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Let’s Start All Over Again

A new approach to tax reform.

Oct 17, 2011, Vol. 17, No. 05 • By ELI LEHRER and IKE BRANNON
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About halfway through his 1984 State of the Union address, Ronald Reagan laid out the need for major tax reform. “There’s a better way,” he said. “Let us go forward with a historic reform for fairness, simplicity, and incentives for growth.” Reagan then proceeded to lay out an ambitious agenda: simplification of the tax code, base-broadening that would tax a larger percentage of income at lower rates, and a radical reduction in the number of loopholes. Its broad strokes served as a harsh rejoinder to the Carter administration’s wonky-technocratic approach to federal spending that emphasized something called zero-base budgeting.

Photo of the Internal Revenue Service office building

Reagan offered a tax agenda that hardly anyone could argue with. Two years later, a bill originally sponsored by two Democrats, Senator Bill Bradley and Rep. Dick Gephardt, ended up under Reagan’s signing pen in no small part thanks to the yeoman work of the Democratic Ways and Means Committee chairman Dan Rostenkowski. Nearly everything Reagan asked for became part of the tax code: Dozens of deductions went away, and personal and corporate income tax rates fell.

But things didn’t stay the way Rea-gan, Rostenkowski, Bradley, and Gep-hardt intended. Although marginal rates for most individual taxpayers remain lower than they were before the 1986 tax reform, nearly everything else Reagan promised has vanished. Dozens of loopholes have narrowed the range of income taxed, American businesses pay rates based more on the ingenuity of their accountants than on any reasonable definition of their profits, compliance costs for U.S. taxpayers are among the highest in the world, and hardly anybody thinks the system is particularly fair or efficient. 

Thus, it’s not surprising that, as in 1984, both parties seem willing to talk tax reform even as they fight bitterly over everything else. If one major piece of legislation passes both houses of Congress and gets signed into law before the November 2012 elections, there’s a good chance it will deal with tax reform and an equally good one that it will aim to follow the same principles that Reagan laid out in 1984.

And that’s where the problems arise. Keeping the tax code simple, broad, and friendly to investment is much easier said than done. Many companies rely on special tax treatment to provide much of their profits. Furthermore, both parties, not wanting to be accused of “adding more bureaucrats,” often create new tax expenditures (i.e., loopholes) to achieve policy objectives rather than establishing new programs. This often gets done without anyone really considering whether a new program might accomplish a goal more efficiently or, indeed, if the program’s goal is worth federal attention at all. 

The most radical existing plans for wholesale tax reform, however, are fatally flawed. The FAIR Tax would, among other things, impose enormous levees on doctor’s bills, home purchases, and other things that are lightly taxed today. Financing the government via a bank transaction tax would end up creating a higher tax on bread than on diamonds. And a national Value Added Tax would be incredibly regressive while making future tax increases a little too easy for most Americans’ comfort. 

Even if major changes did pass Congress and were signed into law, it is unlikely that these changes would resemble anyone’s concept of an ideal tax code; some groups would certainly defend their tax code handouts successfully.

If there is a path to a better tax code, it may lie in dusting off and modifying the very Carter administration innovation that Reagan himself cast aside: zero-base budgeting.

Zero-base budgeting, which reached its apogee when the Carter administration applied the concept to most of its 1977 federal budget proposal, is a system for managing expenditures that analyzes programs as a whole rather than only changes in spending levels. It gets its name because it assumes that the “base” budget is “zero” rather than what was spent the previous year. Peter Phyrr, a Carter adviser who published the first systematic articles about zero-base budgeting, says that evaluators should ask two questions: “Are the current activities in the budget efficient and effective?” and “Should current activities be eliminated or reduced to fund higher priority new programs or to reduce the current budget?”

Because every expenditure must be evaluated anew each cycle, the process generates enormous amounts of paperwork (a Council of State Governments committee estimated it was three times as burdensome as a conventional process). Zero-base budgeting thus proved unworkable as a yearly exercise. Even the Carter administration stopped using it.

What didn’t catch on for federal spending, however, may have a lot of promise for simplifying the tax code. Rather than a “zero base,” a procedure for developing a better tax code would begin with what might be called a “flat base”: an assumption that the federal government would tax all income (by the broadest possible definition of income) from all sources at a level at least sufficient to maintain current levels of revenue​—​probably somewhere between 15 and 20 percent. 

All current deviations from that flat base​—​deductions, credits, rate changes, special treatment, deferrals, rebates, etc.​—​would require justification. For any deviation, evaluators would ask two questions similar to those Phyrr devised: (1) “What goal or relevance to a national government (if any) does this provision attempt to accomplish?” And (2) “Is this goal most efficiently and effectively achieved through the tax code or by some other means?” Like the fundamental questions asked by zero-base budgeters, of course, these “flat-base tax” questions would be fraught with political and ideological baggage. Nonetheless, if asked honestly and forthrightly by people of all persuasions, they might produce some surprising agreement. 

Looking at what may be the single most sacred provision in the tax code​—​the deduction for almost all mortgage interest on first and second homes​—​reveals how these two simple questions can clarify things. In response to the first question​—​what goal of the federal government does this program serve?​—​the social consensus seems to be that the government should help make homeownership affordable for people of modest means. However, on the second question​—​is the tax code the most efficient or effective way to promote homeownership?​—​the mortgage interest deduction fares quite poorly by any objective measure. Many people who benefit from the deduction right now could easily own homes even without the deduction, and for them it merely encourages the purchase of houses with extra bedrooms, hot tubs, and granite countertops. Some sort of grant program for first-time, middle-income home buyers could likely encourage home ownership more effectively and at a much lower cost to the federal treasury. 

Similar tests can be applied to nearly every part of the tax code. Such an exercise might result, for instance, in a vast simplification of the many different existing inducements to retirement savings in the tax code. Few other major features in the current tax code would make the cut. If posed in terms of national interests, most narrow provisions​—​special credits for certain water-heater designs, tax breaks for opening new oil wells, and tax rules that incentivize small businesses to buy large vehicles​—​are testaments to the power of certain lobbying groups rather than any reasonable assessment of national goals. Other far more consequential provisions, such as the limitless deductibility of employer-provided health insurance, may advance legitimate goals of the national government but, like the mortgage tax deduction, are costly ways to do so.

It goes without saying that eliminating a boatload of deductions and credits would smooth the path towards lower marginal tax rates on individuals and businesses. This, in turn, would help stimulate investment, productivity, and economic growth while reducing compliance costs. 

Developing a flat-base tax code would surely entail political compromises. In a few cases conservatives might have to support new spending programs to replace ineffective tax provisions targeted towards worthy goals. Liberals, likewise, would have to admit that certain tasks now carried out through the tax code ought not to be the federal government’s business at all.

While certainly cumbersome in the first instance​—​developing alternative scenarios for every tax code provision would probably require (temporary, one hopes) staffing increases at the Office of Management and Budget, Joint Committee on Taxation, and Congressional Budget Office​—​flat-base tax reform would simplify the overall
tax writing process going forward. If all rigorous “flat-base” tests were applied to all changes after the adoption of a new tax code, the bar special interests would have to jump to get favors from the tax man would be much higher. 

A flat-base tax reform process isn’t a panacea, of course. It won’t, by itself, disarm the special interests that now lard the tax code with narrow favors, nor will it necessarily balance the budget. At the very least, though, a fresh look at tax code provisions could point the way towards a more efficient means of funding the necessary functions of the federal government.

Eli Lehrer is vice president of the Heartland Institute. Ike Brannon is director of economic policy at the American Action Forum.

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