Seeing the forest in the fiscal cliff: 3 ways tax policy must be reformed

December 24, 2012
Obsession
Fiscal Cliff
December 24, 2012

As lawmakers engage in negotiations over the fiscal cliff, there is broad, bipartisan agreement that tax reform is necessary. But there are still many conflicting ideas about what they realistically can and should accomplish, and many reform efforts are based on misconceptions or lack of evidence. The Hamilton Project, an economic-policy group at the Brookings Institution that we are involved with, released a paper earlier this year titled, “A Dozen Economic Facts About Tax Reform,” which studied how taxes affect economic growth, the distribution of the tax burden, and the limits of tax reform.

In the near term, the US faces obvious economic difficulties. With high unemployment and few forecasters predicting a quick return to robust growth, the focus is appropriately on supporting economic recovery. But longer-run challenges cannot be ignored. Even as the economy recovers, policymakers face three broad challenges: a daunting outlook for budget deficits, an increasingly competitive global economy, and rising income inequality. The tax code interacts with each of these issues, and any comprehensive tax reform plan should take all of them into account.

The long-run deficit

Even after the nation recovers from the Great Recession, spending is expected to continue to outpace revenues, which, left unchecked, will contribute to a spiraling debt. Without intervention, the deficit will remain above $1 trillion in 2020 and the national debt will exceed 89% of gross domestic product (GDP) and continue increasing. The result will be hardships on future Americans, limited economic growth, and a potential crisis of confidence in our government’s ability to deal with its finances.

When addressing the fiscal cliff, it is necessary to take a hard look at both government spending and tax revenues in order to address the long-run budget deficit. Although revenues are currently low because of the economic climate, even after the economy recovers, current tax policies will not produce enough revenue to cover spending for Social Security, Medicare and Medicaid, defense, and interest on our debt, let alone any other government services. At a time when an aging population and increasing healthcare costs will increase spending well above historic norms, we are on a path to collect less revenue as a percentage of GDP than we have spent in each of the last 40 years. As well as the need for additional revenue, it will be necessary to cut spending, with everything—including the nation’s most sacrosanct programs—on the table for discussion.

American competitiveness

Policymakers are facing these budget issues even while many Americans fear that some US industries and workers are losing their edge in the global economy. While he rise in well-educated, capable workforces around the world and the growth of business-friendly economies has expanded markets and opportunities for American workers, it  has also increased competition. One sign of these global pressures is that the typical American male has seen his earnings decline by 19% over the past 40 years, and the earnings for the typical male high-school graduate have fallen by an astonishing 41%.

Growing concern about competitiveness has led to greater scrutiny about how tax policy encourages or impedes economic activity. Since taxes impact so many sectors of the economy, reforming the tax code is often touted as a way to significantly boost growth. Many advocates for reform argue that certain provisions of the tax code—such as high statutory tax rates and preferences and penalties for certain activities and investments—channel economic activity into less-productive sectors and thus stifle economic growth. However, the most recent economic evidence suggests that the impact of modest changes in current tax rates on economic growth is small. Indeed, tax reform has much more of a significant effect on income distribution and the national debt than on overall growth.

Income inequality

Technological advances, along with globalization, have benefitted certain Americans more than others. Earnings have increased for households in the top 1% of the income distribution by more than 250% since 1979, while middle- and low-income households have experienced stagnating income growth and declines in earnings. Changes to the tax system during the past 30 years have exacerbated this disparity, because the same people who have received the greatest income gains have also seen the largest tax cuts. Indeed, a progressive tax code is an important tool counteracting income inequality, although other policies, including those that increase college completion rates, are necessary to fundamentally reverse these trends.

The best way to evaluate the many competing proposals to address both our near-term and long-run fiscal challenges is to consider each plan in light of how they impact these three critical issues. Any resolution to the fiscal cliff and our budget deficits that focuses on one at the expense of the others is misguided.

We welcome your comments at ideas@qz.com

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