Building a Tax Code for Today

As Congress pursues comprehensive tax reform, policymakers have made numerous references the 1986 Tax Reform Act, which has been the principle framework for overhaul to date.

The 1986 reforms are revered because they succeeded politically, passing a divided Congress and enacted by a lame-duck president. Comprehensive reform today similarly would have to overcome major political hurdles, particularly Republican intransigence over raising revenue. Yet many policymakers today seem unaware that 1986-style reform is no longer viable.

The 1986 model was designed to be both revenue neutral and distributionally neutral—meaning that average tax rates would remain roughly unchanged across incomes. Replicating these objectives today would imprudently disregard shifts in the economic and budgetary landscape. The Bush-era tax cuts enacted a decade ago violated the spirit of the 1986 reforms by lowering revenue and shifting the burden of taxation further down the income scale. In so doing, they contributed to sizable structural budget deficits and revenue levels inadequate to support the baby-boomers’ retirement (an outlook essentially unchanged by the lame duck budget deal). And today, rising income inequality—exacerbated by reductions in top tax rates—has surpassed Gilded Age levels.

Rather than addressing our most pressing economic challenges, repeating 1986-style reform today would largely lock in misguided shifts in tax policy since 2001. Comprehensive tax reform must raise more revenue from market-based income that is increasingly skewed to the very top of the income ladder, and use tax policy to deliberately slow inequality growth.

But there is a deeper problem with using the basic contours of the old reforms as a modern template—specifically, the 1986 dual objectives of broadening the tax base (i.e., eliminating or curbing deductions, exclusions, and preferences) and lowering marginal income tax rates.

That approach runs contrary to modern economic theory.

Broadening the tax base today is actually complemented by raising top tax rates. With fewer opportunities for tax avoidance, more income will be subject to taxation at the top of the income distribution—unless rates are simultaneously and regressively lowered.

Critically, recent research suggests that upper-income households exhibit only modest labor supply responses to higher rates (such as working less)—roughly comparable to those of middle-income households. But upper-income households’ reported taxable income is more responsive to marginal tax rate changes than that of moderate-income households because of greater access to tax avoidance and income shifting strategies, as opposed to greater sensitivity of productive economic activity.

For upper-income households, economists Jonathan Gruber and Emmanuel Saez found (pdf) that taxable income (after deductions) is much more responsive to tax rate changes than broad income (before deductions). This important finding implies that reported taxable income (hence revenue) becomes less responsive to tax rate changes when avoidance strategies are curtailed by increasing tax enforcement or eliminating deductions, exclusions, and preferential treatment of investment income over labor income. Essentially, cleaning the tax code will reduce tax avoidance, thereby increasing revenue collected from existing tax rates and the revenue-maximizing tax rate.

And top tax rates are already well below revenue-maximizing levels. Research by Saez and economist Peter Diamond suggests (pdf) that the revenue maximizing income tax rate is 73 percent (combining federal, state, and local taxes), implying that policymakers could raise the top statutory federal income tax rate to roughly 66 percent—more than 26 percentage points above the prevailing 39.6 percent rate—before maximizing revenue.

This research on behavioral responses is buttressed by time series analyses finding that decreases in top income tax rates have had a statistically insignificant impact on overall economic growth and its driving factors, including labor supply, labor productivity and savings. Conversely, reductions in the top tax rate since World War II have been found to be a statistically significant driver of the rising income share accruing to the highest income 0.1 percent of households.

Put simply, if the aim of future tax reform is to broaden the tax base and generate revenue, lowering top income tax rates as the 1986 framework did would be a step in precisely the wrong direction. Doing so would also decrease the progressivity of the tax and transfer system and likely exacerbate market-based income inequality growth.

Short of reneging on the nation’s commitments to ensuring health care for the elderly, poor and disabled, Congress must realistically raise substantially more revenue than projected under current policy.

To do that, we don’t need a repeat of 1986-style reform any more than we need a reimplementation of Cold War foreign policy. Things have changed.

We need a context-based overhaul that eliminates some of the more regressive tax preferences (particularly the “carried interest” loophole and preferential rates on capital gains and qualified dividends) but also decelerates income inequality growth. We need tax reform that ensures revenue adequacy for the future, restores lost tax progressivity and treats raising marginal rates and broadening the tax base as complements rather than substitutes.

Cross posted on the Century Foundation’s Blog of the Century.

  • Ken

    I read of a good idea the other day. It proposed a flat tax from minimum wage to 25X the minimum wage, then step up to a 50% or more (or 66% per above) rate. Labor income & investment income treated the same. No deductions but keep personal exemptions for spouse & kids. Tax rates would be set to generate revenue needed to sustain the safety net programs but a reduced military. An across the board temporary rate increase would be added to pay for wars as needed. No true entrepreneur would be discouraged by this code. It would put a lot of tax prep folks out of business (artificial complexity business) but it could do wonders for the economy as a whole. One can dream ….