President Obama’s Tax Reform Proposal: Good Policy, Brilliant Politics
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by Chip Krakoff

In a move bold and radical by the standards of Washington political gridlock, President Obama yesterday called for comprehensive tax reform. In so doing, he has given Congressional Republicans the rope with which they may choose to hang themselves.

Everyone from Paul Krugman to Rush Limbaugh can agree that the U.S. tax code – weighing in at around 10,000 pages it is the third longest in the world, after India’s and Britain’s – is a mess, shot through with loopholes, incentives, and exemptions: $1 trillion worth each year, according to the President’s bipartisan deficit reduction commission, which released its preliminary findings a couple of weeks ago. The gist of the President’s remarks is that the tax code could be simplified by removing these loopholes, broadening the tax base, and lowering both corporate and personal income tax rates.

The United States now has the second highest headline corporate tax in the OECD group of wealthier nations. This doesn’t mean that the average corporation pays 35% of its income in taxes; exemptions and loopholes result in much lower effective rates for many companies, but not all. Companies that do not operate in favored industries will pay much higher taxes than those that do. Consider as an alternative Sweden and Denmark, those bastions of high taxation and the welfare state, which impose corporate tax rates of 26.3% and 25.0%, respectively. Or some of the newer members of the European Union, in a rush to raise investment and employment after the breakup of the Soviet Union. Poland, the Czech Republic, and Slovakia have corporate tax rates of 19%, Romania 16%, and Bulgaria 10%. China and Vietnam, both still under Communist rule, tax their corporations at 25%. Even Cuba – Cuba! – has a corporate tax rate of 30%, not that it has much in the way of corporate profits to tax. The corporate tax codes in these countries have far fewer loopholes and exemptions, of course, and all of these countries have high rates of value added tax, but most of them also have a wider base of taxpayers and a simpler tax regime perceived by most as reasonably fair. The U.S. cannot make such a claim.

One of my principal gripes with the President has been his insistence on trying to achieve fiscal balance by raising taxes on wealthier Americans, while at the same time increasing the proportion of Americans who pay no Federal income tax at all. As gratifying as it may be to impose confiscatory taxes on neurosurgeons and Wall Street bankers, it is impossible to reduce the deficit in this way. The numbers simply don’t add up. I have advised a fair number of governments in emerging and developing economies on tax reform, and the mantra has been, and remains: broaden the tax base and lower rates.

Broadening the tax base makes sense for all kinds of reasons. It gives more people a real stake in society and its governance, changing them from passive recipients of government benefits to active contributors, who may be less eager to vote for expenditures they will have to pay for.  It also lowers the average burden on taxpayers, since with more contributors each one has to pay less. Broadening the tax base also means abandoning the obsessive focus on income tax in favor of multiple forms of taxation, which in turn allows us to lighten the tax burden on behavior we want to encourage (work, employment) and increase it on behaviors we want to discourage (carbon emissions, excessive indebtedness, overconsumption). It is possible to go too far in this direction and get deeper into the business of social engineering (ever-rising taxes on tobacco and alcohol and proposed surtaxes on sugary soft drinks, for example), but our government has been in the business of social engineering for some time. The mortgage interest deduction, the employer-provided medical insurance exemption, incentives to buy hybrid cars or solar water heaters, and tax breaks for oil drilling were all introduced to promote behaviors that politicians at one time or another considered virtuous and certain corporate interests favored.

The trouble is that what may once have been a perfectly justified social policy may become something else, but by then so many have come to depend on the resulting exemptions and subsidies that resistance to reform becomes entrenched. We have recently seen that our government’s compulsion to increase home ownership encouraged bankers to lend and people to borrow for houses they couldn’t afford. If renting instead of owning one’s home were less stigmatized in government policy and popular perception, the housing crisis would never have occurred. But home builders, real estate agents, and mortgage lenders have powerful lobbies that will pull out all the stops to block abolition of the mortgage interest deduction. Just about every other potential reform also has a well-funded opposing special interest group and lobbyists, who will fight hard to protect their benefits.  You don’t get rid of a trillion dollars in tax breaks without upsetting a lot of people. You don’t introduce new taxes (a national carbon tax and/or a value added tax, for example) without upsetting an equal number of people, and not just no-tax Republicans.

The outraged reactions we can expect to every tax loophole threatened with closure and every exemption set to be eliminated could be the key to the success of tax reform. The lobbyists will squawk and spend vast amounts of money no matter what. But if there is a widespread sense that everything is on the table, nothing is sacred, and the pain will be shared more or less equally, it’s just possible that everyone would agree to sit down together and thrash out the details. It’s a process that could take years, but could just work.

This is where President Obama could rescue his Presidency. Never the radical leftist some think he is, the President may be moving closer to the center as a result of Republican gains in the November mid-term elections. If he succeeds and gets the Republicans to work with him on tax reform, he wins – the more so if the process yields some results. But if, as so often happens, the Republicans manage to snatch defeat from the jaws of victory by refusing to work with the President in a self-destructive obsession to vanquish him, he also wins. The Republicans will stand revealed as the mad obstructionists he has accused them of being, and he could ride the wave of revulsion into a second term in the White House. If the Republicans were smart, they would get out in front on this, encouraging the President and the Congressional Democrats to work together with them on meaningful tax reform. If the President is smart, he will do likewise. Unfortunately, the Republicans show no recent evidence of smarts and are likelier to denounce the President’s proposal as a ploy. In that case, they risk going down in flames in 2012, in one of the greatest-ever reversals of political fortunes.

Posted 12-17-2010 9:02 AM by Charles Krakoff