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Markets & Finance

Fight the Deficit Monster with Tax Reform


Simplifying the U.S. code could lower overall income tax rates and raise more revenue, says Bloomberg BusinessWeek columnist Chris Farrell

The numbers are daunting. The U.S. federal budget deficit is projected to add up to a cumulative $9 trillion over the next 10 years. The national debt already tops $12 trillion. The interest bill alone on servicing the government's debt will more than triple, to $700 billion, by 2019. To paraphrase and update the legendary Senator Everett Dirksen: A trillion here, a trillion there, and pretty soon you're talking about real money. Scared? Don't be, at least not yet. The figures aren't anywhere near as frightening as they appear at first glance. For one thing, much of the deficit reflects dramatic but temporary measures taken by government to shore up an economy in free fall, with credit frozen, managements fearful, and households hoarding cash. For another, interest payments as a percent of gross domestic product (GDP) will average 2.4% over the next decade, according to the Congressional Budget Office. That's considerably less than the average 3.1% of GDP from 1985 to 1994. Perhaps most important, given record budget deficits, is that bond yields haven't spiked. The bond market vigilantes aren't taking fright, and interest rates remain low. Simpler Tax Rules

Still, complaints about the deficit and national debt are legion in Washington and town hall meetings around the country. The Administration is on board with deficit reduction, too, once the business cycle upturn is in full swing. It seems almost everyone essentially agrees that the red ink needs to be reduced. The current projected path is not sustainable, especially since the federal government should shore up its finances before the next downturn in the business cycle. The question, as always, is how to do it. The politics of spending and taxes has been and will be vicious, especially since 2010 is an election year. Ignoring the problem down the road isn't an option. Here's one way to break the political logjam: Leaders of both parties should embrace major tax reform with an emphasis on simplification. In essence, eliminate all or most tax credits and tax deductions, income phase-ins and phase-outs, exclusions and exemptions. A dramatic broadening of the tax base can allow for both lowering overall income tax rates and raising more revenue. It would make it far easier to match federal tax revenue with federal spending obligations. It isn't just the pressure of the long-term budget deficit that makes for tax reform. A number of important tax cuts from earlier in the decade are scheduled to expire in 2010, including the low rates on dividend and capital gains taxes. The Alternative Minimum Tax, originally aimed at high-income taxpayers, is so badly designed it now threatens increasing numbers of middle-income families. It's a tax monster that Washington is struggling to keep at bay with one-year fixes, yet every year the potential problem gets bigger and more troublesome. Broader Revenue Base

The tax code is far too complicated, too. In 1913, New York State Senator Elihu Root moaned about the new federal income tax to a friend. "I guess you will have to go to jail. If that is the result of not understanding the Income Tax Law I will meet you there …. no one understands the Income Tax Law except persons who have not sufficient intelligence to understand the questions that arise under it." Imagine what he would say today considering all the twists and turns in the code, phase-ins and phase-outs, credits and deductions for everything from mortgages, child care, low-income housing, energy conservation, and employer-provided health insurance (to name just a handful of the myriad social engineering tactics pursued through the tax code). Of course, while there is a general agreement on the benefits of simplification, plenty of powerful interests enjoy specific tax benefits. Yet major reform has occurred before, the most notable example being the Tax Reform Act of 1986. President Ronald Reagan, his Treasury Department, House Democrat Dan Rostenkowski [Chairman of the House Ways and Means Committee], and Senate Republican Robert Packwood [Chairman of the Senate Finance Committee] combined forces to simplify the tax code. It was a step in the right direction, although the gains were eroded over time. This time around the Administration could dust off the tax simplification blueprint written by President Bush's 2005 Advisory Panel on Tax Reform. It's a good starting point. The spending obligations won't go away. The U.S. has seen a massive expansion of government between the trauma of 9/11 and the Great Recession. The costs of retirement and medical care are rising along with an aging baby-boom population. The way to sell fiscal responsibility is to expand the revenue base and reward ordinary citizens with a much simpler tax code. The budget deficit offers an opportunity for leaders of both political parties to seize the mantle of tax reform.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on BusinessWeek.com.

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