Why Tax Reform Is Hard

As we noted in our last newsletter, September was, perhaps, the cruelest month.  A bevy of high stakes deadlines (and potential crises) loomed— many, but not all, were met.  But the real blow to the party in power was the failure to meet a parliamentarian-decreed deadline to repeal and replace the ACA.  At least for the moment, this Republican passion of the past seven years goes unfulfilled.  Republicans in Washington have turned their eyes to a new legislative priority, one even closer to their hearts: tax policy.  Given the recent release of President Trump’s tax reform plan and efforts to understand it, it’s important to consider some of the basic issues involved.  In short: true tax reform (not just tax cuts) is extraordinarily difficult, both because of the political conditions necessary and current arithmetic realities.

Tax reform is rare because it is hard.  It tends to take years of substantive work to produce: the 1986 Tax Reform Act took about two years, and former Ways and Means Chair Dave Camp took three years to put together his 2014 proposal (which still failed).  It involves concentrated costs (often to vocal interests) and diffuse benefits; special political circumstances are generally seen as being needed to insulate the process from these strong, moneyed headwinds.  Traditionally, strong Presidential support, firm congressional leadership, effective messaging, and political insulation are seen as important.  (See CRS scholar Gravelle’s piece, beginning on page 457.)  Meanwhile, the increasing salience of electoral cycles on legislation, and the steep decline of regular order, make the kind of sustained focus necessary even harder still.

Why is tax reform so hard, and what are some of the major issues involved? With all of Washington’s rhetoric, some of these policy distinctions can get clouded or colored.  We still talk about tax reform in the same conventional terms—namely, broadening the base (curtailing tax expenditures) and lowering the rates.  Additional elements have been suggested — including new revenue sources (often to pay for lower rates) like a BAT, a bank tax, or a VAT—reforms such as taxing corporate profits once, or ideas to fundamentally transform the system (a flat tax, or a “9-9-9”, etc.).

The possibilities for conventional tax reform are far different today than in 1986.  This is true both because major revenue numbers of different varieties have changed, but also because of more modern challenges—particularly that international tax avoidance has become a lot more sophisticated.

In terms of revenue numbers, both broadening the base and lowering the rates is harder now.  There were far more opportunities for broadening the base in 1986, and today’s options are not as attractive as those 30 years ago. Today, the most costly tax expenditures are not only very politically popular, but many are arguably good policy on the merits.  

As for lowering the rates, in 1986 it was much easier to lower the top personal income tax rate when it was 50% (it’s currently 39.6%) and lower the top corporate rate when it was 46% (it’s now 35%).  (The 1986 Tax Reform Act raised the capital gains tax to 28%, matching the reformed top personal income tax rate.)

To be sure, the current top corporate marginal rate is 35%, higher than other nations—but our effective corporate rates (i.e. what’s actually paid) are roughly the same.  The real issue is that the effective rates vary wildly between corporations and industries.  For those actually paying 35%, many economists and politicians agree that the rate is too high.  But many don’t pay that rate—some are far from it.

Finally, the question of whether tax reform should be revenue-neutral (neither losing nor raising revenue), as 1986 was designed, will be a major element in the upcoming debate.  Some argue that, given the structural deficits in our system, greater revenue (in addition to the spending cuts underway) should be considered as part of any serious reform.  Meanwhile, Republican leaders have not ruled out tax cuts without corresponding revenue increases.

Our current circumstances are different from 1986 in another major regard: the international angle to American taxation is much different.  Waves of inversions (where a domestic company becomes a subsidiary of a foreign company in order to pay less under a different tax regime) started gaining major attention by the early aughts.  Despite ongoing efforts by Treasury, this remains a significant problem.  Trying to tax American multinationals abroad can be difficult because of intangibles—intellectual property like patents (technology and medicine being the most problematic industries) is highly mobile and hard to catch on a balance sheet.  Companies have also gotten very sophisticated at shifting debt for tax avoidance purposes.  While it would be possible to collect more revenue by going after tax avoidance, that would pit congressional leaders against the wealthiest interests in the world, on policy issues that are understood well by very few specialists, making it harder for the public to demand them.  

We’ll return with an analysis of the tax proposal – and its path through Congress – as it evolves.  But for now, dear reader, be wary of anyone, regardless of political stripe, who promises an easy lift on tax reform.

Laura Blessing is a Senior Fellow at the Government Affairs Institute