Americas Lousy Tax Code

It’s that time again – there is less than a week to the IRS deadline and Americans once more focus on taxes. In the spirit of the Oprah Era, let me share a little bit. This is traditionally a tough time of year for me. It’s not just that I feel like the last American paying the income tax. Or that I won’t qualify for any refundable credit. Or that I won’t get a refund. I’ve got good emotional bulwarks built against those ailments. No, the real problem is that I’m a former editor of the National Tax Journal – a publication dedicated to good tax policy – and I care about taxes. (Upon further reflection, it may be that the real difficulty is that I ever became the editor of the NTJ – but I digress.) And the U.S. tax code is a mess.

Taxes are not complicated economic animals like derivatives, trade agreements, or airline pricing strategies. They are simple – the sovereign power of the state is used to take your money – and they should be evaluated by simple metrics: (1) do they raise enough money? The primary reason for taxes, after all, is to pay for presumably valuable government programs; (2) are they easy to comply with and administer? (3) do they do a minimum of damage to growth and innovation needed for economic success; and (4) does the burden of taxation fall fairly across the population?

It is thinking about these criteria that engenders my annual depression. (And this is serious; there are days I feel like Bob Samuelson sounds.) (1) The Obama Administration is advocating taxes that fall short of spending by a trillion dollars as far as the eye can see. The important term here is “advocating.” If the federal tax code and spending rules were left on autopilot, the budget would come to balance – the Obama budget document reveals this. So it is the politics of taxation that lead us to pretend we are Argentina. More on that below. (2) We find out more every day about the gap between legal liability for taxes and the actual payments sent to the Treasury. Some of this is flat-out cheating; some is the incomprehensibility of the tax code (evidently it is too hard for the average Cabinet appointee); and some of it is ingeniously-engineered tax shelters. But nobody believes that taxes are reasonable to calculate and cost-efficient to verify. (3) The U.S. tax code is an impediment to our economic goals. The corporate tax mitigates against our ability to compete around the globe and rewards tax-planning over business savvy; the individual tax is riddled with perverse incentives and is moving toward steadily higher levels of damaging effective marginal tax rates; and the Alternative Minimum Tax lurks in the background introducing a second set of damaging distortions and uncertainty. (4) The individual income tax has morphed from a broad-based revenue raiser to a surtax on high-income Americans; the corporate tax is increasingly borne by the American workers as a consequence of the inability of our firms to gain international market share and profits; and the payroll tax has grown to be the most important tax for the majority of Americans. The payroll tax is by itself terribly regressive, but when viewed over the lifetime as part of the social safety net is part of a system that is on-average progressive, but once more caught in the bind that spending outstrips revenues as far as the computer can project.

It is an appalling disaster and begs the question: how did we get here? A long time ago – think 1970s – the tax code was not indexed for inflation and it would push citizens into higher tax brackets even if they were not really (inflation-adjusted) richer. As a result, on a regular basis, the political community could convene and deliver a “tax cut for every American”. Ronald Reagan recognized something deeper – a desire for a more contained government – and delivered both tax cuts (1981, offset by 1982 and 1984) and tax reform (1986) to finance a smaller government more effectively. But his lasting legacy was to index the tax code for inflation. Ever after, to deliver “tax relief” politicians would have to lower real taxes, and the phrase “will take ___ million Americans off the tax roles” became the seductive gold standard. (The exception was the AMT – not indexed for inflation – where we now get to view a miniature version of the tax cut drama in the form of AMT relief.) This approach reached its political zenith in the demagogic hands of Barack Obama, who promised a tax cut for 95 percent of Americans, even though a minority of Americans pay any significant income tax. Even now, his budget proposals raise taxes on high incomes and businesses enough to offset checks (negative taxes) and lower payroll taxes (yes, it is spilling over to that as well), but not enough to be an overall tax increase, even as spending spirals north.

This is madness. It is bad for democracy to promise to revolutionize health care, education, infrastructure, energy, and the environment and tell people that 5 percent of Americans will bear the burden. It is dishonest to say to the same 95 percent that their economic frustrations are solely due to the Bush Administration (and its love of tax cuts for rich people); take our “Make Work Pay” tax credit and life will be fine. 

So, where do we go from here? It would be possible to develop a real-world 21^st Century income tax by admitting that it is a high-income surtax and designing it for the tax lives of global investors, individual entrepreneurs, and the financially-savvy among us. It would be even better if that reform rolled in the realization that the U.S. corporate tax lags behind even European business tax systems. But to really come to grips with the U.S. revenue system will require rolling into the tax reform the payroll tax, simply because it has become such a dominant feature of the landscape. That means that tax reform requires dealing with Social Security at a minimum.

None of this will happen proactively; instead the conventional wisdom says that it will take a crisis to force action. I used to dodge the “when will the crisis occur” question with a clever soliloquy on the mysteriousness of financial markets. No more. The Congressional Budget Office reckoning of the Obama budget says that by the end of the 10-year window the United States is borrowing solely to pay the interest cost of previous borrowing. If you are getting new credit cards to pay the old ones, you are toast. The crisis has arrived. I hope it is resolved so that I can face the next April 15.