The US tax system needs rebuilding

Whoever wins this year’s US election, the combined effect of three events – the expiry of former president George W. Bush’s tax cuts , a renewal of the legally binding limit on federal borrowing and the start of a Congressionally mandated sequester, a mechanism that will automatically cut domestic spending from 2013 – will force the president and Congress to engage deeply with fiscal issues. The decisions made will do much to determine the country’s future.

For many observers, the central question in debates over deficit reduction is what can be done about entitlements. Growth in spending associated with an ageing population will be the major factor fuelling the growth of federal spending.

The rising number of retirees to workers means that Social Security benefits at the current ratio to wages and salaries will not be sustainable without some kind of tax increase. Sooner or later revenues will have to rise or outlays will have to be curtailed.

But it is the trajectory of healthcare costs that will be the single most important determinant of the budgetary picture. While almost everyone agrees on the desirability of containing federal spending, achieving this is likely to be more difficult than many suppose.

Certainly, some beneficiaries can bear more of the cost of their government insurance. There are also steps such as malpractice reform and the further encouragement of preventative medicine that should be taken. Yet without intrusions into the private healthcare system that are unlikely to be politically acceptable, there are severe limits on what can be done to curb federal health spending.

The consequence of not acting, however, will be unacceptable reductions in the availability of care for the clients of federal programmes. And given all the uncertainties associated with new technologies, changing lifestyles and ongoing changes in the private system, healthcare reform will and should be a continuing project.

Less discussed in the context of major deficit reduction is tax reform. For a variety of reasons, 2013 should be the year when the tax code is overhauled in a substantial way.

First, the US will need to mobilise more revenue. This year, the federal government will collect less than 16 per cent of gross domestic product in taxes – far below the post-second world war average. The reality is that the combination of an ageing society, rising healthcare costs, debt service costs that will skyrocket whenever interest rates normalise, a still dangerous world in which our allies defence spending is falling even as that of potential adversaries rises rapidly, and a growing fraction of the population unable to hold steady work means that, in all likelihood, federal spending will need to be larger relative to GDP in the future.

Increasing marginal corporate rates or increasing individual rates beyond their Clinton-era level raises serious questions about incentive effects or the encouragement of shelter activities. It is in any event unlikely to be politically feasible.

A much better strategy for raising revenue would start from the premise adopted by the Simpson-Bowles bipartisan commission: that tax expenditures are a form of government expenditure and presumptively should be cut back unless they can be justified in the current environment.

Second, the current tax system is in certain ways manifestly unfair at a time of rising inequality. As is well recognised, America’s rich have become richer with the share of income going to the top 1 per cent increasing from about 10 per cent to about 20 per cent over the last generation while middle class incomes have stagnated.

There is plenty of room for discussion about the causes of this growing gap, the extent to which reducing inequality should be a central objective of government policy and the possible disincentive effects of excessively progressive taxes. But it is undeniable that certain fairly expensive aspects of the current tax system favour the most fortunate and border on the indefensible. Recent political debates, for example, have highlighted loopholes that permit a few to accumulate tens of millions of dollars in a tax-free individual retirement account (IRA) when almost everyone else is constrained by a $2,000 contribution limit.

Can the observation that Ireland, Bermuda and Luxembourg are three of the five jurisdictions where the US corporate sector earned the most profits reflect anything other than rampant tax sheltering? Anyone who doubts this should ponder the fact that in 2007, US corporate profits in Bermuda totalled 646 per cent of Bermuda’s GDP. The treatment of profit incentives paid to investment operators who do not use their own money but simply receive the “carry” as they invest other people’s money is another example of an inappropriate provision.

These examples, and the many more that could be adduced, are significant not only because of revenue the US Treasury could recoup while also making the tax system fairer. They also point to the power of special interests to shape fundamental aspects of economic policy. Reform could be an important step towards rebuilding confidence in the federal government that is sorely lacking today.

Third, even while raising too little revenue and giving much away to various shelter efforts, the current tax system places an excessive burden on economic activity. Corporate rates in jurisdictions at the very high end of the world range encourage businesses to manage their affairs in order to minimise reported US profits – using devices such as transfer pricing – and support the use of debt rather than equity finance. Employers who know that their workers face high tax rates endeavour to find ways of providing compensation in the form of tax-free perquisites, rather than money income. High marginal rates on individuals, along with a substantial capital gains differential, encourages them to devote a disproportionate amount of time that could be better spent to the problem of converting ordinary income into capital gains.

While the US tax code is altered frequently, serious reform is no more than a once in a generation occurrence. The last serious tax reform effort took place in 1986, so another is long overdue. The Simpson-Bowles proposal for eliminating all tax expenditures and radically reducing tax rates provides an excellent starting point for discussion.

The delicate question is how Washington should prepare for serious tax reform during what is likely to be a unique window of opportunity in late 2012-2013. The timing is essential both because of all the deficit reduction activity and because spending side reforms will have a much more difficult time becoming reality if the revenue side is not addressed as well.

It is tempting to say presidential candidates should put forward their tax reform proposals in detail and allow voters to choose. But this is unlikely to work. The more tax issues are discussed during the campaign, the more the candidates will be driven to make pledges about the things they will never do – pledges that might make tax reform that much more difficult.

So, here is an alternative. Leaders in both parties should commit themselves to the goal of tax reform for growth, fairness and deficit reduction. They should acknowledge that every tax expenditure or special break has to be on the table. They should ensure their staffs are compiling a large inventory of options. The relevant Congressional committees should take testimony from experts of all persuasions. And then, right after the election, the negotiations should begin. Nothing that is likely to done during the next presidential term will be more important.

The writer is Charles W. Eliot university professor at Harvard University and a former US Treasury Secretary