Tax Reforms Are Worth Making if Changes Have Staying Power

“April is the cruelest month,” wrote T.S. Eliot in 1922 as the opening of “The Waste Land,” the most famous poem of the 20th century. Today, tens of millions of Americans feel the same way. Back then, Eliot was referring to the change of seasons, “mixing memory with desire.” The contemporary source of April anxiety, of course, is the filing deadline for income taxes. In 1922, federal income taxes collected were well under $1 billion. This year, the haul is expected to be about $800 billion. (Of course, Eliot had moved to England, so perhaps he knew more of taxes then than did all but a few Americans.)

Virtually no one speaks in favor of the current tax structure. Although there are defenders of almost every specific provision, everyone excoriates the current system. Many argue that taxes are too high, especially marginal effective tax rates. Others argue that the tax base is wrong, that it should be on only that part of income that is spent, not the part that is saved. Still others decry the complexity of the tax code and the huge compliance and administrative costs it imposes. And others deplore the lack of fairness in the code, although fairness has many definitions. Perhaps most important, the tax code is viewed by many, myself included, as one of the culprits in America’s sluggish growth.

Not surprisingly, then, tax reform is in the air. Tax reform is hardly a new phenomenon: The federal tax system underwent major or complete overhauls in 1978, 1981, 1982, 1983, 1985, 1986, 1990 and 1993. Additional tax cuts and reforms were proposed last year, but seem to be going nowhere in the budget battle between Congress and the president.

Tax reform will be an issue in this year’s presidential campaign and 1997 may well see a serious legislative push toward a flatter, fairer and simpler tax code. What’s really wrong with the tax system? First, it is too complex. More than half of tax filers use a tax preparation service, including 650,000 families using the supposedly simple short form. Independent audits confirm that fewer than two-thirds of taxpayer phone inquiries to the IRS are answered correctly. Public opinion polls indicate that many taxpayers believe the complexity of the tax code opens up avenues for others to cheat on their tax returns.

Economic analysis demonstrates that the harm done to the economy from high tax rates, which distort taxpayer behavior by saving, investing or working less and shifting from cash to fringe benefits. As tax rates rise, the damage to the economy goes up even more rapidly. Thus, raising the tax rate from 20% to 40% doubles the tax rate, but quadruples the damage to the economy. The small increase in marginal tax rates in 1990 and the large increase in 1993, reversing the 1986 reform, were movements in exactly the wrong direction. Finally, saving is taxed twice in the income tax, first when it is earned and then when interest and dividends accrue. Actually, if the investment is in corporate, it is taxed a third time by the corporate tax. And if the saver is successful and/or lucky, even if only accruing at a few thousand dollars a year over a lifetime, the saving can be taxed a fourth time in the estate tax. While there are numerous exceptions to this rule--employer-paid pensions, for example--the tax code is one of the culprits in America’s lowest saving rate in the world.

The most widely discussed reform proposals would address these problems by sharply lowering the rate or rates and eliminating the double taxation of saving.

While presumptive Republican presidential nominee Sen. Bob Dole of Kansas has pointed to some issues worth debating in the flat tax, he has strongly endorsed a flatter, simpler, fairer tax system and is a proponent of lower taxes and tax reform.

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Given the proclivity to change the tax code every few years, perhaps the simplest tax code would be to keep the same tax system in place for many years. That is why one of the requirements of tax reform should be to move to a new tax system that is widely enough supported that it is likely to remain unaltered for many years. And, of course, any new tax device should only be implemented if it totally replaces the income tax, lest it lead to an expansion of government spending as has happened with the VAT in Western Europe. Finally, recall that the only way to keep the tax rate or rates at reasonable levels is to keep government spending at reasonable levels. Eventually, government spending has to be paid for by taxes. Running deficits only postpones the taxes.

Is tax reform worth the candle? If the world is complex, is a simple tax appropriate? Or is a complex tax worth the trouble and economic costs? Economists’ estimates suggest that fundamental tax reform could increase gross domestic product by about 10%, or roughly $600 billion a year. This occurs because increased saving and capital formation increase wages and future incomes. Such potential gains are worth seriously considering fundamental tax reform if, but only if, a major improvement can be made and sustained for many years to come. Hopefully sometime soon, April will no longer be the cruelest month.