Changing System of Tax Breaks Could Reduce Budget and Improve the Nation’s Tax System

Jul 18, 2010

Authors: admin

Publisher(s): The Century Foundation

Even though unemployment remains well above 9 percent, and the federal government could be doing much more to strengthen the economy, attention in Washington has turned to how best to reduce long-term federal deficits. In “How to Reduce the Deficit and Improve the Tax System without Hurting Most Families,” a new issue brief from The Century Foundation, economist and senior fellow Bernard Wasow weighs in with a solution to a significant part of the long-term deficit challenge that would be relatively pain free for low- and middle-income citizens: reform the income tax system to fix the problems with tax breaks.

President Obama created the National Commission on Fiscal Responsibility and Reform, co-chaired by Democrat Erskine Bowles and Republican Alan Simpson, to develop recommendations for significantly reducing long-term deficits, and their report is due by December 1, 2010. As deliberations unfold, one common refrain will likely be that there is no painless way to reduce deficits. Many will argue that cuts to important and popular social insurance programs such as Social Security, Medicare, and Medicaid are the only path to fiscal responsibility.

However, Wasow determines that simply by revising our system of tax breaks, it should be possible to collect additional federal revenues while improving the efficiency, fairness, and user-friendliness of the tax system. He reports that the U.S. income tax code’s profusion of tax breaks totals to more than double the additional revenues the government will need after recovery to bring the federal debt under control. He concludes that reforms addressing tax breaks could eliminate half the deficit problem with relatively little consequence for middle- and low-income families. Because most of the existing tax breaks benefit specific industries, and the most costly breaks disproportionately benefit upper-income households, tax reform could be implemented in ways that impose costs primarily on those who can most afford them.

The reform Wasow proposes would combine some tax breaks, eliminate others, cap benefits, and otherwise modify special favors in the code. Reform also could revisit basic income tax rates, which can be cut, even while revenues are increased, because reform of tax breaks will broaden the tax base, namely the amount of income subject to taxation.

Wasow cautions that a successful strategy to reform tax breaks cannot be put together piecemeal. Reform must be planned comprehensively so that costs and benefits are shared; and costs must fall most heavily on those best able to bear them. He proposes that any strategy for comprehensive reform of tax breaks should be based on these principles:

 1.      Move in the direction of treating income from all sources uniformly (no special rates for capital income—dividends, interest, and realized capital gains).

2.      Replace deductions from taxable income with direct tax credits—reductions of taxes owed—which should have a uniform rate for households of all income levels.

3.      Put caps or ceilings on the tax benefit a taxpayer can obtain from a single tax break, as well as all tax breaks combined.

4.      Eliminate to the maximum extent possible narrow, special interest breaks for industry.

Wasow believes that because the economy still is struggling, it would be premature and counterproductive to try to reduce tax breaks today. But since the debate over deficit reduction is sure to focus on cuts to programs that mainly help middle-class and poor Americans, it is important for the public to understand that there are other alternatives that would be less painful and more beneficial to the country as a whole. “Once the economy has recovered beyond the need for fiscal stimulus, reforms such as these should be introduced,” he writes. “But now is the time to begin a new, long overdue debate over reforms to the federal income tax.”

“How to Reduce the Deficit and Improve the Tax System without Hurting Most Families,” is available on The Century Foundation website at www.tocf.org. For more information or to arrange an interview with Bernard Wasow, contact Christy Hicks at hicks@tcf.org or (212) 452-7723.