- The Washington Times - Tuesday, October 25, 2011

ANALYSIS/OPINION:

Consensus in Washington is rare, so the strong agreement about the lousy federal tax system is remarkable. And it is leading to a renewed push for fundamental tax reform.

Whatever one thinks about Republican presidential candidate Herman Cain’s 9-9-9 plan, its strong initial appeal cannot be denied. There is a deep national well of support for tax reform - details to be decided.

Nor is the tax-reform revival limited to the campaign trail. The supercommittee tasked with finding $1.2 trillion to $1.5 trillion in savings over the next 10 years is reportedly looking seriously at tax reform. This may seem odd at first. What does reforming the tax system have to do with cutting the budget deficit?

It depends. If the intention is to improve the economy, then the rationale is sound and the question becomes one of the implementation. The most powerful force for deficit reduction is a stronger economy. Smart tax reform can produce a stronger economy and stronger deficit-cutting revenue growth.

But if tax reform is part of a deficit-reduction exercise because the language of tax reform has been co-opted to disguise a tax hike, then both the hike and the reform should and likely will fail. Be very clear - tax reform is revenue neutral as traditionally scored. If a tax proposal is shown to raise revenue, then it’s not tax reform, it’s just another big-government tax hike.

The heart of true tax reform is to pursue one overarching goal, to obey one golden rule and to follow one simple mantra. The overarching goal that makes the whole effort worthwhile is to achieve a stronger economy. The golden rule is that tax reform should seek no more gold - it should be revenue neutral. The simple mantra is that the base must be expanded to become more economically neutral and that marginal tax rates must be lowered.

Successful, pro-growth tax reform then follows a basic two-step process: First the base, then the rate. A major concern with regard to the tax reform ideas reportedly circulating in the supercommittee is that this process may already have been violated in ways sure to fritter away gains.

Step one: Agree that the key to a more growth-friendly tax system is to get the tax base right - to move toward an economically neutral tax system. Tax reform should eliminate any tax bias against saving and investment, and eliminate narrowly targeted tax distortions to economic decision-making. Economic decisions by families and businesses should be made by the market’s untainted price signals, not by the signals they get from the tax code.

A word of caution, however: The official lists of tax loopholes, called tax expenditures, are flawed to the point of near uselessness. Many items listed as loopholes are steps toward neutrality, whereas some of the biggest loopholes of all don’t even make the lists.

Having identified the tax base - what is to be taxed and when - and seeking a revenue-neutral tax reform, step two is settling on a tax-rate structure linking the tax base to the revenue need. If tax reform is done well, there should be sufficient base broadening as the tax base is moved toward neutrality to achieve significant rate reduction and, preferably, a single tax rate for all taxpayers.

The sequencing is critical. First, identify the most neutral tax base possible, and then settle on the lowest tax rates possible.

Much of what went wrong with the 1986 tax reform occurred because President Ronald Reagan initially insisted on a top individual income tax rate of 25 percent. But the tax system design could not achieve the necessary revenue at that rate. So the rate was pushed up, and then pushed up again, until Reagan drew the line at 28 percent. But total revenue still fell short. So Congress turned to all manner of misbegotten tweaks to make up the revenue difference, and in the process many of the simplifications and advantages of tax reform were lost.

Reagan was right to insist on a low tax rate. And sometimes it takes the promise of a low tax rate to create sufficient interest in tax reform to kick-start reform. But picking a rate first and then corrupting a neutral tax base to fit the rate is a surefire path to trouble.

Many in and outside Congress have latched onto the idea of a top corporate income tax rate of 25 percent as the goal. It’s an excellent goal. It would go a long way to strengthening America’s corporations competing in a global economy. But if the only way to push the corporate tax rate to 25 percent is to corrupt the tax base further, the economic gains could prove illusory or worse.

J.D. Foster, Ph.D., is the Norman B. Ture senior fellow in the economics of fiscal policy in the Roe Institute for Economic Policy Studies at the Heritage Foundation (heritage.org).

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