America’s Tax Code Failure

Recent economic news has been promising; the Bureau for Economic Analysis reported that economic growth for the second quarter of 2003 was 2.4 percent, which far exceeded expectations. Unemployment data, while dropping from a peak of 6.4 percent, remained a concern, with total payroll numbers shrinking by 44,000 as July’s unemployment rate was reported at 6.2 percent. Orders to U.S. factories rose by 1.7 percent in June and personal consumption also increased by 3.3 percent in the second quarter. Overall, the news suggests the economy continues to improve, leaving the worst of the slump behind.

In Washington, the economic news has taken a political spin, with Republicans pointing to the power of tax cuts, and Democrats clinging to the weak job numbers as an example of continued economic mismanagement by the Republican White House. In reality, the tax cuts are beginning to work their way into the system, but Congress’s unwillingness to make the cuts permanent may limit their ultimate impact. The looming presidential campaign provides a perfect opportunity to revisit the issue and drive home the importance of lowering marginal rates while providing permanent relief from a punitive tax code. Congress needs to pass fundamental reform that eliminates the complexities and biases in the existing tax code, replacing it with a tax code that is simple, fair, and flat.

There is no doubt that the recent tax cuts are popular and will allow taxpayers to keep more of their hard-earned money. A recent survey conducted by the Tarrance Group for Citizens for a Sound Economy found that the key components of the $350 billion tax cut package are widely supported. The child tax credit, the reduction in the marriage penalty, and the idea of making the cuts effective immediately rather than phasing them in over time received strong approval. The survey also found strong support for continued fundamental tax reform to make the tax code “simpler, fairer, and flatter.”

While the tax cuts are beneficial to economic growth, their impact on the recent economic statistics may have been dwarfed by increased federal spending. In fact, defense spending saw its biggest one-quarter jump since the Korean War. But such government spending is not a sustainable source for economic growth; it diverts resources from other productive uses in the private sector. The tax cuts on the other hand, which began with the 2001 tax legislation and have continued with this year’s tax bill, offer a more sustainable economic growth path that provides stronger incentives for individuals and businesses to save and invest. Yet those incentives are muted by the fact that the tax cuts are not permanent; for example, the Death Tax, a highly punitive and inefficient tax, reappears in 2011 unless Congress acts to make repeal permanent.

Even beyond the political grandstanding over the sunset of the tax cuts, the tax code that Congress continues to cling to is clearly a burden on taxpayers. It is inefficient and complex, it treats individuals with the same income completely different, and it punishes savings, which is the source of future economic growth. Ideally taxes should be structured in a manner that minimizes the burden of tax collection. Yet, as Council of Economic Advisers points out, the I.R.S. spent $8.9 billion administering the income tax, and consumers spent 3 billion hours to comply with the tax code. The Council also report that 72 million taxpayers needed professional tax preparers and that the typical Fortune 500 company spends $4 million a year dealing with the tax code.

Just as concerning, the tax code distorts important decisions that people make about investing and saving money. High marginal rates and double taxation reduce incentives to invest and special interest tax policies push resources to politically favored investments rather than the most efficient investments. Finally, social engineering and special interest politics have generated inequities in the tax code that leave individuals paying taxes not based on income, but on how that income is used. Neighbors with the same income can pay vastly different taxes based on whether they own their house, if they give to charity, where they invest their money, and so forth. All these discrepancies suggest that the tax code should be revisited. It has moved well beyond a mechanism that simply collects revenue. Political interests have modified and distorted the code to the point where even tax professionals have difficulties understanding it.

The coming election season provides the perfect opportunity to renew the push for fundamental tax reform. Its popularity with voters is strong, and the flaws of the current tax code are well-known. Collecting revenues should not be so difficult. Rather than the current tax code, which has become a feeding ground for lawyers and lobbyists, a simple, fair, and flat tax code could easily generate the revenues needed by the government. Economic growth is important to all Americans and provides the engine for families to live the American dream. To shackle growth with a tax code that is inefficient, complex, and unfair makes no sense.