|Positive federal tax reform may be on the horizon regardless of who the
next U.S. President is, according to Scott Hodge, President of the
Washington-based Tax Foundation.Hodge argues that the next President and Congress will have to deal with
the collision of two cataclysmic tax events: The 2011 expiration of the
Bush tax cuts and the growing irritation of the Alternative Minimum Tax
(AMT). He says the seeds for compromise lie in the fact that both sides
have something to gain by addressing these problems at the same time.Republicans, of course, want to avert the largest tax hike in history by
maintaining the lower tax rates on income, capital gains, dividends, and
married families with children. Meanwhile, Hodge says, Democrats will be
brought to the table by the fact that the AMT is largely a Blue State
problem, mostly affecting those living in high-tax and high-income
states such as California, Massachusetts, New Jersey, and New York.Two “Land Mines” bring Democrats and Republicans together
The first land mine is the distribution of the tax burden itself, Hodge
explains. The 2001 and 2003 tax cuts knocked millions of lower income
people from the tax rolls. When Bill Clinton left office, some 29
million tax filers had no income tax liability after they took advantage
of their credits and deductions. Today, the number of “non-payers” has
grown to more than 43 million, or one out of every three Americans who
file a tax return. And since so many lawmakers see the IRS as a giant
ATM dispensing “refundable” credits, such as the Earned Income Tax
Credit, it will be very difficult to convince them to support
fundamental tax reform.
With the nation’s tax burden now so concentrated at the top—the top 20
percent of taxpayers pay about 86 percent of all the income taxes—any
tax reform plan is caught in a rhetorical Catch 22; tax reform equals
“tax cuts for the rich.”
Enter land mine number two: AMT and the interests of Democrats.
Although the vast majority of households affected by the AMT earn
between $100,000 and $500,000, Democrats have masterfully positioned it
as a middle-income issue. Wrapping fundamental tax reform around AMT
reform could inoculate the debate from the predictable class warfare
Considering these land mines, how do we craft a politically realistic
tax reform plan?
In light of these land mines, Hodge provides a 5-step plan for tax reform.
Step 1: Eliminate tax exemptions and deductions.
More than 80 percent of the benefits of these tax deductions flow to
households earning more than $80,000, and more than half of the benefits
flow to those making more than $118,000.
Eliminating these deductions would solve several problems. It would free
up dollars for marginal rate cuts to keep effective rates down, and it
would add greater simplicity and equity to the tax code.
Affluent taxpayers may be the initial beneficiaries of these tax
exemptions and deductions. But in the end, the real economic subsidies
flow to well-heeled interest groups such as the housing industry, state
and local governments, and public employee unions.
In particular, the state and local tax deduction allows local
politicians and school districts to shift as much as onethird of the
cost of any tax hike along to Uncle Sam—and thus other taxpayers.
Step 2: Make any tax reform a tax cut and tax simplification.
Next, Hodge explained, one must recognize that tax cuts will always
generate more support than a revenue-neutral tax shift. A 2007 Tax
Foundation/Harris Interactive Poll found about half of all American
adults would give up their credits and deductions for an
across-the-board cut in their income tax rates.
The repeal of deductions, as outlined above, would fund signifi cant
marginal rate cuts. However, the task of mobilizing the other half of
Americans who said they were not sure or who rejected the idea will
require the sweetener of a lower tax bill as well as the promise of a
simpler 1040 form.
Step 3: Continue to shield low-income earners with a super-deduction.
Politicians are not likely to put the nonpayers back on the tax rolls by
shrinking the value of the personal exemption, standard deduction, or
child credit. With the political consensus that some low income people
should be protected from income taxes, the practical solution is to
collapse the various credits and deductions into a super-deduction that
accomplishes what current policies already do inefficiently: Eliminate
the income tax bill for a family of four earning up to about $42,000.
Continuing to protect low-income taxpayers in this way will help earn
goodwill from the left without actually creating any new programs.
Step 4: Make everyone a stakeholder.
An ideal plan would take this process a step further (as did the 1986
act) by slashing all tax rates equally, giving every taxpayer a stake in
Better yet, the plan could condense the number of brackets to no more
than two, as existed in 1988.
Such a tax code would be simpler, fairer, and closer to the kind of
efficiency economists have long called for. It would reduce the
compliance costs for families and small businesses. It would almost
certainly strengthen the American economy and help move the tax code
back to its proper purpose of revenue raising and away from its current
distorted function of social policymaking.
Step 5: Fend off the special interests.
None of this is to say that fundamental tax reform will come easily or
With absolute certainty, every interest group and lobby will line the
halls of Congress demanding their interest have protections carved into
the new legislation.
Advocacy groups of every stripe will take to the airwaves bemoaning the
plight of their specific interest. They will scream that this new tax
bill will evict people from their homes, leave children hungry on the
street, and force seniors into destitution.
Of course, like most cries from special interests, none of this would be
What would be true is that the United States would enjoy one of the best
and most effective tax systems the world over. The new tax code would
still show compassion for the poor and take a hefty chunk from the rich,
while becoming considerably more fair and equitable.