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November 14, 2012 10:57 PM Tax Reform Won’t Save the World

By Ezra Klein

Washington loves its panaceas. A few years ago, it was Army General David Petraeus who could fix any problem — up to and perhaps including the presidency. Then it was the Simpson-Bowles commission, or maybe the congressional supercommittee on deficit reduction. Today’s cure-all? Tax reform.

Tax reform “will result in the additional revenue the president seeks,” said House Speaker John Boehner in his post- election news conference. “It will support economic growth, which means more revenue is generated for the Treasury. And it will improve the efficiency of the system, which means additional revenue as well.” He went on to quote former Treasury Secretary George P. Shultz, who said the 1986 tax reform was “the unsung hero of the very good economic times we had for a long time.”

That’s the Washington consensus on tax reform: It slices, it dices, it cleans up after itself. But that’s not the economic profession’s consensus.

In 1997, Alan Auerbach and Joel Slemrod conducted an exhaustive survey of studies conducted after the 1986 tax reform. The results were mostly disappointing. The strongest effect they found was in “the timing of economic transactions” - - for instance, the rush to take capital gains before a new, higher rate kicked in. After that, it was “financial and accounting responses,” such as the effort to transform corporate income into individual income in order to, again, avoid higher taxes. All this is good news for tax lawyers, but what about moving the growth needle?

“At the bottom of the hierarchy is the response of real activities chosen by individuals or firms.” On this, the authors concluded, the evidence is “mixed.” Oh.

Economic Consensus

Over the past week, I’ve asked a dozen economists whether tax reform is likely to supercharge — or even kind of charge — growth. The consensus is summed up well by former White House economic adviser Lawrence Summers: “Given there’s a need to raise revenue, doing it by closing loopholes is probably a better way to do it than doing it by raising rates,” Summers said. “It can promote fairness, simplicity and resistance to special interests. But the idea that this is some important offensive growth strategy is implausible.”

Bruce Bartlett, who helped write President Ronald Reagan’s 1981 tax plan, is even more emphatic. “I am not familiar with any tax reform that raised growth, here or anywhere else,” he said.

Some kinds of tax reform could raise growth, at least in theory. Additional research by Auerbach, for instance, suggests that a sharply regressive consumption tax could add as much as 4.5 percent to gross domestic product over 15 years, in part because of the labor market effects of cutting taxes significantly on the rich and raising them on the poor. But no one is advocating that.

Instead, Washington policy makers are debating an approach — broadening the tax base through closing tax expenditures, credits and deductions — that isn’t likely to do much at all.

Tax economists Alex Brill and Alan Viard put the problem clearly in a brief for the American Enterprise Institute: “One of the major arguments some supporters of base broadening make - - that such reforms reduce work disincentives — is generally mistaken. Work incentives depend on effective marginal tax rates rather than statutory tax rates, and revenue-neutral base broadening leaves the former roughly unchanged.”

Reform’s Effect

Translated from tax policy-ese, the basic point is that if you’re not cutting total taxes — the “effective marginal tax rate” — you’re not going to drastically alter the incentives people have to work. As a result, you’re not going to see much added growth from tax reform, especially if the revenue contributed by various groups remains largely unchanged. All that should be pretty intuitive; if you’re not changing who pays taxes or how much they pay, you’re not changing all that much. Simplifying the tax code only gets you so far.

However, if Republicans and Democrats can agree on tax reform, it almost certainly will do more than simplify the code. It will increase taxes on the rich. And though there’s no reason to expect that will harm the economy in a major way, it will probably create a slight drag on growth. “I think of tax reform more as a way of limiting the losses the tax increases bring,” Auerbach says.

Another argument in favor of tax reform is that it will improve economic efficiency by letting the market, rather than the tax code, direct the flow of resources. Eliminate the exclusion for employer-provided health insurance and less money will flow to health care. Cap the mortgage-interest deduction and housing won’t be such an attractive investment.

“In their hearts, almost all economists believe that getting rid of tax expenditures will be good for growth because decisions will not be distorted by differences in taxes,” said Michael Greenstone, an economist at the Massachusetts Institute of Technology who also directs the Hamilton Project at the Brookings Institute. “Unfortunately, I don’t think there is much empirical evidence on this question either way.”

Which isn’t to say that tax reform isn’t worth the effort. Everyone agrees that it can help a bit, and most everyone agrees that raising taxes by reforming the code is probably better for the economy than raising taxes by increasing marginal rates (though many caution that, given our fiscal problems, generating revenue is the most important goal and promises of higher revenue through tax reform often don’t pan out). Tax reform doesn’t slice, dice or cut through cans. If it’s a “game changer,” it is only in the sense that it gives Republicans a face-saving way to do what needs to be done: raise taxes.

Ezra Klein is a columnist for Bloomberg View.

Comments

  • Anonymous on November 17, 2012 12:38 AM:

    I think Republicans are arguing tax reform, deficit cut and deregulation as the solo solution. free market will grow the economy once government gets out of its way, they say.

    I kept hearing from Democrats about the need for educational reform, infrastructure bank, energy/environmental policies, research and development investment during the campaign.

    I think both parties have the merits.
    Since Democrats have been also caring about deficit and entitlement cut unlike Republicans who dismiss the Democrats' investment ideas as socialism, i voted for Democrats.

    i was right because democrats are indeed working on deficit but and tax reform with Republicans right now.

  • meander on November 18, 2012 10:43 AM:

    I think the call for GOP's tax reform in exchange for dropping consideration of higher rates is bait and switch -- they know that loophole closing is politically impossible. It's easy to talk about cutting loopholes, but just try to go before the public (and associated lobbyists) and say you're going to get rid of the mortgage interest deduction, or the health insurance deduction. People will go bonkers! (Even if the economic case is very solid, e.g., most of the interest deduction goes to the LA, SF and NY areas.) And if the loophole affects businesses, there will be a sh*tstorm of opposition from the affected businesses and their allies.

    So let's try this: raise rates now, but make a deal that the rates will be cut back to today's levels IF AND ONLY IF the loophole is closed. If you close the mortgage interest deduction, drop the tax rate by 1% (or whatever makes sense). Get rid of the health insurance deduction, drop rate by 1%. And so on...

  • kris on December 04, 2012 11:03 PM:

    I disagree, but do note your last paragraph,
    tax reform can promote economic growth, stability, confidence, and reduce debt, the current tax code is full of special exemptions and carve outs, from corporations like ge, and so on, of course the big ticket items are things like charitable deductions, mortgage interest and state and local, health savings accounts and so on, unless the GOP and dems are really serious about gutting and really scaling back these things, which I doubt since many republicans have called for either expanded use or promotion of hsa, its a non-starter.

    Tax reform is not just about loopholes, its about a level playing field, and fairness, also there does need to be lower tax rates.
    A person who buys a few homes and sells them
    for enormous profit and takes a residency tax deduction, will either a lower rate or nothing to the irs since there is a 500k exclusion on cap gains, on the other hand someone who owns a stock from 12 years ago, will pay a tax of 15%, great, until you realize that inflation is 30%, for instance in 1980 a dollar was worth much more, a dollar could buy a loaf of bread, today $2 may not buy you a loaf but you would owe tax probably more than you gained,adjusted the tax for inflation is a must.

    Foreign income is taxed which is not true in many nations, sure there is an 88k exemption, but that does not apply to all people, and hurts business, if I go to the uk and do a transaction why should I be taxed twice?


    Tax deductions and credits however, even if they won't reduce debt without the big ticket items which are a must, are still valuable, I will not invest or start a business or not be as incentively if I know I can flip houses or trade stocks at a lower tax rate.

    Take a great example, a bit far fetched, you want to revitalize downtown so you give sales tax breaks, a bagel shop opens, great,
    in NY if you slice a bagel its taxed, but if its unsliced and you order a tub of cream cheese, and later go and get the utensils, you eat tax free, these little things may not reduce the debt, but they add up , and discourage investment, more so than paying a few extra in marginal tax rates.

    The AMT is tax reform, the tax reform of 86, did not go far enough, but in some areas it did, too far, people rushed to do transactions, and strict rules of passive real estate which were relaxed did not go far enough, in addition, tax provisions are not inflation adjusted, going back to the dollar no longer buying a loaf of bread. Eliminating state and local would be hard, but if you eliminate that and mortgage interest and make all the other loopholes, charity, and so on, people may accept, and its far better than ending up like greece, which ironically has a tax evasion problem because people are exempt from paying taxes unfairly, "I'm not paying 30% if the doc across the street is paying 5%".

    The charity or non profit deduction is misused because many organizations including think tanks are classified as non profit and lobbying firms, if I own or have connections to a church, I can donate money and have my cake and eat it too, behind the scenes, sure enforcement is necessary but if its going to be ineffective, abusive, and "government can't do anything right or do its job", why not eliminate the problem in the first place.

    Then of course,there are those who argue for tax deductions, after all countries with flat taxes may not be the most vibrant, I do agree in part, and of course there will probably be at least certain deductions, maybe medicine is not taxed, food should be taxed, steak v. ground beef, beef vs. oatmeal, dough nuts vs. water or seeds/soda.

    The above author had a point about raising rates and then lowering it by deductions,
    the hypocrisy of no new taxes or revenue neutral ones are silly, if we lower tax rates to 25% and then add the ethanol, mortgage interest, oil, deductions, should we th