The Next Labor: Tax Reform

Like Hercules, whose labors went on and on, President Obama’s work stretches out before him without respite.  Even before the fate of health care reform is settled, the next giant task is looming.  The administration will have to tackle fiscal policy or risk loss of confidence, not only in this administration but in the dollar.  One piece of that fiscal policy reform should be a full restructuring of the tax system.

The fate of President Obama’s efforts to reform health care is not yet clear.  The Democratic majority probably will get some bill passed, but whether it can guarantee health care to all Americans while reducing the rate of growth of health care costs is another matter.  With opponents eager to inflict political wounds, and the insurance industry fighting for a package that will enrich it, the light has not yet appeared at the end of this tunnel.

Yet the administration must already be laying its strategy for the battle over fiscal policy.  Control of rising health care costs is essential for the long run viability of the federal budget (as well as the budgets of businesses and households).  But the damage from the previous administration’s “tax-cut and spend” policies will not be resolved through health care reform alone.   Fiscal policies that pushed up the national debt faster than income (GDP), even in 2005 and 2006, years of relatively rapid economic growth, are unsustainable.   We need to run big deficits when the economy is in the tank, as it is today, but the same fiscal system needs to run small deficits or surpluses on the other side of the business cycle, cutting the debt/GDP ratio when times are good.   The previous administration – by taking the politically easy course of cutting taxes and raising spending  –  crafted a fiscal system that generates big deficits every year.

Policy makers faced a very similar problem following the Reagan tax cuts of the early 1980s.  It took a decade of political struggle to return the tax code and spending to a sustainable pattern.  Tax increases in 1986, 1990, and 1993 all helped to turn the budget deficits of the mid 1980s into the surpluses of the late 1990s.  Of these increases, the most modest were those under GHW Bush in 1990.  Yet these were the most politically damaging, contributing to his defeat in 1992. 

Arguably, the least politically damaging of the tax increases that corrected the damage from the Reagan fiscal policy was the reform of 1986.  That increase was combined with a major revision of the tax code.  Many tax breaks were removed, the tax base was broadened, and so revenues could be increased even as many tax rates were cut.  By incorporating revenue increases into a broader tax reform, the fiscal reforms of 1986 avoided some of the political damage from raising tax rates.

President Obama should similarly package revenue increases with wider ranging tax reforms that have some political appeal, to counteract the damaging effects of tax increases.   As in 1986, the detritus of special tax breaks crafted for special financial and voting interests should be cleared, all at once.  If almost all special interests lose their special tax breaks together, none can complain of discrimination.   Insurance companies and mining interests should feel the pinch, but so should families that benefit from home mortgage interest deductions.  Capping such household deductions will affect few families, removing from tax shelters  the incomes of the wealthiest, who least need special tax breaks.  Tax breaks for saving and health insurance should be reformed as well.  At a lower total cost in lost revenue, these tax breaks can be targeted exactly at the families that really need new incentives, not at the families with the biggest incomes and therefore the most to gain from sheltering their income from the marginal tax rate.

Finally, tax reform should consider a brand new tax, the Value Added Tax.  Almost every country with a functioning tax system now has a VAT, which is a modified sales tax in which every transaction is taxable, with deductions for the tax already paid on purchased inputs.  Liberals are wary of a VAT because it is not progressive.  Conservatives are wary of a VAT because it is so painless they fear it will lead to a solution of the country’s fiscal problems.  A VAT of a few percentage points (remember, every percent of a VAT is almost a percent of GDP in new revenue) combined with a reformed income tax system – with tax breaks reined in, the corporate tax simplified, and personal rates made more progressive – can be simple, easy to collect, and fair.  And it can solve our fiscal mess.