Deficit reduction through tax reform

On April 15, every Washington policy wonk’s fancy turns to thoughts of streamlining the tax code.

This year’s most-talked-about idea comes from two iconoclastic senators, Oregon Democrat Ron Wyden and New Hampshire Republican Judd Gregg. The two have proposed a plan that would simplify the tax law, shrink your 1040 form to a single page and even cut taxes slightly for most people who make less than $200,000 a year.

Their plan still has a few kinks. It counts, for example, on billions of dollars in revenue from closing corporate loopholes, but doesn’t spell out what those are. Still, the senators have raised two important concepts: First, we’re overdue for major tax reform. And second, fixing the tax system may be key to solving an even bigger problem -- the ballooning federal deficit.

The last time Congress passed a major tax reform bill was a generation ago in 1986, when Ronald Reagan was president. That law eliminated loopholes, simplified the tax code and cut the top tax rate from 50% to 28%. Since then, rates have crept back up; the top rate is now 35%, and next year, after George W. Bush’s tax cuts expire, it will rise to almost 40%. Also, thanks to gifted and energetic lobbyists, special provisions -- better known as loopholes -- have affixed themselves to the tax code like barnacles.

Wyden and Gregg propose reducing the number of tax brackets, increasing the standard deduction and eliminating almost all itemized deductions except for mortgage interest and charitable contributions. They would set the top tax rate at 35% for income over $140,000 and would abolish the dreaded Alternative Minimum Tax, which hits people hard in high-tax states such as California. In a proposal that has already drawn criticism from conservatives, they would cut the capital gains tax rate for low-income investors but raise it for high-income people (to almost 23% from the current 15%). And they would attempt a grand bargain on corporate taxes, eliminating almost all loopholes and special provisions in exchange for lowering the corporate tax rate to a uniform 24% (from a top rate of 35% today).

The underlying trade-off is a conscious echo of the Reagan bill of 1986. Gregg, the Republican, likes the lower rates, especially the corporate rate. Wyden, the Democrat, likes seeing most of the benefits flow to people making under $200,000 a year. They both like the idea of a simpler, fairer tax code.

The two senators carefully designed their bill to be “revenue neutral” on paper -- that is, to produce the same level of revenue as the current tax law. But -- and this is important -- they both predict that one long-term effect of tax simplification would actually be a revenue increase, and a virtually painless one at that.

Wyden says revenues would increase because a simpler tax law would be easier for people to obey and easier for authorities to enforce. Gregg says revenues would increase because a lower corporate rate would stimulate investment and job creation at home.

And that leads to the other big reason to do tax reform: the growing federal deficit. Last year, the federal government collected 15% of GDP in revenue but spent 26% of GDP, an unsustainable gap of 11%. Once the recession ends, that shortfall is expected to shrink to about 6%, but economists say the budget won’t be healthy until the deficit falls below 4%.

Wyden and Gregg both believe more tax revenues are part of the solution. “You’re going to have to generate [more] revenues,” Gregg said. “I don’t think there’s any choice. . . . Looking at our fiscal house, we’re going to have to address tax reform.”

Is the Wyden-Gregg bill likely to pass? Not this year. Congress has too many other priorities on its plate: financial regulations, immigration law and a reelection campaign this fall. President Obama has said he favors tax reform in general, but he’s handed off the details to a commission headed by former Federal Reserve Chairman Paul Volcker. “If, at the end of the day, we need to raise taxes, we should raise taxes,” Volcker said last week. But neither party in Congress wants to pass a tax increase between now and November.

Besides, Wyden and Gregg are unlikely engineers of a backroom grand bargain. Wyden is a maverick among Democrats, an idea generator but not a legislative deal-maker. Gregg is a maverick among Republicans -- and he’s leaving the Senate at the end of the year.

But they deserve credit for raising the issue and for drawing up a proposal that could serve as a base for future efforts -- not only for simplifying the tax code but for tackling the deficit.

Sooner or later, taxpayers will have to pay for the tab the federal government is running up now. Spending cuts alone can’t do it; so far, at least, voters have rejected the deep cuts in Social Security and Medicare that would be needed to balance the budget. That means tax revenues must rise.

But those tax increases will be a lot more palatable if the tax system is simpler, clearer and fairer.

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