Congress starts its lame-duck session this week with a tax battle. Democrats want to extend, at least temporarily, the Bush tax cuts for families making under $250,000. Republicans want to extend the cuts for everyoneincluding those in the upper-income bracketsforever. Theyre both wrong. A better approach would be to keep all the cuts, but only on the condition that we pay for them by junking the tax breaks that corrode our economy.
An effective tax code would raise money for the government without intruding on private economic activity. Tax ratesthat is, the percentage of your income that you fork over to Uncle Samwould be as low as possible while still funding public spending. Tax breaksthe governments rewards and penalties for certain behaviorwould be minimal to nonexistent. That is, you wouldnt get a tax break for carrying a big mortgage on your house or living in an expensive state (or both).
The 2001 and 2003 Bush tax cuts only partly met the definition of successful policy. The good: President George W. Bush and Congress slashed tax rates across the board, from 39.6 to 35 percent at the top of the income scale and from 15 to 10 percent at the bottom. Tax rates on investment income came down significantly, too. The bad: the governments tax take has never been enough to cover spending, meaning that year in and year out, Washington has piled onto an already big pile of debt borrowed from future taxpayers. And the ugly: the Bush tax cuts didnt simplify the tax code. Such simplification would allow people to devote their scarce dollars to investments and enterprises that they view as productive, rather than following the governments directions. Instead, government allocation of resources has hobbled the economy even as it must soar high to overcome deficits.
Congress has an opportunity now to fix the bad and the ugly. Extending the Bush tax cuts for families earning less than $250,00098 percent of householdslikely would reduce tax revenue by $136 billion annually by 2013, according to Congresss Joint Committee on Taxation. So lets cut back elsewhere to pay for most of it. Killing the deduction for mortgage interest for these families would save roughly $91 billion annually by 2013. Eliminating their deduction for state and local taxes would save another $30 billion, good for a total of $121 billion in savings.
Washington can achieve sufficient savings for upper-income taxpayers to keep their tax-rate cuts as well. Keeping these tax cuts, including the lower rates on investment income, likely would reduce federal revenue by $50 billion annually by 2013. But Congress could make up this figureas well as the shortfall that the tax cut for the other 98 percent of families leavesby rolling back wealthier earners tax breaks. Chopping out their mortgage-interest deduction would save $43 billion, while slashing their deduction for state and local taxes would save another $31 billion, for a total of $74 billion.
All in all, then, killing these breaks would more than cover the cost of keeping todays tax rates. Even better: $9 billion would remain to help close preexisting deficitsthough tax estimation hardly offers mathematical certainty. (Those deficits would be even larger, by the way, under current plans to keep 98 percent of the tax cuts without touching how much the government spends on the tax breaks.)
Politicians and voters would scream that such savings measures are just tax hikes in disguise. Theyre nottheyre spending cuts. Tax breaks, after all, are simply a pernicious way for the government to spend other peoples money. Washington doesnt get the money to bestow mortgage-interest deductions out of thin air. It gets that cash from renters and other taxpayers who dont take this deduction, or who have saved more and borrowed less to buy smaller homes. Similarly, a wealthy Texas taxpayer must pay more so that a wealthy New York taxpayer can deduct the cost of his much higher state and local taxes from his federal return.
Killing tax breaks would be fair policy. A full three-quarters of Washingtons spending on the mortgage-interest deduction, for example, goes to taxpayers earning six figures and above. Yet this cheap debt, thanks in part to Washington subsidy, has helped distort the entire housing market over the decadesforcing all homebuyers to pay more. Similarly, upper-middle-class and rich people enjoy nearly 84 percent of Washingtons subsidy of state and local income, sales, and property taxes. All this policy does, though, is mute taxpayer outrage against ever-rising state spending. Since the rich cant pay all state and local taxes, states raise sales and other taxes on the middle-class and poor, too, to feed their voracious budgets.
Moreover, cutting tax breaks would be in the best supply-side tradition. Supply-side economists, after all, have long counseled lower tax rates for a reason: they figured that regular people could spend and invest their money more wisely than the government could. But rate reductions cant work if the government continues to run peoples lives through the rest of the tax code.
Right now, we may have supply-side tax rates, but thanks to tax breaks, weve got a thoroughly demand-side tax code. Thats a toxic combination, considering that we need healthy economic growth to help us confront our national debt. The economy cant grow optimally if Washington encourages Americans to pour more borrowed money into their houses at the expense of more productive investments. Nor can the economy fight its way out of stagnation if state and local governments keep pushing up their own taxes, with an assist from Capitol Hill and the White House.
Unfortunately, political prospects for enacting these reforms and making the Bush tax cuts a more effective economic policy are basically nil. During the mid-eighties, the last time the country achieved some real tax-code reforms, President Reagan and Congress tried to repeal the tax break for state and local taxes. Mario Cuomo, then the governor of New York, rallied a bipartisan coalition of wealthy earners around the nation to beat the effort back. For their troubles, these taxpayers won higher state taxes in the ensuing two decades. As for mortgage interest, Reagan wasnt one of the most astute politicians of the last century for nothing. He promised during his 1984 reelection campaign that his second-term tax reforms wouldnt touch this goodie, which has long placated homeowners and homebuilders alike. A generation later, the constituency for rolling back either of these giveaways is, if anything, smaller, especially as federal policy since the financial and economic crises has focused on propping up housing prices and helping state and local governments delay necessary cutbacks.
So Americans should understand something crucial about the Bush tax-cut debate: even if Congress does make the cuts permanent, absent real reform, this permanence will be temporary. Tax rates inevitably will go up as tax-code distortions impede the nations recovery.