6 ways to make tax reform happen

The year 2013 just might be the year that tax reform gets done in the United States. Key members of both parties in Congress say they are committed to passing such legislation. President Obama is calling for it. And fixing the tax code is an integral part of fixing the federal deficit and debt.

To withstand the political pressure of special interests that want to preserve their own tax goodies, reform must be broad and produce tangible benefits for taxpayers, such as lower rates and a simpler code. Today, preparing tax returns and complying with tax law consumes 6.1 billion hours every year, the equivalent of 3 million full-time workers, imposing costs on taxpayers of about $168 billion (yes, with a “b”).

Here at the Bipartisan Policy Center, we’ve put together six ideas that can guide Congress to a deal that both parties should be able to live with, a deal that will raise necessary revenue and help pay down the debt.

1.Reduce rates for individuals and corporations

Dressed as the Statue of Liberty, part-time employee Zidkijah Zabad waves to passing motorists while holding a sign to advertise for Liberty Tax Service in Los Angeles Jan. 22. Op-ed contributor Steve Bell writes: 'To withstand the political pressure of special interests that want to preserve their own tax goodies, reform must be broad and produce tangible benefits for taxpayers.' (Jae C. Hong/AP)

Including state and local taxes, the US now has the highest statutory corporate tax rate in the industrialized world, stifling investment in America. That rate must come down.  And lowering individual rates would improve incentives to work and encourage economic growth. 

The Bipartisan Policy Center’s Debt Reduction Task Force, chaired by former Senate Budget Committee Chairman Pete Domenici, a Republican, and former White House Budget Director Alice Rivlin, a Democrat, recommends lowering the top rate for both individuals and corporations down to 28 percent. This would be part of a larger package that would eliminate or reform a host of tax breaks, simplify the code, and raise revenue.

Equalizing the top rates would also eliminate incentives to vary corporate structures for the sole purpose of better tax treatment (currently a deadweight loss to the economy).

Convert itemized deductions into refundable credits

Itemized deductions are often called “upside-down” subsidies. They encourage some taxpayers to spend money on housing, charitable contributions, and to support higher state public expenditures, but the structure of the subsidy is perverse.

High-income taxpayers who are in the top tax bracket (39.6 percent in 2013) receive the largest subsidy – because an additional dollar spent on mortgage interest or given to charity costs them only 60.4 cents. And the two-thirds of tax filers who use the standard deduction or have no income tax liability receive no subsidy at all.

Instead, if Congress wants to motivate certain behavior, it should use refundable credits that provide the same benefit to everyone, regardless of income. The Bipartisan Policy Center recommends converting the deductions for both mortgage interest and charitable contributions into 15 percent refundable credits.

Eliminate special-interest tax loopholes

The individual tax code is riddled with deductions, exemptions, and credits that provide benefits to certain groups of taxpayers and favor certain forms of consumption and investment over others.

In some cases, these provisions are similar to earmarks that used to plague the annual appropriations bills in Congress. These preferences make the income tax unfair because it can impose radically different tax burdens on two different taxpayers with precisely the same annual income.

An ideal reform must eliminate such distortions, as the Bipartisan Policy Center’s plan does.

Reform health-related tax breaks

Many employers provide health benefits for their employees, but employees don’t pay tax on these benefits. Excluding them from taxable wages is the single biggest tax break in the entire code, costing the federal government almost $200 billion each year. 

Not only that, the exclusion also encourages giving employees overly lavish health insurance plans in lieu of additional wages. Capping or phasing-out the exclusion would increase revenue to help pay down the federal debt and lower private health-care spending. It should even help reverse the trend of stagnating middle class wages, as employers shift some compensation back toward cash.

Further, the current tax code subsidizes health costs that not even lavish health plans cover, through Flexible Spending Accounts. Eliminating this subsidy would help to pay down the debt by upward of $100 billion over 10 years.

Restructure benefits to low-income taxpayers

Tax benefits for low-income taxpayers and families with children are exceedingly complex. Instead of the confusing Earned Income Tax Credit (EITC), Congress should consider implementing a large, simple, refundable earnings credit. This would better encourage work and automatically provide needed money to low-income workers without any sort of complicated enrollment process.

The Bipartisan Policy Center recommends a 17.5 percent refundable credit on an individual’s first $20,000 of income, providing a large, understandable incentive to work and helping to lift people out of poverty.

Equalize tax rates on capital gains/dividends and ordinary income

While lowering income tax rates, an ideal reform would at the same time eliminate special tax rates for capital gains and dividends. These income sources would instead be taxed as ordinary income. The Bipartisan Policy Center recommends equalizing these rates at 28 percent.

If reform is unable to lower the top rate on ordinary income below 30 percent, however, the discrepancy between the top income tax rate and the rate for capital gains and dividends should at least be minimized. Mitigating this differential will establish more equal treatment among taxpayers with different sources of income and dampen the use of tax shelters to convert ordinary income into capital gains. 

Now, before everyone reading this laughs at the implausibility of some of these suggestions, a few side notes are needed. It was President Reagan who supported capital gains taxation as ordinary income. He also endorsed ending the state and local deduction in his 1985 tax reform plan, which the Domenici-Rivlin plan would also accomplish.

Twenty-five years later, a serious bipartisan Senate proposal for tax reform, authored by Senators Ron Wyden (D) of Oregon and Judd Gregg (R) of New Hampshire, mirrored many of the proposals presented here, although the Bipartisan Policy Center plan as well as the bipartisan “Simpson-Bowles” plan from 2010 are more far-reaching. Other fundamental reform plans for simplification have been authored over the years in Congress. 

These plans have all failed because of special-interest pressure. That’s why, in order to succeed this time, Congress will have to stick to the two main goals I suggested in the beginning: Keep the plan broad enough so that no one gets extraordinary treatment and everyone has to compromise; and make sure the reform has tangible benefits for taxpayers.

Steve Bell, former staff director of the Senate Budget Committee, now runs the Bipartisan Policy Center’s Economic Policy Project