October 24, 2005 | WebMemo on Taxes
On November 1, the President's Advisory Panel on Tax Reform will release its report on how to improve America's tax system. According to the President's instructions, the Panel's primary goals are growth, simplicity, and fairness. Hopefully, the Panel has taken these instructions seriously and will issue recommendations to make America more prosperous and competitive. A successful report should explain the necessary conditions for:
To judge the Panel's report, there must be a yardstick-a benchmark, so to speak, of an ideal tax system. This theoretical ideal would have a low tax rate, and it would tax income only once. This system would eliminate loopholes, and taxpayers would find it easy to understand. This is why the Panel should recommend a low-rate, consumption-base system like the flat tax. The flat tax simultaneously achieves all the goals identified by the President.
By most accounts, however, the Panel is not looking to replace the internal revenue code completely. But this does not mean that the Panel's recommendations should be dismissed. There are many incremental reforms that would improve the tax code by moving in the direction of a single-rate consumption-base system. The Panel's report can and should be judged by this criterion.
Why Does Tax Reform Promote Growth?
By definition, economic growth occurs when people produce more and thus earn more income. The goal of tax policy, therefore, is to minimize the impediments to the behaviors-work, saving, investment, and entrepreneurship-that generate production and income. Fundamental tax reform is capable of generating growth because it changes incentives. Specifically, it alters the costs and benefits of engaging in productive activity. The key ways that reform leads to better economic performance include:
National history provides strong evidence in favor of a low-rate, consumption-base system such as the flat tax. Whenever America has moved in the direction of fundamental tax reform, such as with the Kennedy tax rate reductions in the 1960s and the Reagan tax rate reductions in the 1980s, the economy has expanded at a faster rate. But when tax policy has moved in the opposite direction, such as when Hoover and Roosevelt increased tax rates in the 1930s and inflation pushed people into higher tax brackets in the 1970s, the economy has suffered.
International experience presents an even stronger case for fundamental tax reform. Hong Kong has had a flat tax system ever since 1947, and it has been the world's fastest growing economy since that time. Recent tax reforms in Eastern Europe have yielded equally impressive results. Led by Estonia, the Baltic nations adopted flat taxes in the 1990s and have enjoyed above-average growth rates since. More recent flat tax reforms in places like Russia and Slovakia also have generated positive results, and the pro-growth impact will become even more apparent with the passage of time.
The tax code is complex and unfair because politicians have spent the past 93 years adding provisions to it. Ever since the income tax was adopted in 1913, endless revisions have turned a 14-page law into a legal monstrosity of more than 17,000 pages of incomprehensible fine-print that enables the rich and powerful to game the system.
The good news is that policy makers can kill two birds with one stone. Many of the reforms that boost growth would also reduce complexity and make the tax system fairer. For instance:
The preceding list is a good place to start when judging the report of the President's Advisory Panel. These incremental changes satisfy the President's goals of growth, simplicity, and fairness.
Other potential reforms may not satisfy all three goals, but they nonetheless would be desirable additions. America has the second-highest corporate tax rate in the developed world. Lowering the rate would boost growth and help make U.S. companies more competitive. While a lower corporate tax rate does not make the system simpler, it would indirectly help by reducing the incentive for companies to engage in complex and inefficient tax-minimization strategies).
Similarly, further reductions in the double-taxation of corporate dividends and capital gains would improve economic performance. But taxpayers still would have to fill out forms and keep records. To achieve faster growth and simplicity in one fell swoop, these forms of double-taxation should be completely eliminated. Likewise, shortening depreciation schedules (and thus reducing the tax on new business investment) would be pro-growth but would still require businesses to incur substantial compliance costs.
In today's global economy, it is increasingly easy for jobs and capital to escape high-tax nations and migrate to low-tax nations. This means that the reward for good tax policy is greater than ever before, but it also means that the penalties for bad policy are greater than ever before.
President Bush's Advisory Panel on Tax Reform has an opportunity to produce a roadmap that leads to a better, fairer, and more competitive tax code. Members of the Panel should ask themselves whether the specific proposals they consider would bring the internal revenue code closer to a single-rate, consumption-base tax system. If a provision shifts the tax code closer to a system that taxes income only one time and imposes just one low rate, it will be a step towards all three of the President's goals.
Daniel J. Mitchell, Ph.D., is McKenna Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.