Tax Reform Magic?

Hardly a day goes by lately without a trumpet call for tax reform. Hurray! We desperately need tax reform. The Tax Code is a mess. I’m all for reform, but let’s return to the real world and face up to what tax reform can and cannot do.

Tax reform won’t create any jobs or boost the economy in the short run, in the first two years.

Tax reform won’t raise any revenue for deficit reduction in the short run.

So why do tax reform? Because it has lot’s of long run benefits, after five years. It will make U.S. multinationals more competitive and more likely to increase employment here in the U.S. It will shift employment away from the tax avoidance industry of lawyers and accountants to skilled workers who actually produce goods and services. It will cut down on the roughly $2 trillion U.S. multinationals have stashed overseas to avoid high U.S. taxes. It will stop rewarding U.S. multinationals for carrying debt and building financial services subsidiaries and will make them less vulnerable to financial crises. It will increase dividend payouts. It will lower the cost of capital and increase investment. These benefits only arise after firms change the way they operate, and that will take time, like many years.

On the individual side of the income tax, tax reform will reduce the excessive subsidies for housing and redress the disadvantage of renting. It will reduce health benefit subsidies which drive up health care costs. It will reduce the complexity which forces most taxpayers to use a tax preparer. With some extra effort, we could go to a return free system for most taxpayers.

The downside of tax reform remains hidden from most Americans. Those of us who benefit from tax loopholes are loath to admit it. Most American taxpayers have no idea that only 34% of 2008 tax filers itemized their deductions. Tax reform means closing loopholes and using the revenue raised to lower rates. If tax reform is done on a revenue neutral basis, which seems to be the operating assumption today, it will create almost as many losers as winners. Those losing tax loopholes will get lower rates too, but most will not get enough rate reduction to make them whole because there are plenty of taxpayers who don’t benefit from the loopholes who will get rate reduction too. That’s why tax reform won’t create many jobs or boost the economy or raise revenue in the short run.

Washington is a town notoriously addicted to quick fixes, which tax reform is not. That’s why tax reform doesn’t come along every day. The last time we had major tax reform was in 1986, after two years of legislative effort. When it becomes obvious that tax reform won’t produce short run benefits and when losers start lobbying their elected officials, tax reform could stall. In the past, tax reform has been enacted only after strong presidential leadership. So far, despite a lot of work within the Treasury Department that has yet to see the light of day, President Obama has steered clear of tax reform in favor of targeting a few loopholes.

One final sobering thought — Why would you expect the very same elected officials who junked up our Tax Code to reform it? Maybe, with enough voter pressure, tax reform could happen, but for how long?

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