Nothing Focuses the Mind Like a Fiscal Cliff

The Federal government is facing a self imposed deadline to reduce the budget deficit or face a mandated combination of large tax increases or budget cuts. Everyone agrees that allowing the mandated cuts to occur could cause serious harm to the economy, so the White House and Congress will have to come to some agreement (soon) to avoid driving the economy off the fiscal cliff.

The process of confronting this problem provides an opportunity to reform the U.S. tax code. No one likes our current income tax system -- there are a bewildering array of deductions, exclusions, and loopholes. This not only makes it hard for people to complete their income tax forms, it leads to serious distortions in incentives -- costing our economy billions of dollars.

A straightforward solution is to simply eliminate all exclusions, deductions, and loopholes. Under this reformed tax code all income will be taxed -- period. Both earned (wages and salaries) and unearned (capital gains) income will be taxed at the same rate.  Higher incomes will be taxed at higher rates. This will be a truly progressive income tax because individuals with high incomes won't be able to avoid taxes via the shelters and loopholes that are present in the current tax system.  Further, resources will flow to their highest valued use, rather than those that allow the avoidance of taxes.

Pursuing this option will mean eliminating some tax exclusions and deductions that are popular -- the mortgage interest deduction and the tax exclusion of employer sponsored health insurance benefits for example. But not taxing these inefficiently distorts incentives and also means that income tax rates have to be higher. For example, it's estimated that these two features of the tax code alone will cost the Federal government over $1 trillion in foregone tax revenues over the next five years. Further, since the value of these features of the tax code rises with an individual's tax rate, they are regressive. High income individuals derive more benefit from these (since they avoid more tax) than do lower income individuals.

As a practical matter, it's unlikely that we'll actually eliminate all exclusions and deductions from the tax code. It may be desirable to retain some, such as deductions for charitable donations (although even that can be debated), and we'd likely gradually phase out those features to be eliminated. Of course, pursuing tax reform doesn't eliminate the need to address spending, but it can help. It's also important to point out that there still may be a need to increase tax rates, even if serious tax reform is undertaken.

I am not being particularly original or innovative in calling for this kind of tax reform. Many economists, politicians, and others have proposed this kind of tax code simplification over the years. What I do think is that our current set of fiscal challenges, not just the looming fiscal cliff, may finally provide our politicians with the stimulus they need to pursue meaningful tax reform.

While moving from our current system to a simplified tax code would be a big change, I think it's a change that most people would welcome. The current system is widely perceived as arbitrary, byzantine, and unfair. A tax code where all income is taxed would be simpler, more efficient, and fairer. The looming fiscal cliff provides our government with an opportunity for real tax reform -- one they shouldn't pass up.