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Tax Reform, Anyone?

The budget deal's tax cuts dim the prospects for significant change

Just one year ago, politicians took comprehensive tax reform seriously. The flat tax, the retail sales tax, and broad-based income tax reform were seen as alternative ways to reduce rates, simplify tax compliance, make taxes fairer, and encourage economic growth. Although there was substantial disagreement on the various packages, reformers were at least addressing the right issues.

These issues stand in sharp contrast to those embraced in the recent budget deal, where Congress and the administration have conspired to cut taxes in a way that introduces new loopholes, makes taxes more complex, and does little to improve the equity or efficiency of the tax system.

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It may seem odd that many of last year's political champions of serious reform could this year favor the budget deal. Some claim that this is the best we can do under the current divided government. These claims ignore the fact that the tax reform act of 1986 - which reduced rates, simplified taxes for many households, and closed loopholes - was a bipartisan package.

Others justify their apparent flip-flop as part of a grand "plan." The idea is to make the income tax such a complex, contorted instrument of public policy that the voters will rise up to throw it out. Are politicians really that smart?

If so, they are too clever by half. Make no mistake: The budget deal will make it harder to enact serious, structural reform - either cleaning up the income tax, or throwing it out and starting over with a whole new system.

Any major restructuring will create winners and losers. Tax cuts enacted along with tax reform make the reforms more politically palatable by reducing the losers and increasing the winners. For example, the flat tax proposed by Rep. Richard Armey (R) of Texas and Sen. Richard Shelby (R) of Alabama would provide a significant tax cut and reorganize the tax system. Even the 1986 tax reform act, a relatively minor set of changes compared with the flat tax, reduced taxes for individuals and hid increased burdens in corporate taxes. In this light, the budget deal makes serious reform harder in two ways:

First, it cuts into long-term tax revenues to the tune of $250 billion over 10 years, and $750 billion over 20 years. The largest losses are outside the five-year budget window and thus do not officially constrain the package. But the revenue consequences grow over time, and responsible lawmakers may hesitate at providing another long-term tax cut on top of the one just passed.

THUS, while some politicians may try to portray the budget deal as a "down payment" for more fundamental tax reform, it is anything but that. It is more like trying to save for a down payment by running up huge credit card bills.

Second, by creating new subsidies, the budget deal creates several new classes of "winners" under the current system - including parents, owners of stocks, small businesses, etc. These groups will now be less likely to want to give up those gains, or will require greater tax cuts to move to a new system.

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Although people dislike complicated taxes, they like complexity that cuts their taxes a lot more than complexity that raises their taxes. Thus, people will grumble about having to fill out more complex forms to claim education and child credits, sort through several IRA options, and pay several different tax rates on their capital gains - but don't expect many to volunteer to give up those cuts.

A third problem with the deal is that loopholes breed demand for more loopholes. If tax credits are given for college attendance - what the president calls 13th and 14th grades - why not give credits for K-12 schooling costs? Why not for home schooling as well? Republicans already have indicated their desire to push for extended education tax breaks. If withdrawals from IRAs can be made for education, then why not for other "worthy" purposes, such as starting a business or buying a house? What about buying a car? If IRA funds can be used for such purposes, why not 401(k) balances as well? Where does one draw the line?

This clearly is a slippery slope. Lawmakers who just passed the budget deal may find it very difficult to draw a line in the sand and oppose further subsidies that look very much like the tax breaks they just lavished on selected groups of taxpayers.

In short, the real damage done by the tax changes is not just the added complexity today. Bigger problems will be caused by the increased obstacles that the deal places in front of comprehensive tax reforms - to broaden the base, reduce rates, and simplify taxes.

* William G. Gale is a senior fellow at the Brookings Institution in Washington.

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