Two distinguished economists at Rice University's Baker Institute for Public Policy advocate a comprehensive reform of the nation's corporate and personal income tax system in a new report issued this week. John Diamond, the Baker Institute's Edward A. and Hermena Hancock Kelly Fellow in Public Finance, and George Zodrow, the Allyn R. and Gladys M. Cline Chair of Economics at Rice University and a Rice Scholar at the Baker Institute's Tax and Expenditure Policy Program, argue that such an overhaul is needed now.
Titled, "Fundamental Tax Reform: Then and Now," the report examines the conditions that led to the passage of the 1986 Tax Reform Act (TRA86), the last major effort to update the U.S. income tax system. It then compares those circumstances to today's environment and concludes, "The conditions are right for another sweeping reform of the tax system and, indeed, the case for reform may be even stronger than it was prior to the passage of TRA86."
The report describes their views of the general contours that fundamental individual and corporate tax reform should take.
Diamond, who is also the forum editor for the National Tax Journal, and Zodrow, who is also an International Research Fellow at Oxford University's Centre for Business Taxation and editor of the National Tax Journal, maintain that political conditions in 1986 in many ways resemble the current environment. In particular, 1986 was characterized by a highly partisan atmosphere -- with each party controlling one house of Congress and each seeking political advantage for the coming battle for the White House –- that had most pundits predicting legislative gridlock.
The report also notes the "widespread disgust with the income tax system” that characterized conditions in 1986, including:
the prevalence of tax shelters that enabled wealthy taxpayers to escape much of their tax liability.
high tax rates that hampered economic growth by discouraging labor supply, saving and investment.
distortions of consumption, saving and investment decisions caused by differential tax treatment of similar economic activities.
a tax code that was “hopelessly complex, resulting in high compliance and administrative costs and a pervasive sense that the tax system was fundamentally unfair as only those knowledgeable enough and willing to ‘game’ the tax system were able to significantly reduce their tax burdens.”
Those concerns, Diamond and Zodrow note, were sufficiently important to win the day for fundamental tax reform 25 years ago. The executive and legislative branches collaborated to craft a bill that "significantly improved the tax system from an economic perspective while still maintaining political feasibility" and passed the Senate by a 97-3 vote in an impressive display of bipartisanship.
The current environment offers similar possibilities, Diamond and Zodrow write. President Barack Obama is looking for causes that have appeal to members of Congress on both sides of the aisle and demonstrate his willingness to compromise and his ability to get things done. The president discussed the need for tax reform in his State of the Union address in January and mentioned it again Monday in a speech to the U.S. Chamber of Commerce, where he said, "Another barrier government can remove is a burdensome corporate tax code with one of the highest rates in the world."
Comprehensive tax reform could attract both Democrats and Republicans, the Baker Institute report argues. "In particular, the standard base-broadening, rate-reducing approach implemented in 1986 and advocated in many current proposals could have considerable appeal to Democrats to the extent that it reduces tax preferences that primarily benefit the wealthy, and to Republicans as it lowers marginal tax rates and reduces distortions of decisions regarding labor supply, saving and investment, as well as implicit government intervention in the allocation of resources in the economy through the tax system," they write.
Diamond and Zodrow point to five criteria that any tax overhaul should include. Specifically, fundamental tax reform should be revenue neutral, equitable, simple, efficient and create a favorable environment for foreign investment.
The report argues that any fundamental tax reform plan should reduce or eliminate many tax credits, deductions and exemptions, and use the resulting revenue to reduce rates in a revenue and distributionally neutral manner. It should also consolidate and simplify any remaining tax preferences. Diamond and Zodrow address the sensitive issue of the home mortgage interest deduction by proposing "a combination of reducing the cap on the amount of mortgage principal on which interest receives a tax preference, coupled with either (1) deductibility of only a fraction of home mortgage interest, or (2) a fixed-rate non-refundable tax credit for home mortgage interest." They also advocate capping the deduction for employer-provided health insurance, and then indexing the cap to general inflation, rather than to the inflation in health care costs, so that the deduction would gradually decline relative to real health care costs and raise revenues over time.
Other individual tax deductions face scrutiny in the report. Diamond and Zodrow call for full repeal of the deduction for state and local taxes on the grounds that "most state and local expenditures approximate consumption expenditures and do not have significant national spillovers." State and local bonds should also lose their tax-exempt status in their view. The authors suggest transforming the deduction for charitable contributions "into a nonrefundable fixed-rate credit that can be claimed by all taxpayers that give more than 2 percent of adjusted gross income."
Turning to business taxes, Diamond and Zodrow propose eliminating "as many tax preferences as politically feasible" and using the resulting revenues to lower the corporate tax rate and follow the general principles underlying the 1986 legislation. Their goal is to "reduce costly distortions of economic decisions and thus promote economic growth and economic efficiency in resource allocation, simplify tax administration and compliance, reduce incentives for tax evasion and tax avoidance including incentives for income shifting abroad by U.S. multinationals, and create a fairer tax system."
The Baker Institute business tax proposal would also be a traditional base-broadening, rate-reducing reform plan. Among the business deductions singled out for elimination are accelerated depreciation allowances, the special deduction for U.S. manufacturing activities, and various industry-specific tax preferences.
Finally, Diamond and Zodrow propose an additional potential element of fundamental reform of the corporate income tax: the introduction of a new "allowance for corporate equity" or ACE, which they acknowledge is more ambitious – a corporate reform that they believe is economically sound but politically more challenging. An ACE "would allow companies an extra deduction equal to the product of the book value of equity capital and a risk-free nominal interest rate." It would result in roughly uniform treatment of debt and equity finance and lower the taxation of investment income at the business level to that associated with a consumption-based business tax," they emphasize.
They close by noting that if passage of a full-scale ACE is politically impossible, they would urge lawmakers to consider a partial ACE, which would "lower the tax burden only on equity-financed investment, narrowing the differential between the tax treatment of debt- and equity-financed investment while providing an overall stimulus to investment." Such a provision could even be used as a counter-cyclical tool if deemed desirable – an approach that they argue would be preferable to current practice under which full or partial expensing is used as a counter-cyclical tax instrument.
To read the full report, go to http://www.bakerinstitute.org/publications/TEPP-pub-FundamentalTaxReform.pdf.
To view a video interview of Diamond and Zodrow, go to http://www.youtube.com/watch?v=Pemti3EYad4.
Source: Rice University
Titled, "Fundamental Tax Reform: Then and Now," the report examines the conditions that led to the passage of the 1986 Tax Reform Act (TRA86), the last major effort to update the U.S. income tax system. It then compares those circumstances to today's environment and concludes, "The conditions are right for another sweeping reform of the tax system and, indeed, the case for reform may be even stronger than it was prior to the passage of TRA86."
The report describes their views of the general contours that fundamental individual and corporate tax reform should take.
Diamond, who is also the forum editor for the National Tax Journal, and Zodrow, who is also an International Research Fellow at Oxford University's Centre for Business Taxation and editor of the National Tax Journal, maintain that political conditions in 1986 in many ways resemble the current environment. In particular, 1986 was characterized by a highly partisan atmosphere -- with each party controlling one house of Congress and each seeking political advantage for the coming battle for the White House –- that had most pundits predicting legislative gridlock.
The report also notes the "widespread disgust with the income tax system” that characterized conditions in 1986, including:
the prevalence of tax shelters that enabled wealthy taxpayers to escape much of their tax liability.
high tax rates that hampered economic growth by discouraging labor supply, saving and investment.
distortions of consumption, saving and investment decisions caused by differential tax treatment of similar economic activities.
a tax code that was “hopelessly complex, resulting in high compliance and administrative costs and a pervasive sense that the tax system was fundamentally unfair as only those knowledgeable enough and willing to ‘game’ the tax system were able to significantly reduce their tax burdens.”
Those concerns, Diamond and Zodrow note, were sufficiently important to win the day for fundamental tax reform 25 years ago. The executive and legislative branches collaborated to craft a bill that "significantly improved the tax system from an economic perspective while still maintaining political feasibility" and passed the Senate by a 97-3 vote in an impressive display of bipartisanship.
The current environment offers similar possibilities, Diamond and Zodrow write. President Barack Obama is looking for causes that have appeal to members of Congress on both sides of the aisle and demonstrate his willingness to compromise and his ability to get things done. The president discussed the need for tax reform in his State of the Union address in January and mentioned it again Monday in a speech to the U.S. Chamber of Commerce, where he said, "Another barrier government can remove is a burdensome corporate tax code with one of the highest rates in the world."
Comprehensive tax reform could attract both Democrats and Republicans, the Baker Institute report argues. "In particular, the standard base-broadening, rate-reducing approach implemented in 1986 and advocated in many current proposals could have considerable appeal to Democrats to the extent that it reduces tax preferences that primarily benefit the wealthy, and to Republicans as it lowers marginal tax rates and reduces distortions of decisions regarding labor supply, saving and investment, as well as implicit government intervention in the allocation of resources in the economy through the tax system," they write.
Diamond and Zodrow point to five criteria that any tax overhaul should include. Specifically, fundamental tax reform should be revenue neutral, equitable, simple, efficient and create a favorable environment for foreign investment.
The report argues that any fundamental tax reform plan should reduce or eliminate many tax credits, deductions and exemptions, and use the resulting revenue to reduce rates in a revenue and distributionally neutral manner. It should also consolidate and simplify any remaining tax preferences. Diamond and Zodrow address the sensitive issue of the home mortgage interest deduction by proposing "a combination of reducing the cap on the amount of mortgage principal on which interest receives a tax preference, coupled with either (1) deductibility of only a fraction of home mortgage interest, or (2) a fixed-rate non-refundable tax credit for home mortgage interest." They also advocate capping the deduction for employer-provided health insurance, and then indexing the cap to general inflation, rather than to the inflation in health care costs, so that the deduction would gradually decline relative to real health care costs and raise revenues over time.
Other individual tax deductions face scrutiny in the report. Diamond and Zodrow call for full repeal of the deduction for state and local taxes on the grounds that "most state and local expenditures approximate consumption expenditures and do not have significant national spillovers." State and local bonds should also lose their tax-exempt status in their view. The authors suggest transforming the deduction for charitable contributions "into a nonrefundable fixed-rate credit that can be claimed by all taxpayers that give more than 2 percent of adjusted gross income."
Turning to business taxes, Diamond and Zodrow propose eliminating "as many tax preferences as politically feasible" and using the resulting revenues to lower the corporate tax rate and follow the general principles underlying the 1986 legislation. Their goal is to "reduce costly distortions of economic decisions and thus promote economic growth and economic efficiency in resource allocation, simplify tax administration and compliance, reduce incentives for tax evasion and tax avoidance including incentives for income shifting abroad by U.S. multinationals, and create a fairer tax system."
The Baker Institute business tax proposal would also be a traditional base-broadening, rate-reducing reform plan. Among the business deductions singled out for elimination are accelerated depreciation allowances, the special deduction for U.S. manufacturing activities, and various industry-specific tax preferences.
Finally, Diamond and Zodrow propose an additional potential element of fundamental reform of the corporate income tax: the introduction of a new "allowance for corporate equity" or ACE, which they acknowledge is more ambitious – a corporate reform that they believe is economically sound but politically more challenging. An ACE "would allow companies an extra deduction equal to the product of the book value of equity capital and a risk-free nominal interest rate." It would result in roughly uniform treatment of debt and equity finance and lower the taxation of investment income at the business level to that associated with a consumption-based business tax," they emphasize.
They close by noting that if passage of a full-scale ACE is politically impossible, they would urge lawmakers to consider a partial ACE, which would "lower the tax burden only on equity-financed investment, narrowing the differential between the tax treatment of debt- and equity-financed investment while providing an overall stimulus to investment." Such a provision could even be used as a counter-cyclical tool if deemed desirable – an approach that they argue would be preferable to current practice under which full or partial expensing is used as a counter-cyclical tax instrument.
To read the full report, go to http://www.bakerinstitute.org/publications/TEPP-pub-FundamentalTaxReform.pdf.
To view a video interview of Diamond and Zodrow, go to http://www.youtube.com/watch?v=Pemti3EYad4.
Source: Rice University
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