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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.

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