Economics, Taxes and Spending

The Benefits and Limitations of Income Tax Reform

As tax reform chatter picks up again in Washington, a surprising twist is that both parties are generally moving in the same direction: clean out the clutter of the tax code and bring down the rates. That was the recommendation of the Bowles-Simpson Fiscal Commission report last December and the Bipartisan Policy Center recommendation last November. The fiscal plan that President Obama released earlier this month also called for tax reform based on similar principles.

As is often the case in public policy, however, the devil is in the details. Done right, broadening the tax base by ridding the code of its many distortionary “tax expenditures” can promote economic efficiency. Done wrong, it can lead to a less neutral tax system and higher taxes on saving and investment. Today, we are releasing an AEI Tax Policy Outlook that tackles the “do’s” and “don’t’s” of eliminating tax expenditures in exchange for lower rates. While no income tax reform is a substitute for replacing the income tax with a consumption tax, good base broadening and an accompanying rate reduction can yield substantial benefits for taxpayers and the economy.

Whether the recently created Super Committee, tasked with drafting $1.2 trillion in deficit reduction, will pursue any type of base-broadening tax reform effort remains to be seen. If they do look to curtail tax expenditures, whether it be for cutting rates, reducing the deficit or both, they must chose carefully to disentangle the good from the bad.

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