Will tax Reform Work?

Tax reform should be a top priority, provided that the right approach is taken.

As the US grapples with the twin goals of deficit/debt reduction and the imperative of restoring economic growth, there are very few bullets left in our economic policy arsenal. We’ve tried stimulus, monetary policy and tax cuts and need to do more. Economists of all stripes as well as the American public believe true tax reform can help get us back on our feet economically and restore confidence in our political system.

We have two models for tax reform in our recent history: The Economic Recovery Tax Act of 1981 and The Tax Reform Act of 1986. Tax reform in ’81 cut tax rates for individuals and corporations but also reduced taxes on saving and investment. Tax reform in 86 did the right thing in cutting tax rates but the wrong thing by “paying” for it with higher taxes on saving and investment. The capital gains tax went up; IRAs and Keoghs were not expanded; the tax treatment of businesses investment became much harsher. It may be no coincidence that real economic growth averaged 3.5 % over the 1982-1986 period and only 2.5% from 1987 to 1991.

Again, there is little disagreement among economists and the public, that our current tax system is broken. “Tax gamesmanship” is often the order of the day for individuals and businesses. Lower taxes rates will truly spur economic decisions, grow the economy and generate more needed revenue for our treasury.

Our experts and the American public also understand that a major obstacle for US economic growth is our low saving and investment rate. Whether it be personal, business or government saving (our deficit is dissaving), we’d be shooting ourselves in the foot if we paid for lower tax rates with higher taxes on savings and investment—the engine needed for reducing our growing debt and growing the economy.

Take capital gains, which have been prominent in the news recently thanks to Warren Buffett and his secretary. Many politicians believe that we could pay for lower tax rates by taxing capital gains the same as ordinary income. But they are dead wrong if they think that this will have no bearing on savings and investment decisions.

An econometric study by respected economist Dr. Allen Sinai notes that the economic activity sparked by eliminating the capital gains tax increases GDP by a little over 0.23 percentage points per year. Jobs increase by an average of 1.3 million per annum while the unemployment rate drops 0.7 percent at its lowest point. Conversely, Sinai found that raising the top rate from the current 15 percent to 20 percent, as suggested in several deficit reduction plans, would cut annual economic growth by an average of .05 percent per year and an average of 231,000 jobs would be lost from 2011-2016.

As the wise 17th century philosopher Thomas Hobbes said “It is fairer to tax people on what they extract from the economy, as roughly measured by their consumption, than to tax them on what they produce for the economy, as roughly measured by their income.” It also makes economic sense and should be kept in mind as we begin the great debate on tax reform.