The Best Way to Reform America's Tax Code

Suppose you are given a choice among several competing tax policies. A few of them work, but most of them don’t. Which would you prefer? The tempting answer is “the one that works,” but does anyone really know what “works” means?

Hank Gutman does. From 1991 to 1993, he was chief of staff for the Joint Committee on Taxation and the primary non-partisan advisor to the House Ways and Means and Senate Finance Committees which is concerned with the technical, economic, and revenue aspects of tax legislation. He also served as deputy tax legislative counsel in the Treasury Department Office of Tax Policy. He is now with KPMG.

Gutman and others like him are how tax laws get made before the politicians and lobbyists get involved. Gutman and I had lunch the other day (well, along with about 100 others) at an event billed as a response to the Grover Norquist speech of several weeks ago.

Two important events are coming up this year: the presidential election on November 6 and a potential swan dive off a fiscal cliff on December 31. Most believe that the former is more important but, for long-term thinkers, a good case can be made for the latter.

It would be useful to get this right.

According to Gutman, “The Bush era tax cuts expire and the annual 'AMT patch' —the provision that limits the number of taxpayers who are subject to the Alternative Minimum tax expires. So do the payroll tax cut, many unemployment benefits, the Medicare reimbursement “doc fix,” and a number of other temporary tax provisions that are extended perennially. The Affordable Care Act tax provisions may be at risk. Sequestration mandated by last summer’s Budget Control Act will become effective for fiscal year 2013 and we may have reached the existing national debt limit. These are issues a lame duck Congress must address.”

Douglas Elmendorf, the current head of the Congressional Budget Office (CBO), stated recently, that “Increasing tax revenues by one-sixth or reducing entitlement spending by one-fourth could, if done separately, put the country on a sustainable fiscal path.” But anyone who has tried to quantify precisely what it would take to achieve those objectives understands the practical and political improbability of that outcome. Consequently, the consensus view of most objective observers is that revenues need to increase and spending, particularly “entitlement” spending, must be reduced.

There were charts.

The first showed a projection of the total budget deficit over the next 10 years, according to the CBO. If nothing is done, the deficit continues to exist, but probably at sustainable levels. This represents the “swan dive” scenario. Since the CBO is not populated with dummies, it also estimates what will happen if our elected officials behave as they normally do — call this the “kick the can” scenario. That approach would increase the aggregate budget deficit by $11 trillion over the next 10 years, sending our national debt from about $16 trillion to $27 trillion.

During the post Election Day lame-duck session, expect much can kicking.

The second showed the types of tax revenue as a share of GDP for the 34 OECD countries. Where does the U.S. rank? We rank 31st out of 34 countries. If taxes are your hot button, your only choices to improve your lot are Turkey, Chile, and Mexico. Forget Europe, Japan, Australia, New Zealand, or Canada, where overall tax burdens are higher than ours. China is not an OECD country so it was not included. Nor was Singapore, the alleged tax choice of Eduardo Saverin.

The final chart showed that the United States is the only OECD country that lacks a consumption tax or, in Gutman’s words, “we have an untapped revenue source.”

How should a tax system be designed? Well, according to Gutman:

“When policy makers confront the question of what a tax system should look like they focus on three criteria: equity, efficiency and administrability. Equity reflects judgments as to the appropriate distribution of the tax burden. Efficiency means that the system should be neutral with respect to decision-making. Administrability means that the system should impose the least possible compliance and administrative costs. Our existing system is a disgrace when measured against each of these criteria.”

Lobbyists did not choose the suggested design criteria. That is not what they are paid to do.

“Equity” is the fairness argument that inevitably concludes don’t tax you, don’t tax me, tax the fellow behind the tree. Fairness supports whatever conclusion is best for your voters and “the American people” inevitably understand that perfectly, at least according to stump speeches.

Gutman shredded the “46% of Americans don’t pay taxes” argument by refuting the selection of the anomalous 2011 as the base year and including payroll taxes. These changes bring the percentage of taxpayers to the mid-80s. He then added state and local taxes to bring the percentage even higher.

Republican talking point writers were much aggrieved.

Efficiency suggests, “the ideal tax system is neutral with respect to its economic effects.” According to Gutman, “Our system fails that test in a spectacular way. It is a hybrid system that contains some elements of a consumption tax, particularly our treatment of retirement savings, and some elements of an income tax. It affects economic behavior and is used as a substitute delivery mechanism for a multitude of government programs ranging from low-income support to subsidies for specific activities. As a consequence, it is an administrative and compliance nightmare.”

In economic terms, efficiency argues for a consumption tax though this can present problems in trying to achieve the “equity” goal.

Tax expenditures, like the home mortgage interest deduction, do not fare well when considering efficiency. It is not alone; there are now over 280 tax expenditures in the tax code.

“Administrability” is longhand for simplification. “There is universal recognition that the complexity of the tax code has led to a system that is almost impossible to administer efficiently. The call for simplification is universal — until specifics are put on the table and then consensus disappears. It should be obvious that unless and until the tax structure is streamlined an administrable system is a pipe dream.”

The impact of the tax pledge is a little like asking for directions in Maine — you can’t get there from here. By identifying the need for more revenues, Gutman sets himself apart from Republican orthodoxy, but not far enough to label him a taxer and spender. He left no doubt that he favored tax reform and laid the blame on a failure of executive leadership. All decisions in this area are now made in the White House — read “political” — where those who know the answers find no audience.

After branding a consumption tax as “political suicide,” Gutman concluded with a quote from Larry Summers: “A well designed VAT, with appropriate provisions to deal with regressivity, can raise up to $50 billion a point. Larry Summers has said we do not have a VAT in the U.S. because the Republicans think it is a cash cow and the Democrats think it is regressive. We will have a VAT when the Republicans realize it is regressive and the Democrats realize it is a cash cow.”

 Though a Hank Gutman tax code is an unlikely outcome, the criteria he sets forth for designing a good one are worthy of consideration especially as we are subjected to endless talking points in the coming months.