Small steps could help

The Pak Banker - - Editorial - Chris Far­rell

Is the Amer­i­can sys­tem of tax­a­tion near­ing a wa­ter­shed moment? It doesn't seem like it, con­sid­er­ing the po­lit­i­cal brawl in Washington over the soon-to-be­ex­pired 2001 and 2003 tax cuts passed dur­ing the Bush era. Law­mak­ers have known for the past sev­eral years that, if they did noth­ing, the tax breaks would au­to­mat­i­cally end on Dec. 31, 2010. Now, Washington is scram­bling as the dead­line looms and the econ­omy sput­ters. The Obama Ad­min­is­tra­tion is push­ing to keep all the cuts ex­cept those for in­di­vid­u­als mak­ing more than $200,000 and cou­ples earn­ing more than $250,000. Some con­gres­sional Democrats would like to let the pack­age ex­pire. Con­gres­sional Repub­li­cans are ral­ly­ing around the pol­icy of ei­ther ex­tend­ing the cuts or mak­ing them per­ma­nent.

At first glance, what we're wit­ness­ing is the same old, same old about taxes in Washington. The pitched bat­tles be­tween sup­ply-siders and ad­vo­cates of rais­ing taxes on the rich mostly lead to tax cuts here and tax hikes there. And that tax ap­proach over the past quar­ter-cen­tury past has cre­ated a be­wil­der­ing maze of ex­emp­tions, ex­clu­sions, de­duc­tions, cred­its, carve-outs, loop­holes, in­come pha­seins, and in­come phase-outs. Econ­o­mists, let alone tax­pay­ers, despair at the waste from the bil­lions of hours and bil­lions of dol­lars spent on fil­ing, ad­min­is­tra­tive, and com­pli­ance costs.

De­spite una­nim­ity about the prob­lem and a brief moment of im­prove­ment un­der Pres­i­dent Rea­gan in 1986, the tax code con­tin­ues to ac­cu­mu­late ever more com­plex­ity. Re­form is hard since far too many in­dus­tries and in­di­vid­u­als ac­tu­ally sup­port the cur­rent setup, ei­ther be­cause re­form would hurt their pock­et­books by re­mov­ing things like mort­gage-in­ter­est de­ductibil­ity or be­cause they are adroit at or­der­ing their fi­nances around ex­ist­ing in­cen­tives (and dis­in­cen­tives). Washington law­mak­ers from both par­ties like hand­ing out tax good­ies to fa­vored con­stituents in re­turn for power and votes.

That said, ma­jor re­forms have swept the nation be­fore. Specif­i­cally, the tax his­to­rian El­liott Brown­lee ar­gues in So­cial Phi­los­o­phy and Tax Regimes in the United States, 1763 to the Present that there have been four ma­jor shifts in U.S. tax pol­icy. The turn­ing points were all as­so­ci­ated with fis­cal cri­sis: the Civil War, World War I, the Great De­pres­sion, and World War II. The com­mon thread is that each cri­sis forced the govern­ment to come up with an­other way to raise money.

For ex­am­ple, the post-Civil War fed­eral govern­ment largely re­lied on steep tar­iffs and ex­cise du­ties on such items as al­co­hol and to­bacco. The flaws of the sys­tem were in­creas­ingly ap­par­ent in the late 19th and early 20th cen­turies, but the trade dis­rup­tions of World War I forced an over­haul. The tax regime that held sway from 1916 to 1931 was dom­i­nated by new cor­po­rate and in­di­vid­ual in­come taxes, as well as ex­cise levies on con­sumer goods.

"Ul­ti­mately, durable tax re­form hap­pens when it must, not when it should. It hap­pens when old taxes just can't keep up any­more-not with fis­cal de­mands, not with changes in the econ­omy," writes Joseph J. Thorndike, of the Tax His­tory Project at Tax An­a­lysts, a non­profit pub­lisher of tax in­for­ma­tion.

The cu­mu­la­tive crises of the past decade have shown that the cur­rent tax regime isn't up to the fund­ing task. Fol­low­ing the tragedy of 9/11, the wars in Afghanistan and Iraq, and the fall­out in fi­nan­cial mar­kets from the Septem­ber 2008 bank­ruptcy of Lehman Broth­ers Hold­ings, the fed­eral govern­ment's obli­ga­tions have greatly ex­panded. Yes, much of the fed­eral govern­ment's red ink re­flects the fis­cal pinch from the worst down­turn since the 1930s. Even­tu­ally, an eco­nomic re­cov­ery will boost the tax cof­fer and some of the costs as­so­ci­ated with war, bank bailouts, and spend­ing to jump-start the econ­omy will dis­si­pate, too.

But en­ti­tle­ment spend­ing is grow­ing along with an ag­ing pop­u­la­tion. Econ­o­mists Alan Auer­bach of the Uni­ver­sity of Cal­i­for­nia at Berkeley and Wil­liam Gale of the Brook­ings In­sti­tu­tion cal­cu­late that if the econ­omy reaches full em­ploy­ment in 2014 and stays there for the rest of the decade, stay­ing the course with cur­rent fis­cal poli­cies would lead to a na­tional debt in the range of 90 per­cent of gross do­mes­tic prod­uct by 2020. (The Con­gres­sional Bud­get Of­fice says the debt will reach 62 per­cent of GDP by yearend; it was nearly 35 per­cent of GDP in 2000.)

That said, Washington seems spent af­ter the po­lit­i­cal fights over fis­cal stim­u­lus, health care, and fi­nan­cial-ser­vices re­form. With midterm elec­tions com­ing in Novem­ber, it's hardly an aus­pi­cious time for grand ne­go­ti­a­tion and bold bar­gains. But in the ab­sence of con­sen­sus on a mas­sive over­haul of the U.S. tax regime, there are still smaller steps law­mak­ers could take that might prove more po­lit­i­cally palat­able.

For in­stance, a grow­ing num­ber of tax mavens be­lieve a Value Added Tax, or VAT, is needed in the U.S. to re­store fis­cal san­ity. While that is not likely to hap­pen any­time soon, there are a num­ber of steps shy of a VAT-like ini­tia­tive that could move the coun­try to­ward a health­ier tax regime. Just ask James Poterba, head of the Na­tional Bureau of Eco­nomic Re­search and an econ­o­mist at MIT. He headed up the 2005 White House task force on tax re­form. The com­mis­sion came up with sev­eral good blue­prints that de­serve a hear­ing.

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