Obama’s Treasure Hunt

This article appeared in Tax Notes, September 9, 2009.
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One news headline announcing the Obama administration'stax reform task force got it exactly right: "Obama Tax Panel onTreasure Hunt." The task force, which is to report its findings byDecember, does not appear to be a serious effort at tax reform.Instead it seems to be another administration initiative to holdAmericans upside down by the ankles and shake them.

A presidential "tax reform" effort reminds one of the bipartisanTax Reform Act of 1986, which eliminated loopholes anddramatically cut tax rates. Could the Obama task force lead tosimilar major reforms? Very doubtful. While the task force hassome talented members, the Democrats have moved so far to theleft that there are few centrists around these days to broker acompromise deal with the Republicans, as occurred in 1986.

Consider that President Obama has been actively workingagainst all four major themes of 1986: marginal rate cuts, tax basereform to increase neutrality and horizontal equity, distributionalneutrality, and revenue neutrality.

Rather than cutting marginal tax rates, Obama plans to increaseeffective marginal rates at the top end in a variety of ways.Rather than reforming the tax base, Obama has proposed creatingnumerous special breaks, such as a new tax credit for collegeexpenses.

Regarding the distribution of tax payments, Obama is raisingtaxes on households at the top while providing refundablegiveaways to households at the bottom, such as the MakingWork Pay tax credit and expansions in the child and earned income tax credits. But the top fifth of households already pay an effective federal tax rate of 26 percent, while the bottom fifth pay just 4 percent, on average. The tax code is already far toograduated, and Obama is exacerbating this inequity.

The fourth theme of 1986, revenue neutrality, is of no interestto the Obama administration. When announcing the new taskforce, the administration reiterated its promise not to raise taxeson families with incomes of less than $250,000. But the presidentalready broke that promise with a cigarette tax increase inFebruary, and his cap-and-trade energy plan is effectively a largetax increase on all families. Healthcare reform might also includea significant tax increase on average families. Thus, it wouldn'tbe surprising if the Obama tax task force also morphed into adrive to raise taxes on the middle class.

Another issue is that the three stated goals of the task force —simplifying the tax code, closing loopholes, and reducing taxevasion — are in direct conflict with current Obama policies.Many of Obama's tax plans would further complicate the taxcode, including his proposed tax credits and tax increases onmultinational corporations. As for tax loopholes, Obama favorsadding more special tax breaks in numerous areas such asalternative energy.

What about the task force's goal of reducing evasion? Obama'sefforts to raise tax rates on individual income, dividends, andcapital gains will increase incentives for evasion. And his plan toincrease corporate taxes will likely erode the U.S. tax base asbusiness activity moves offshore. Microsoft Corp., for example,has already said it will move jobs abroad if the Obama plan goesthrough.

All that said, the task force's goal of cutting "corporatewelfare" is a good one. It could, for example, propose eliminatingthe low-income housing tax credit (LIHTC), which is a $5-billion-a-year giveaway to real estate developers. Even better, it could propose cutting the $90 billion of corporate welfare on the spending side of the federal budget.

However, eliminating codified giveaways such as the LIHTC isa different matter than the general issue of growing business taxavoidance in the global economy. The Obama effort to imposeeven more tax rules and regulations on corporations is a deadend. We've been going down that road for more than twodecades, and the only result is a highly complex and uncompetitivecorporate tax code.

A much better way to deal with corporate tax avoidance andevasion is to cut statutory tax rates, as just about every othermajor nation has figured out.6 Recent reforms in Canada'sindustrial heartland of Ontario, for example, cut the combinedfederal-provincial corporate tax rate to just 25 percent — 15points lower than the average U.S. federal-state rate. Ontario'smarginal effective tax rate on business investment is being cut inhalf. Why did Ontario make those changes? To improve taxcompetitiveness, to generate economic growth, and to increaseproductivity, according to the government.

While Canada is making fundamental reforms, Obama's taskforce is on a wild-goose chase to "aggressively" close the $290billion federal tax gap. That won't do anything for Americancompetitiveness, and it seems like a total waste of time given thatU.S. tax compliance is already at a high level of about 86percent. That rate is higher than the U.S. compliance rate withseat belt laws, and it appears to be a higher tax compliance ratethan in most other countries.

The tax gap is not a primary problem—it is a side effect of ourgrossly complex tax law and high tax rates. The GovernmentAccountability Office has noted that the proliferation of specialtax breaks increases the tax gap by providing return filers morechances to claim unjustified benefits. For example, about onethirdof EITC payments are fraudulent or erroneous. Politicianscomplain about the tax gap, but they are the ones responsible formore than doubling the number of federal tax expenditures since1974.

In sum, the Obama administration needs a more consistentand constructive tax policy approach. If it believes in a simplifiedtax code with fewer loopholes, then it should stop pushing toadd new tax credits. If it favors reduced corporate tax avoidance,it should propose a reduction in the statutory tax rate.

Most importantly, the Obama administration should rethinkits devotion to tax increases as the solution to seemingly everypolicy issue. Tax increases make no sense in the competitiveglobal economy, and they imply that there are no savings left tobe made on the spending side of the federal budget. But afteryears of studying federal spending programs, I am confident thatthat is not the case.