The President's call for fundamental tax reform combined with this committee's continued interest in repairing and improving our tax code provides an enormous opportunity for expanding the social and economic well-being of all Americans.  Attaining a simple, fair, and pro-growth tax system, however, involves disciplined thinking by policy makers about a number of important changes to current law.  I would like to draw your attention to some of the considerations you should make when thinking about fairness. 

Let me ask you to hold a mental construction in mind for the next few minutes.  It is this:  in a perfect tax world, every taxpayer at each income level would be treated equally and the more people made in taxable income the more tax they would pay.  In this world, as well, the taxes levied to raise the necessary revenues for needed government would not interfere with the equal right of all taxpayers to use their labor and capital in such a way as to achieve their economic and social goals.

That simple mental construction is crucial to the work you do day in and day out and especially to the product we all hope will flow from this committee once the President's Advisory Panel on Federal Tax Reform completes its work.  You need to have a model against which you can evaluate the horizontal, vertical, and forward equity of changes to our current tax code.

If you lived in this simple tax world, then every change to the nation's tax law would have to pass the test: does the change treat equals equally, does it re-enforce vertical proportionality of our tax system, and does the change disturb the peaceful and lawful work of taxpayers toward their economic and social goals.

Unfortunately, we do not live in this perfect world, even though this model is a key to the survival of good policy in a political environment awash with conflicting interests.  Also unfortunately, the analytical tools you have at your disposal for evaluating the equity elements of proposed changes are rather crude, easily abused, and not well suited for answering these key equity questions.

As I observed, nearly every major tax bill is challenged to prove that it is fair.  Fairness, however, can (and probably does) mean something different to each person who thinks about it.  I imagine there are differences on this subject even on this committee.  Since you cannot entertain an infinite number of different definitions of fairness but must instead be governed by a definition that enjoys wide support and also allows you to make decisions on fairness, it is appropriate to start with the question: What is tax fairness?

I think we all can agree that "tax fairness" at least means that everyone pays their fair share.  That is, the total amount of taxes a person pays is proportional to their economic ability to pay taxes.  Thus, taxes paid are proportional to income or to consumption or to some other measure of our use of government. 

"Tax fairness" also should mean (and I think generally does mean) that tax policy enacted today will act on each person's taxable income so as to disadvantage no type of taxpayer over another in achieving their economic ends.  This forward equity of the tax code is a crucial but seldom-noted fairness consideration.  Lawmakers should consider whether policy change facilitates individual economic, social, and personal choices that set in motion a sequence of activities that lead to goals a person sets for him or herself.  For example, do tax policy changes made today raise barriers to women re-entering the workforce years from now after raising a family, or to immigrants starting micro-businesses, or to retiree pursuing part-time work?  Do policy changes make it more or less difficult for young people to achieve their goals?

Economists have developed techniques for analyzing how tax policy changes affect taxpayers and non-taxpayers.  This family of techniques, known as distribution analysis, provides policy makers with crude but sometimes effective tools for determining whether their policy changes meet the tests of vertical, horizontal, and forward equity.

Distribution analysis, however, often flounders on two, central problems:  1) what should we use to measure tax incidence against and 2) how does the passage of time affect the distribution of taxes.

What policy makers frequently want to know is simply enough stated (how will tax policy change affect the economic well-being of taxpayers), but just as frequently is hard to answer.  How do you measure the relationship between tax policy and economic well-being?  Because we cannot measure all of the things that affect a taxpayer's well-being, economists often settle on proxies for those data we cannot obtain or activities we cannot observe.  Certainly, the most common of such proxies is income.

However, what is income?  Most people think of income as the total amount of money they make each year.  But, does that amount count the income from previously taxed income, like interest on a savings account or dividends from an investment?  Is "income" the total amount that is spent on all goods and services and leisure?  Does it include net worth?  Do we count non-cash compensation when distributing the effects of a tax policy change?

Even if we could settle on an income concept that most analysts would accept, how good are the income data that we would use to create distribution tables.  For example, the U.S. Census Bureau obtains a pretty good idea about household and individual income at each decennial census.  During the intervening decade, Census regularly surveys the population and produces updates to its decennial estimate of income (most notably the March supplement each year) that form the basis for so much of our economic work on taxes. 

This important dataset, however, is composed of only 60,000 households out of total population of over 110,000,000 households.  While that survey size assures statistical significance on most demographic concepts, it produces at best a crude representation of the types and ranges of income, particularly among high-income households.

What about distributing tax policy changes by consumption?  Consumption generally is a public act, and the very fact that consumption leaves highly visible footprints means that using it for distributional purposes avoids many of the definitional problems surrounding "income."  If we were to use consumption as the metric against which to measure the fairness of a tax system, we would assume that levels of tax payments would follow levels of consumption. 

Simple enough, but what do you do with young taxpayers?  They are consuming very expensive education that they pay off over time, buying homes to start a family that are paid through mortgages, buying their first car, their furniture, and raising children (by itself an expensive proposition).  Short-term and long-term consumption get mixed together in real life, which raises problems for distributional analysts.

Anyway, consumption patterns tend to follow the cycle of life:  high consumption and debt early on, followed by increases in net worth and less consumption in middle life, which ends with low consumption and depletion of savings over retirement.  If a tax system followed that pattern of consumption, would it be fair?  Probably not.

Finally, some analysts argue that we can learn a great deal about the fairness of a tax system by studying the actual marginal tax rates faced by taxpayers across income.  If a tax system meets the vertical and horizontal tests for fairness, then marginal tax rates will be roughly the same for all taxpayers in each income class. 

However, our current tax policy is, if anything, one of targets, not of equal treatment.  That is, Congress has decided to use the tax system to achieve specific social and economic goals, which has resulted in a significant decay in vertical equity.  To illustrate this point, I have provided in my full testimony a wonderful graph prepared by Kevin Hassett of the American Enterprise Institute, a tax economist well known to this committee.  Dr. Hassett compares the current tax code to tax law in 1986 and 1988 and how tax policy has affected the marginal income tax rates faced by a family of four.  While this graphic shows many things, its single most important message is how targeting tax relief has produced significant equity distortions in the code.

As Dr. Hassett's chart shows, drifting away from a tax system governed by principles has led to tax law that is less just.  Achieving a significantly better tax code obviously involves major legislative efforts.  Having guiding principles before the members of the House and the Senate should help them extract our tax code from the dramatic difficulties into which it has fallen.