This piece originally appeared in The International Economy
The United States is overdue for tax reform, and the dual challenges of stabilizing the long-term fiscal outlook and rebuilding the middle class necessitate that this reform raise more revenue and distribute the tax burden more fairly. These realities, however, render the Tax Reform Act of 1986—which was designed to be both revenue- and distributionally-neutral—a wholly inappropriate benchmark. Given valid concerns about widening income inequality and unsustainable long-term budget projections, it makes zero sense to lock in the tax code’s revenue levels or distribution.
In fact, these problems were actually caused in part by the very policy that is now being promoted, namely flattening marginal tax rates. The Bush-era tax cuts cost $2.6 trillion over the last decade, accounting for roughly half the public debt increase over this period. Over the next decade, a continuation of these tax cuts represents the difference between a sustainable and unsustainable fiscal outlook. Roughly half the tax cuts went to the highest-income 10 percent of earners, even though the top 10 percent of earners captured more than 90 percent of national income gains between 1979 and 2007. Average tax rates for the top 1 percent have been cut by one-fifth over that time, to the point where more than a quarter of millionaires now pay a lower effective tax rate than middle-class families earning $40,000 or more annually.
Despite claims that rate-flattening will accelerate economic growth, our experience with the Bush tax cuts once again suggests otherwise; these cuts coincided with the worst U.S. economic expansion since World War II. By just about every economic indicator—gross domestic product, non-residential fixed investment, employment, and total compensation—the Bush tax cuts failed to generate even mediocre economic performance. There is no reason to believe that further flattening tax rates will yield better results.
To address some of our most pressing economic challenges, tax reform must adhere to two basic principles. First, it must restore the basic tenant of a progressive tax code that effective tax rates are supposed to rise with income. This means crafting a tax code to reflect today’s income distribution, not the distribution three decades ago. Flattening the rate structure will hardly simplify the tax code but will almost certainly undermine progressivity, shifting the tax distribution away from upper-income households and toward the middle class.
Second, reform must raise revenue. Taking revenues off the table—as revenue-neutral tax reform would do—would render a sustainable fiscal trajectory practically impossible.
There are, however, valuable lessons from the 1986 reforms. Equalizing the tax treatment of wealth and work, as we did in 1986 by raising capital gains tax rates, would drastically improve the tax code. But tax reform should restore a greater degree of progressivity by equalizing the treatment of income derived from work and that derived from investments across a schedule of tax rates more closely mirroring the income distribution. Further flattening marginal tax rates will only succeed in exacerbating inequality while failing to generate meaningful economic growth.