Sooner or later the American tax code will be reformed — probably sooner. Raising revenue will be the main motivation, but at a time of sharply increasing economic polarization, issues of fairness will be prominent too. There are also legitimate concerns about the complexity of current tax rules and their adverse effects on the economy.
So far, the debate has focused on scaling back provisions of the tax code that have favored activities traditionally deemed to be valuable. For example, there is talk of reducing deductions for charitable contributions, taxes paid to state and local governments, home mortgages, employer-provided health insurance and many less important provisions.
There are reasonable arguments to be made in each case. But taking only the “limit tax incentives” approach to tax reform has several major defects. First, if reform is designed to avoid perverse outcomes — such as the crushing of charitable contributions or more pressure on state budgets — then it will raise limited amounts of revenue. Second, this approach will address very little of the complexity in the code and is not likely to do much for recovery, since it will do little to increase demand. Third, it will do little to address concerns about fairness: The richest taxpayers actually make relatively little use of deductions and credits.
What is needed is an additional element, one that has largely been absent to date: the numerous exclusions from the definition of adjusted gross income that enable the accumulation of great wealth with the payment of few or no taxes. The issue of the special capital gains treatment of carried interest – performance fee income for investment managers – is only the tip of a very large iceberg. There are far too many provisions that favor a small minority of very fortunate taxpayers. Because these provisions effectively permit the accumulation of wealth to go substantially underreported on income and estate tax returns, they force the federal government to consider excessive increases in tax rates if it is to reach any given revenue target.
All parties — whether their primary concern is preserving incentives for small businesses, closing prospective budget deficits or protecting the social safety net — should be able to come together around the idea that it should not be possible to accumulate and transfer large fortunes while avoiding taxation almost entirely. Yet this is all too possible today.