Attack the Deficit, Not Tax Code

At the start of this year, the great majority of analysts and politicians from both political parties agreed that fixing the nation’s existing budget problem would require raising taxes as well as cutting expenditures. The amount of new revenue needed would be greater if substantial new policy initiatives were pursued--whether on drugs, education, the environment, infrastructure, the homeless or whatever.

Now it is fall, and rather than a realistic approach to the unpleasant business of raising revenue, we have a Republican plan for cutting the tax rate on capital gains, a Democratic proposal to resurrect the individual retirement account tax shelter and continued buzzing out of the Treasury Department to untax dividends.

Why has this come about? Certainly not because the President and Congress have found a way to reduce the deficit that has made it unnecessary to raise revenue. They have taken cosmetic steps to help meet the Gramm-Rudman-Hollings deficit ceiling for fiscal year 1990--moving the military’s October payday back a few days so that the expenditure will be included in the fiscal 1989 budget, keeping a major part of the money borrowed for the thrift industry bailout “off budget” (thus increasing actual interest costs) and using optimistic forecasts of crops, interest rates and economic growth. But no genuine progress has been made that would improve budget policy for the long run.

So new tax breaks are on the agenda in Washington, not because the politicians have dealt with the deficit so that we can now afford them, but because tax breaks are popular and dealing with the deficit is not.

Are any of these tax proposals so compelling that they should get priority over other budgetary issues? I think not. The main argument made for the capital gains bill on its way through Congress that temporarily cuts the tax rate on gains is that it will raise revenue. But it will not. Except possibly for a brief period in fiscal 1990 (which would provide one-time assistance in meeting the Gramm-Rudman-Hollings target), the bill would cause a revenue loss and add to the budget deficit.

The other argument for the bill is that it will aid capital formation. This, too, is unlikely, because the connection to capital formation is weak at best--and nonexistent if the tax-rate reduction is only temporary.

The Democratic proposal to bring back the full IRA tax shelter responds to the Republicans’ capital gains proposal. It, too, claims to encourage capital formation while providing its tax benefits to a much broader range of taxpayers than would the capital gains tax cut. Its proponents do not pretend that it would raise revenue. But they do believe that it would encourage increased private saving.

Change Could Undermine Tax Reform

However, to make the effect on total saving positive, private saving must not only rise, but rise by more than revenue falls. This seems unlikely to happen because anyone with enough accumulated assets--$2,000 in some financial form--can take full advantage of the tax break offered by IRAs simply by transferring assets to an IRA account without increasing savings at all. So in many cases, perhaps most, there would be a revenue loss with no gain in private saving.

Aside from these obvious arguments against the tax cuts--lost revenue, increased budget deficits and lower total national saving--there is another that may in the long run be even more important. The kinds of tax changes being proposed would undermine the tax reform accomplished in 1986. The 1986 act was a landmark in tax history. It reformed the income tax system in a way that most observers had said could never be done--lowering top marginal tax rates from 50% to 28%, improving the earned income credit that enhances the income of the working poor and taking the poorest off the tax rolls altogether. It accomplished all this without losing revenue by eliminating most of the special tax breaks that had accumulated in the tax system over the years.

The principle was simple. Broaden the base of taxable income and tax rates could be lower. The political support for each individual tax break was overridden by the argument that so many other special breaks were being eliminated, too.

Putting back one tax break now destroys the principle that tax reform established and risks starting a one-at-a-time restoration of preferences that would surely erode the tax base again. Perhaps raising revenue requires more political leadership than is yet available. But it would not be asking too much to leave tax cuts alone for now. The President and Congress should stop their search for popular tax breaks and confront the unpopular business of getting their budget straight.