Politics Isn't the Only Barrier to Real Tax Reform

(Bloomberg View) -- In the annals of U.S. tax overhauls, 1986 is the modern guidepost. That was when a Republican White House joined forces with a divided Congress to modernize and simplify the U.S. tax code, cutting taxes on most Americans and raising them for some powerful interest groups. It was the last piece of tax legislation to deserve the label “reform.”

Republicans promised another set of reforms this year, but have pretty much abandoned comprehensive change in favor of tax cuts, mainly for companies and wealthy individuals. Lacking offsetting revenue increases as significant as those of 1986, the proposals are likely to increase U.S. budget deficits and the national debt.

Raw political expediency and partisan gridlock do much to account for the retreat from the hard choices needed to accomplish serious reform. But it’s worth pausing to remember that even if partisanship could be magically whisked away, even the most responsible tax reformers would face choices much harder than those of three decades ago.

That’s because there’s much less tax revenue lost now than then to the kinds of deductions and exclusions that bestow tax benefits on narrow classes of taxpayers. Those missing tax “expenditures” mean that tax reformers have much less to work with when they look for revenue-raising loopholes to close.

In 1985, the Joint Committee on Taxation, a congressional panel, compiled a list of tax expenditures totaling $424.5 billion, a figure that corresponded to 92.1 percent of the tax receipts in that year.

In 2016, the panel listed $1.5 trillion of tax expenditures, equal to 71 percent of the year’s tax receipts. In other words, tax expenditures were far more important a year before the landmark 1986 tax-reform measure than they were during the year before the latest effort. The menu for revenue raisers had shrunk. 

Beyond their overall shrinkage, tax expenditures have become more concentrated in a few areas. The exclusion for employer-provided health insurance, for example, has ballooned to 10.1 percent of all tax expenditures last year from 5.6 percent in 1985. The six biggest expenditures total 53.7 percent of the total for 2016 and only 38.4 percent for 1985. 

Politics Isn't the Only Barrier to Real Tax Reform

Why has this happened? The globalization of firms, rising health-care costs, and increasing property and asset values have all led to a more concentrated set of tax expenditures.

The upshot is that there is much less easy money to be had for the purpose of financing tax cuts. And these large tax expenditures are hardly “loopholes” -- they are significant policy choices with big constituencies that can’t be mopped up to fuel broader reform the way smaller expenditures could in the 1980s. The ratio of tax expenditures outside the six biggest categories to overall tax collections (the real menu for revenue raisers) has declined to 29.4 percent from 54.5 percent. 

In one way, this bad news is good news. It means that the U.S. has fewer small preferential items now than in 1985; the tax system is cleaner and there are fewer true loopholes.

But it also means that painful choices await those who believe in revenue-neutral tax reform. There are really only two paths forward -- higher rates on the existing base of income for some people, or new kinds of taxes. Higher corporate tax rates appeal to many liberals, but they would only lead to more flight of capital to lower-tax foreign jurisdictions in the form of inversions, profit shifting and reduced U.S. investment -- the very problems that have made lower corporate rates attractive to politicians on both sides of the partisan divide.

A better alternative is to raise rates on the individual side, which is best accomplished by having a new top bracket. Because wages for high earners have grown so much more quickly than inflation and increases for other groups, the top bracket, which historically had 0.1 percent of the filers, now has closer to 1.0 percent. Such a thick bracket lumps together people who earn $500,000 a year with those who earn $5 million, undermining what progressive rates are meant to accomplish. Moreover, such a thick bracket creates a large and politically vocal bloc well positioned to fight off proposals to raise its taxes.

Alternatively, tax reformers could try to push up taxes on capital gains or dividends, at least for higher-income taxpayers, but that brings disadvantages like discouraging people from saving.

The reality is that the existing portfolio of tax instruments is too small to be an effective tool for serious tax reformers.

That's why real tax reform can’t succeed without giving the government new ways to raise revenue, for example through taxes on carbon emissions and consumption. Without new taxes, the prospect is for chronic fiscal deficits and a struggle to pay for popular benefits like Social Security and Medicare. And forget about repeating the triumph of 1986.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mihir Desai, a professor of finance at Harvard Business School and a professor of law at Harvard Law School, is the author of the book "The Wisdom of Finance: Discovering Humanity in the World of Risk and Return."

To contact the author of this story: Mihir Desai at mdesai@hbs.edu.

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