1040 Individual Income Tax forms are arranged for a photograph in Tiskilwa,… (Daniel Acker/Bloomberg )
Ideas for improving the federal tax system are launched almost daily. Reformers have proposed a flat tax, an optional flat tax, the Buffett Rule. They've advocated broadening the tax base or instituting taxes on consumption or carbon.
Though most tax reform proposals are promoted as simplifying and rationalizing our extremely complex tax code, almost all lack critical details. But with tax cuts expiring and automatic spending cuts looming, taxation will return to the center of debate early in 2012.
That could be a good thing. Over the last 57 years, Congress has created a 4,000-page tax code, in which spending programs are disguised as tax preferences and loopholes favor special interests and distort economic decisions.
A reformed tax system should be simple, fair and predictable. It should promote economic growth. Would-be reformers should consider these guiding principles:
• "Taxes are what we pay for a civilized society." That quote, from former Supreme Court Justice Oliver Wendell Holmes Jr., is inscribed on the IRS headquarters in Washington, and it is worth remembering. Taxes are never popular, but they are necessary to finance governmental functions.
• Reforms cannot be considered in a vacuum. Tax reform should be linked to plans for deficit reduction. At the very least, it should not increase the deficit. Reforms, therefore, must be developed hand in hand with funding decisions. Congress must decide how much it considers appropriate to spend on defense, Social Security, Medicare and Medicaid, interest on our $15-trillion debt and the myriad other things that government funds, then design a tax system that meets those needs. Today, federal tax collections are at a historic low — about 15% of GDP (compared with the historic average level of 18.4% of GDP). This is also quite a low level compared with other developed economies. Deciding on the level of federal tax revenue needed to accomplish deficit reduction will be a key element of the tax reform debate.
• The tax base should be broadened. Tax breaks and exemptions amount to about $1.2 trillion a year. About 90% of those savings goes to individuals and about 10% goes to businesses. Our income tax system subsidizes activities such as homeownership, savings and investment, charitable contributions, health insurance and work. These income exclusions, deductions and credits cumulatively cost more than the entire amount raised by the income tax. Our tax code delivers these subsidies in an upside-down manner: a 35% rate taxpayer gets a $35 savings for $100 of home mortgage interest, while a much lower 15% rate taxpayer gets only a 15% benefit. Tax reform that scales back these special tax deals will subject more income to taxation, thereby broadening the tax base. But it won't be painless. Almost all taxpayers claim these tax benefits, but some benefit far more than others. Eliminating tax breaks will necessarily create winners and losers, and this should be acknowledged. Still, the entire range of such tax expenditures should be on the table.
• Reforms must consider where the tax burden should fall. Taking into account all federal taxes (individual and corporate income, payroll, estate and excise taxes), our current system is moderately progressive, meaning that taxpayers with greater wealth and ability to pay bear a greater share of the overall tax burden. Meaningful tax reform requires asking who should pay. Should the existing tax burden be shifted so wealthier taxpayers pay more? Should we move toward a flat tax, in which the same rate applies to all taxpayers? Under a flat tax that raises the same revenue as today's code, middle-income families would pay, on average, more than they do now, while high-income families would receive substantial tax cuts.
• All kinds of taxes should be considered. Individual income taxes yield about 44% of federal revenue. Payroll taxes bring in about 42%. Corporate income taxes yield about 7%, and excise taxes collect about 3%. Payroll and excise taxes (which we pay on such things as gasoline and alcohol) are generally viewed as regressive because their burden falls more heavily on middle- and low-income families. Before coming to the table, policymakers should consider which taxes they want to change and then identify who would be hurt and who would benefit in each case.