Basic tax reform has long been one of the Republican Party's most cherished ideas. For many conservatives, a simple and flat income tax is the holy grail of public policy. Earlier this year, before the Republican electoral sweep, President Bush asked his treasury secretary to evaluate options for overhauling the tax system. So now that Republicans monopolize Washington, you'd expect a major push to overhaul the tax code. Instead, almost no one is calling for a tax overhaul. The administration reportedly wants only a modest tax package that won't even accelerate most of the 2001 tax changes. What has happened? Economic reality is proving more potent than political desire.
Economists generally favor an approach to tax reform that broadens the tax base and uses the additional revenues from the bigger base to cut tax rates. Broadening the base means ridding the tax code of the special deductions, credits, exemptions, and allowances that currently shield about half of all income from federal income tax. Trading off a simpler code for lower rates makes macroeconomic sense. Eliminating lots of deductions, credits, and so on would reduce the tax code's influence over how the economy allocates its resources, which is good for growth. Lower rates also should promote a more efficient economy, based on the rule of thumb in public finance that the efficiency costs of a tax are proportional to the square of its marginal rate.
The flat income tax has long been the favored version of tax reform for conservatives. They would tax all individuals and corporations at the same rate and exempt any income that an individual saves or a business invests. In theory, this type of tax reform should promote saving, which in turn could produce more investment, productivity gains, and again, economic growth. It's no surprise that a few years ago, Dick Armey, Bob Dole, Jack Kemp, Steve Forbes, and other conservative luminaries all pushed versions of a flat tax.
Yet even with conservatives setting the national agenda, serious efforts from the right to overhaul the tax system have ended. Americans for Tax Reform and the Heritage Foundation, two leading conservative groups that used to agitate for overhauling the code, continue to rouse the troops over extending the Bush tax cuts and repealing the estate tax, but they are quiet about tax reform. Their most recent broadside on flat taxes dates back to March 1999. The appeal of flat taxes has virtually disappeared, and the reasons for that can be found in economics more than in politics.
The first obstacle for any basic tax reform, including a flat tax, is that people value what they have relatively more than what they will receive in the future. Economists call this behavior "discounting." Think of support for tax reform as an investment in which you give up deductions or credits today to get lower rates that will spur the economy and raise your income in the future. But people discount the future gains, and rightly so, because the income shielded by tax preferences in the present can earn returns, while there is no certainty that the higher future income will ever arrive.
Recent history supports the disposition to sharply discount the benefits of basic tax reform. When people (and businesses) surrendered deductions in 1986 in exchange for lowering the top income tax rate from 50 percent to 28 percent and taxing middle-class income at 15 percent, the efficiency and growth gains were exceedingly small. Moreover, the grinding effects of large deficits forced the top rates back up in 1990 and 1993. With deficits of many hundreds of billions of dollars looming again, who can believe that this time out, lower rates will really accelerate growth or even that the rates will stay down once everyone's favorite deductions are gone?
Deficits present another problem: Big tax reform also usually includes tax cuts to assuage anxieties and sweeten the pot for those who give up deductions. In 1986, for example, Congress offered tax cuts for individuals in the process of reforming the tax code. It was able to finance those cuts by taking back some of tax benefits corporations had gained in 1981. Corporate America cooperated that time, but it's not likely to this time around. Business was shut out of the 2001 tax cuts, so with deficits returning there are no revenues available to pay for tax cuts that would calm wary taxpayers.
Basic tax reform faces an even more serious economic problem: People and businesses often face windfall losses when they forfeit deductions or credits that have long influenced spending decisions and market prices. Behind such losses lies a process called "capitalization," in which a market incorporates the value of a tax incentive into the price of the tax-favored good or service. For example, the existence of a home-mortgage deduction, the granddaddy of personal tax preferences, has raised housing prices: By reducing the monthly cost of homeownership, the deduction enables home buyers to bid up the price of housing until it roughly offsets the value of the deduction. That's why homeownership rates in Canada, which provides almost no tax benefits to home buyers, are nearly as high as ours. On balance, U.S. home buyers neither gain nor lose. But if tax reform eliminated the mortgage deduction, housing prices would fall, and current homeowners would face windfall losses.
Similar problems on the business side tell us why large corporations are not keen on a flat tax. In exchange for a flat tax, business would give up many deductions, including interest on loans used to purchase new equipment and the remaining depreciation on equipment. Stock prices, like housing prices, capitalize the value of a business's current tax deductions in estimating future profits. Some experts sympathetic to a flat tax have estimated that this process could knock 25 percent off the share prices of firms that have borrowed and invested aggressively—for instance, firms that form the core of American manufacturing.
And if tax reformers waver and keep big deductions like depreciation and mortgage interest, a low rate becomes unsustainable, and the efficiency benefits melt away. A clean flat tax with just an initial exemption—so we don't tax low-wage families into poverty—could raise today's revenues with a single 21 percent rate. Preserve depreciation on existing equipment, and the 21 percent rate hops to 23 percent; add back mortgage interest and employer-provided health insurance, and the rate hits 26.5 percent; include charitable deductions, state and local taxes, and the Earned Income Tax Credit, and the necessary rate is 29 percent. That's not much of a deal when fewer than one-quarter of U.S. taxpayers face a tax rate higher than 15 percent, and fewer than 4 percent face a marginal rate higher than 28 percent.