jones the Reprobate

    Oh, and I forgot to mention that Mr Kwak has a recent habit of demeaning the opposition. In the latest example, he avers that “it seems pretty obvious to me, as it would to a third grader, that if the problem is the budget deficit, then you want to increase revenues.”

    So anybody who suggests that the issue may be a tad more complex than that is a second grader to Mr. Kwak. I accept that he may think me at that level; I welcome it.

  7. The two big tax expenditures for the middle class are the deductibility of state/local taxes, and mortgage interest deduction. If the governmebt would raise the standard deduction to $11,000 for a single person, doing away with those tax breaks would have no impact on most Americans. Tax expenditures really do create economic distortions whereby people in Washington decide to subsidize things like private home ownership, when, in fact, the economy would be better off with a higher percentage of renters. Home ownership ties you to a community, and right now millions of jobs are unfilled because people are tied to their houses, and therefore cannot move without great financial loss. Why move for a better paying job, when the pay increase will be wiped out by the loss on the sale of your house.

    I really hope Obama gets re-elected, because as a second termer, he is more likely to lead true tax reform.

  8. @randymiller – “….Tax expenditures really do create economic distortions whereby people in Washington decide to subsidize things like private home ownership….”

    And the tax breaks that the oil industry gets is not subsidizing…? Yeah, you know what you are talking about – migrant workers living in high rent shacks – SLUM LORDING. Like the rents don’t go up beyond proportion when people have to go to a spot for slave labor – sickening and savage vision for 21st century USA – from moon walking to YOUR vision – must be the drugs…

  9. I was talking about tax breaks for the middle class. Politicians view mortgage interest and state/local tax deduction as sacred cows for the middle class. I think if Congress made the deal with the middle class on those two items, ninety percent of Americans would be willing to do away with the oil and slumlord subsidies.

  10. Oil companies and slumlord corporations are people too, my friend.

    And those people write the tax *laws*…

  11. I’m in favor of letting ALL the Bush tax cuts expire. The tax rates during the latter Clinton regime worked. We ran a surplus which is what a tax system is supposed to do during fat times. ( When a recession rolls in you run a deficit. ) As it happened we had budget surpluses for four (i.e., 4) consecutive years. The Treasury Dept. stopped selling 30 year bonds. And the employment situation was good.

    The notion that we can have a civic minded House and Senate revamping the tax code, eliminating bad loopholes and preserving good ones, is rubbish. The lobbyists will come storming into Washington like the Chinese army crossing the Yalu River. It will be a disaster.

  12. @ Brian, you got that entire post correct!

  13. bobthebayesian

    Tyler Cowen wrote up what I consider to be a pretty significant deconstruction of the entire premise of the tax arguments that have occurred recently on this blog. I’m interested to see if either James or Simon will respond.

    Here is the link: (Relative to baseline forecasts, ACA and otherwise).