The Romney Reforms?

could Mitt fix the mess that is our tax system without even getting the nomination. 

by Tom Evslin

The President's own National Commission on Fiscal Responsibility and Reform recommended a much flatter tax structure and elimination of most tax deductions and credits in its draft report. The President – and almost everyone else – ignored this recommendation. Ex-candidate Herman Cain made a 9-9-9 flat tax almost famous before he sunk from view. Ron Paul advocates a very flat income tax – zero . The other Republican candidates have advocated flatter taxes without much fervor. But Mitt Romney's incredible political miscalculation in attempting to withhold the fact that he pays only 15% of his income in taxes may have actually given us a leg up on tax reform.

The fact is that we do have a somewhat progressive federal income tax. The 40% of families with the lowest incomes don't pay any income tax at all as a group. The rich AS A WHOLE pay a higher rate than the rest of us. But the statistics obscure huge individual variances in taxes paid because of a tax system riddled with loopholes and special exceptions – like the so-called carried interest deduction and concessionary rate for capital gains, which probably are the reasons why Romney paid such a low rate (see a great post by my friend Fred Wilson who benefits from these concessions but argues they should be eliminated).

These exceptions are not only unfair – they also corrupt government. Politicians get campaign contributions (at least) from those who benefit from the loopholes. Working to add loopholes or defending the ones that are already there attracts lobbyists with full purses like… chose your simile. Individual loopholes don't attract much opposition since the pain of giving a few people a break is spread over the rest of us taxpayers.

Often loopholes are justified as tipping the economic scales in favor of some perceived common good. Unless you're a renter or take the standard deduction, you probably like the deduction for your home mortgage – realtors certainly do. But how do you feel about the tax credit for corny ethanol production, which was just allowed to expire this year? It managed to simultaneously drive up the price of energy and food, while probably doing some environmental damage along the way. Besides leading to bad government by providing congresspeople with a bottomless pit of favors to give out or protect in return for campaign support, loopholes are bad economic policy.

Here are some numbers from the Congressional Budget Office for 2007 (latest available, unfortunately, since some of this must have changed in the recession):

	quintiles
	1st	2d	3d	4th	5th	all		top 10%	top 1%
Individual Income	(6.8)	(0.4)	3.3	6.2	14.4	9.3		16.2	19.0
Social Insurance	8.8	9.5	9.4	9.5	5.7	7.4		4.5	1.6
Excise	1.6	1.0	0.8	0.7	0.4	0.6		0.3	0.1
total	3.6	10.1	13.5	16.4	20.5	17.3		21.0	20.7

Almost all income including interest on tax free bonds for the well-to-do and cash benefits for the not-well-to-do is counted. Note that, on the average, families in the lower two quintiles (low income 40% ) actually paid negative income tax – as groups they received more in earned income, child care, and other tax credits than they paid in income tax. However, people in these two quintiles DID pay a healthy share of their small incomes for social insurance including social security and Medicare (the table properly attributes the payments made by employers to the employees). The wealthy paid a somewhat higher share of their income in income tax; the top 20% paid more than twice the rate of INCOME tax that the 20% immediately below them paid; the top 1% pay 19%, more than the top 10% as a whole who pay only 16.2% (had enough percentages yet?). For those concerned with tax equality (not what this post is about), the top 1% had 19.4% of all pretax income in 2007, just as the occupiers suspect, but, on the other hand, paid 39.5% of all individual income tax.

Takeaway, statistically, we have a somewhat progressive tax system. But loopholes make it unfair.

Let's assume, for this post, that the current actual progressivity is fair. We should then collect these rates from various income groups with a straightforward tax on all income WITHOUT LOOPHOLES. The nominal tax rates would be lower, of course, but the money collected from each group would be the same.

The benefits to the country of a tax system without loopholes would be huge.  The chief, non-measurable but vastly imporant of these benefits would be that it would impose fairness.  People with the same incomes would pay the same taxes.  But there are other payoffs, to include:

The benefits to the country of a tax system without loopholes would be huge.

1. Fairness, fair, fairness. People with the same incomes would pay the same taxes.
2. Actual visibility into how much people are paying according to level of income.
3. A huge decrease in the cost of complexity – (not great for some accountants and lawyers).
4. A huge increase in efficiency when investments are made because of anticipated profit rather than anticipated tax benefit.
5. Eliminating the opportunity for congresspeople to sell tax breaks in return for contributions.
6. Lower rates make the special treatments unnecessary. If the top rate is 20%, it's hard to argue that capital gains or dividends need a special 15% rate. That argument is more compelling (although I still don't believe it) when marginal rates are north of 30%.

Maybe Romney's embarrassment will force him to advocate closing all loopholes for everyone. Maybe Gingrich will demonstrate his economic independence by doing the same. Maybe President Obama will listen to his own advisory commission and introduce a bill for tax simplification. Won't it be a great campaign if candidates are outdoing each other in closing loopholes and lowering the nominal tax rates? Unlike most government programs – certainly unlike tax breaks – tax simplification really will create jobs by making work more rewarding (less taxed because "unearned" income is taxed more than it is now) and making economic decisions more rational.

Related posts:

The Deficit Reduction Draft Proposal is the Stimulus Program We Need!

Good News for the New Year

The End of the Age of Incentives

Comments

[gene laber]

Tom,
You state that federal taxes are somewhat progressive. With respect to the income tax, an OECD study compared the share of income taxes paid by the top 10% of taxpayers with their share of total income. The U.S. had the highest ratio--1.35--of any of the countries in the study. Sweden, that model of liberal policies, had a ratio of 1.0. I would say that our income tax is very progressive.

You refer to "loopholes." The Simpson-Bowles draft calls them tax expenditures, a term that is probably more accurate. I suggest, for example, that when people buy tax-exempt bonds they are simply responding to what politicians of both parties have encouraged them to do--provide lower interest rates to state and local govts. I don't see that as exloiting a loophole, although it may not be a wise economic policy. policy.

Also, you do not mention that various studies have found that the tax base is sensitive to marginal tax rates. Lowering marginal rates would increase the tax base, an outcome that the "tax the rich" crowd finds uncomfortable.

[Tom Evslin]

Gene:

Thanks for the comment.

I said the tax was "somewhat progressive" because it is less progressive that the headline rates make it appear but more progressive than Romney's taxes or the occupiers would make you think.

No question that people respond to economic stimuli and they are often doing exactly what people want them to do - your example of muni bonds is a good one. This is the case where bad economic decisions are "forced" by the tax code.

I do believe that lower headline rates will stimulate the economy in a various ways. I said this as jobs would be created and misallocation of resources avoided. You are right to close the circle and point out this also means more revenue.