The Role of Tax Reform in Deficit Reduction

Abstract

Income tax reform discussions too often are exercises in tax nostalgia. The Tax Reform Act of 1986 was revenue neutral because it could afford to be. (It also was preceded and followed by major tax increases.) The fact that we must raise revenues today means that a contemporary incremental income tax reform effort will look different, not that it is impossible. Unlike in 1986, when the tax system overflowed with unintended tax shelters that could be cleaned up and traded off against lower rates, modern tax reform must tackle some of the deliberate Congressional subsidy programs baked into the tax code, which is to say, tax expenditures. Of these, the most important to address are the personal itemized deductions. They are extraordinarily costly - about $250 billion/year in forgone tax revenues. And they are inefficient, poorly targeted and unfair. The personal itemized deductions invariably are described as political “sacred cows.” But they are sacred cows that we can no longer afford to maintain. Either we eliminate these sacred cows, or we allow them to stampede over us. Incremental income tax reform also must address the corporate income tax, but here there is no choice but a revenue-neutral approach, because the U.S. corporate rate is now a global outlier. A corporate tax reform package should be fashioned along the following lines: (1) Eliminate business tax expenditures; (2) Reduce the corporate tax rate to a rate in the range of 25-27 percent; (3) Tax multinationals on their worldwide income through worldwide tax consolidation. The resulting corporate tax system would represent a huge competitive boost for American domestic firms, would attract inward investment, and would provide a fair tax environment for U.S.-based multinationals.