Time nears for an American tax overhaul

By Lawrence Summers
February 26, 2012

However the U.S. presidential election turns out, the trifecta of the Bush tax cut expiration, the debt limit ceiling on the horizon once again, and the Congressionally mandated sequesters – cuts in domestic spending – will force the president and Congress to wrestle with fiscal issues either in a lame duck session after the election or in early 2013. The decisions they make will have profound impacts on America’s fiscal future.

For many observers, the central question on the table is about entitlement programs: What will be done with them? Growth in entitlement spending associated with our aging population and its rising health care costs is the major factor in overall federal spending growth. But the capacity of near-term policy changes to have large impacts on that spending is less than many would suppose. The rising ratio of retirees to workers means that Social Security benefits at current levels will not be sustainable without some kind of tax increase. Sooner or later, revenue will have to rise or else outlays will have to be curtailed. While it is surely better to act sooner, the reality is that, out of necessity, action on entitlements is inevitable.

While almost everyone agrees on the desirability of containing federal health care spending, this is likely to be more difficult than we’d like to believe. Certainly beneficiaries can bear more of the cost of their government insurance than others, and there are steps like malpractice reform and the further encouragement of preventive medicine that should be taken. Yet without intrusions into the private health care system that are unlikely to be politically acceptable, there are severe limits on what can be done. Otherwise the result will be unacceptable cuts in the availability of care for the clients of federal programs. Given all the uncertainties associated with new technologies, changing lifestyles, and ongoing changes in the private system, health care reform will and should be a continuing project.

But let’s place health care aside for now. Less discussed in the context of major deficit reduction is tax reform. For a variety of reasons, 2013 should be the year when the tax code is overhauled in a substantial way.

First, the United States will need to mobilize more revenue. This year the federal government will collect less than 16% of GDP in taxes—far below the post World War II average. The combination of an aging society, rising health care costs, debt service costs that will skyrocket whenever interest rates normalize, a still-dangerous world in which our allies’ defense spending is falling even as that of potential adversaries rises rapidly, and a growing fraction of the population unable to hold steady work means that in all likelihood federal spending will need to be larger not smaller relative to GDP in the future.

Raising marginal corporate rates or increasing individual rates beyond their Clinton-era level raises serious issues about incentive effects or encouraging tax shelter activities. Raising rates is, in any event, unlikely to be politically feasible. A much better strategy for raising necessary revenue would start from the premise adopted by the Simpson-Bowles bipartisan commission that tax expenditures are a form of government expenditure and presumptively should be cutback unless they can be justified.

Second, the current tax system is, in certain ways, manifestly unfair at a time of rising inequality. As is well recognized, America’s rich have gotten richer with the top 1 percent’s income share rising from the 10 percent range to the 20 percent range over the last generation, while middle class incomes have stagnated or worse. There is plenty of room for debate about the causes of rising inequality, and the extent to which reducing inequality should be a central objective of government policy and about the possible disincentive effects of excessively progressive taxes.

But there are fairly expensive aspects of the current tax system that favor the most fortunate – aspects that border on the indefensible. Recent political debates have pointed to loopholes that permit a few of the very fortunate to accumulate tens of millions of dollars in a tax-free IRA when almost everyone else is constrained by a $2,000 contribution limit. Can the observation that Ireland, Bermuda, and Luxembourg are three of the five jurisdictions where the U.S. corporate sector earned the most profits reflect anything other than rampant tax sheltering? Anyone who doubts this should ponder the fact that in 2007, U.S. corporate profits in Bermuda totaled 646% of Bermuda’s GDP. The treatment of profit incentives paid to investment operators who make no investment of their own money but simply receive the “carry” as they invest other people’s money is another example of an inappropriate provision.

These examples and many others are not only significant because of revenue the government could recoup while also making the tax system fairer. They matter because they illustrate the power of special interests to shape fundamental aspects of economic policy. Reform could be an important step towards rebuilding citizens’ confidence in the federal government, which is sorely lacking today.

Third, even while raising too little revenue and giving much away to various shelter efforts, the current tax system also manages to excessively burden economic activity. Corporate rates at the very high end of the world range encourage firms to manage their affairs so as to minimize reported U.S. profits using devices like transfer pricing, and to encourage the use of debt rather than equity finance. Employers who know that their workers face high tax rates work to find ways of providing compensation in the form of tax free perquisites rather than money income. High marginal rates on individuals, along with a substantial capital gains differential, encourages individuals to spend time and effort that should be used more productively on engineering conversions of ordinary income into capital gains.

While the U.S. tax code is altered frequently, serious reform is no more than a once in a generation happening. The last serious tax reform effort took place in 1986, meaning we are overdue. The Simpson-Bowles proposal for eliminating all tax expenditures and radically reducing tax rates provides an excellent starting point for a debate the country should have.

The delicate question is: How should Washington prepare for serious tax reform during what is likely to be a unique window of opportunity in late 2012 and 2013? The timing is essential, both because of all of the deficit reduction activity, but also because spending-side reforms will have a much more difficult time moving forward if revenue is not addressed as well.

It is tempting to say presidential candidates should put forward their tax reform proposals in detail and allow voters to choose. However, this is unlikely to work. Indeed, the more tax issues are discussed during the campaign, the more the candidates will be driven to make pledges about things they will never do—pledges that might make tax reform that much more difficult.

Here is an alternative: Leaders in both parties should commit themselves to the goal of tax reform for growth, fairness and deficit reduction. They should acknowledge that every tax expenditure or special break has to be on the table. They should have their staffs are compile a large inventory of options. The relevant Congressional committees should take testimony from experts of all persuasions. And then right after the election, the negotiations should begin. Nothing that is likely to be done during the next four years will be more important.

Photo: U.S. President Barack Obama receives a standing ovation as he addresses a Joint Session of Congress inside the chamber of the House of Representatives on Capitol Hill in Washington September 8, 2011.

9 comments

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Stop giving this fake a forum please

Posted by Hinch | Report as abusive

How about stopping these blood- and money-draining wars? None of the countries we are currently pouring money into poses a threat, at least not as much as the arms industry does. Next, force Medicare to negotiate with drug companies instead of being held hostage to them. There are plenty of ways we can resolve tax issues–and they all involve justice and equality, which is why US politicians will never touch them! You first Larry.

Posted by cautious123 | Report as abusive

LS: You’ll need more background facts to make this report legitimate, and these facts speak for themselves.

Putting aside the tax issues, a farce of astronomical proportions which only benefit the 1%, the Social Security and related issues are even more astounding.

SS would have a tremendous surplus and be very healthy today if the contributions into it were not classified as a “TAX” as it was conveniently & criminally decided in the mid 1960′s. Our retirement contributions have been spent on all kinds of federal budgets which profit only the 1% and only a part of it go to retirement benefits.

Former NYC Mayor Ed Koch had made this very clear many years ago on national television.

As for as a national health insurance plan we can only look at our Canadian neighbors, the British and even the Taiwanese who spend less than 10% of their GDP for an effective social health program while we spend more than 17% of ours going to the pockets of the insurance companies and for which we have no insurance plan to speak of. The income of doctors in these countries average 70% less than their American counterparts, and they get bonuses for preventive medicine, something our American Pharmaceutical Cartels will never allow.

The presidential elections are now nothing more than a farce. “Super Packs” the final suicide potion to our democracy. In fact today there is more ‘Democracy’ in China than in the USA. Think of it.

Come on my fellow Americans, how much more abuse can we take. Are we that impotent ?

Posted by GMavros | Report as abusive

The plain fact is that the USA cannot pay its debts to its own people. So it will default (“cut benefits”) on its debts to the people who have the least ability of anyone on the planet to hurt our rulers — the American people themselves. No other fact should be needed to prove the bogus nature of American “elections”.

We the People simply do not have a choice. We cannot stop the past two invasions, nor can we stop the next two. We will continue to be heavily taxed for benefits our Government knows it will not pay, even while it gives money to others who have not paid into the system.

Until some sort of system is created that is beyond the reach of our bribery organized Government, no taxes for social “benefits” should be collected at all. A functioning democracy without politicians openly accepting and soliciting bribes should be a prerequisite to even considering public “benefit” programs.

Posted by txgadfly | Report as abusive

The United States needs a Value Added Tax, dedicated to its deficit. This is what solved Canada’s problems. That, and a national dedication and sense of common purpose.

Posted by stefancaunter | Report as abusive

Leaders in both parties are committed either to staying in or kicking the other party out of power. “Should” therefore takes on different meanings depending on whether one is a Democrat or a Republican. I expect it will remain an arm wrestling contest with the party most at risk of losing seats in Congress yielding as little as possible in an attempt to stave off that unwanted outcome. The populist sentiment that sent a crowd of tea party candidates to Washington has certainly failed to improve the situation; it hasn’t even succeeded in its unadmitted mission of making the president look so ineffective that he wouldn’t stand a chance of being reelected.

Posted by ChicagoFats | Report as abusive

Should, should, should. What deserve attention are not these substantially correct, but fairly obvious, observations, but the structural impediments. Stanley Surrey of HLS had developed all this fully before 1974.

Obama was a fool to squander his 10 minutes of popularity on health care reform, instead of his promise of election reform. He didn’t have the guts to risk his second term in order to accomplish something meaningful. “Yes we can” my behind.

Posted by Realistperhaps | Report as abusive

I always like reading material from LS, but let’s be clear on one basic fact: a majority of the US population has little or no idea what the current status of the economy is – who benefits (and why) – who doesn’t benefit (and why) – and that there will be little to no change in the fiscal course that has been established. Without a cohesive, large scale, peaceful (but energized) push by tens of millions of people; the country will have no choice but to benefits and raise taxes (or cut popular deductions) causing a further divergance between the economic classes.

Posted by ProfMagyar | Report as abusive

Larry, you know as well as we all know that your statement about tax problems, “….will force the president and Congress to wrestle with fiscal issues either in a lame duck session after the election or in early 2013. ” simply has no validity. Congress hasn’t wrestled for so long that it is only a showplace in the Capitol Building. Without political consequences for each member, they’ll continue to do nothing in order to fool the public into thinking that it is the other side whom is ineffective. It is such a charade as to be shameful.

Posted by ReasonRules | Report as abusive