Wanted: A Fairer, Simpler Tax Code

As government has grown, so too has the complexity of the tax code. Rather than an efficient means of financing government activities, the tax code has become a costly tool of social policy and income redistribution. The current debate over permanent repeal of the death tax—a tax that generates very little revenue while distorting incentives for productive investments—demonstrates the intractability of the tax code. Yet, as more Americans find themselves subjected to the perversities of the tax code, the need for fundamental tax reform increases.

Tax policy was established as a means of financing government spending, yet over time taxation came to be viewed as an important tool to regulate economic and social activity in the private sector. Initially, taxes were primarily a means of financing military efforts, but social welfare policy has come to take a larger share of taxes. Since the early 1960s, defense spending has dropped from roughly 50 percent of discretionary spending to around 17 percent in 2001. Non-defense spending actually exceeded defense spending that year. More importantly, mandatory spending on social welfare programs came to dominate federal spending during this time frame; mandatory spending climbed from 26 percent of the budget in the early 1960s to almost 54 percent in 2001.

At the same time, tax policy has been used to promote certain social goals or policies. Progressivity, for example, was introduced as a means to ensure that the wealthy bear a disproportionately greater share of the tax burden. Progressivity has reached the point where the top 25 percent of income earners pay 5 out of every 6 dollars of federal individual income tax collected. The tax code also has been crafted to encourage or discourage certain types of behavior. Everything from home ownership and education to smoking and drinking have been addressed through taxation. Many of the inefficiencies of the current tax code can be traced to earlier ideas of social policy or failed economic theories.

Perhaps the most important developments in tax policy can be traced to fiscal management theories that relied on active government intervention in the economy and an ample dose of federal spending. For more than 40 years, economic policy was driven by concerns over aggregate demand. The overall demand for goods and services was believed to drive growth of GDP. Thus, in bad economic times, when consumers and businesses lacked the resources for economic activity, the government’s role was to increase spending to maintain economic performance. This approach to economic policy, typically referred to as Keynesian economics in reference to the works of economist John Maynard Keynes, led to an inevitable cycle of deficit spending as government sought to maintain aggregate demand through government spending. In the recent economic downturn, many policymakers reverted to this thinking with calls for a stimulus package that was largely a springboard for new federal spending.

However, by the 1970s, Keynesian economics began falling into disfavor among many economists. With negligible real economic growth as well as persistent inflation and unemployment problems, economists were becoming skeptical of the government’s ability to manage an economy where millions of decisions were being made daily. At the same time, economists began to emphasize the importance of incentives in tax policy. Rather than looking at taxes simply as a source of funding for government spending, economists began to emphasize the impact that taxes had on incentives for productive activities, such as investment and capital formation. While most closely associated with the supply-siders, the study of incentives became an important area of research for many students of tax policy.

The new emphasis on incentives called into question much of the Keynesian approach to economic policy. For example, the Keynesian model typically viewed savings as something that reduced consumption and the overall demand for output. Consequently, Keynesians often preferred government spending to tax cuts, because government spending was a certainty, while tax cuts that might promote savings were a drain from aggregate demand. Other than increasing disposable income, tax cuts were not viewed as having a significant impact on the economy.

As a faltering economy prompted a re-evaluation of economic policy, many began to revisit the link between taxation and behavior. In particular, economists began to look at marginal tax rates and how they effected economic decision-making. Marginal tax rates were important because they affected economic decision-making. Unlike average tax rates, which measured total taxes paid as a percentage of income earned, marginal tax rates reflect the impact of a tax on decisions to earn additional income. For example, what effect does the tax rate have on investing in a new company? Such an investment may generate income, but if the tax rate is too high, the decision to invest may be abandoned. Supply side economists focused on the role of marginal tax rates, demonstrating that high marginal rates led to less productive activity. Conversely, tax cuts were viewed as important for permanently increasing output, because lower rates allowed greater returns on investments, leading to increased output. And the greater the cut in marginal rates, the greater the impact on productivity and growth.

Supply-siders and others challenging Keynesian economics viewed savings as an important source of economic growth, not a potential leakage from the economy. The new emphasis on incentives and behavior examined the link between taxation and individual behavior. Studies found that at higher rates of marginal taxation, individuals substituted leisure for work, and invested in tax shelters and other activities that shifted resources away from more productive uses. The study of incentives also demonstrated the importance of savings to capital formation and investment activity.

Despite the transformation in economic thinking about taxation, the tax code remains a relic of an era of Keynesian fiscal management riddled with an assortment of social policies. To this day, Congress and the administration ignore any potential changes in behavior due to taxes. A tax cut is “scored” simply as a loss of revenue; no attempt is made to determine the effect of lower taxes on incentives to invest, even though any new investments that increase productivity or economic growth actually generate new sources of revenue for the government. The interplay between economic growth and revenue is simply ignored by budget analysts. Dan Mitchell of the Heritage Foundation suggests that the unrealistic approach used to evaluate changes in taxes has delayed attempts to adopt a simpler, fairer tax code while making it difficult to lower taxes.

Indeed, those opposed to permanent repeal of the death tax often couch their objections in arguments about losses to the Treasury or unfair tax cuts for the rich. They ignore completely the incentives generated by the current death tax to move assets out of productive activities to avoid the death tax and the effect that death taxes can have on assets that are currently in productive uses that must be disbanded and sold to pay the tax.

Academics and analysts have made the case that incentives matter when evaluating tax policy. The current tax code has yet to incorporate these ideas. In a global economy with fluid capital markets, the United States cannot afford a tax code that punishes productivity and capital formation. The current amalgam of costly social policies and poor economics that underlie the existing tax code must be jettisoned in favor of fairer and simpler tax code that is designed to collect taxes efficiently without distorting incentives to engage in productive behavior.