The Benefits and Limitations of Income Tax Reform

October 4, 2011

A number of recent proposals have called for broadening the individual income tax base while lowering statutory income tax rates.  Such proposals would eliminate or curtail various preferential income tax provisions and use some or all of the resulting revenue to lower statutory tax rates.  The financial implications of this initiative would change drastically the tax structure and tax law of America, say Alan D. Viard, a resident scholar, and Alex M. Brill, a research fellow, at the American Enterprise Institute.

  • Estimates for tax expenditures (deductions and credits) in 2010 total nearly $1 trillion -- substantial relative to the $2.2 trillion in individual income tax revenue collected that year.
  • While the Joint Committee on Taxation lists nearly 200 individual income tax expenditures for 2010, more than half of the revenue loss is caused by the 10 largest programs.
  • The single largest tax expenditure of 2010, an exclusion for various employer contributions to its employees' health care, alone cost $105.7 billion in forgone revenue.

Proposed tax reforms would seek to limit or end many tax expenditures to fund lower marginal tax rates.  This two-prong policy, also called base-broadening, is attacked and defended by numerous arguments that require debunking before its true impacts can be recognized.  Attacking the removal of tax expenditures, some point out that certain of those programs were created to benefit specific income groups (notably, low-income citizens) and that their removal would alter tax burdens to the detriment of the poor.  However, such a change in distribution can be corrected through changes in the marginal tax rates that will occur in tandem.

A common idea on the other side is that expenditure reduction will simplify the tax process.  However, this is ambiguous, as the removal of tax deductions will require more actuarial and accounting work to assess the value of assets not previously subject to taxation.  Others put forth that marginal rate reductions will lower disincentives to working.  Yet this is untrue: while rates go down, various tax shelters will be removed and the average taxpayer will still pay the same effective rate, thereby keeping work disincentives constant.

Ignoring these misleading arguments, the crucial benefit of this policy is that it will restore the power of market forces to dictate the direction of the economy.  Government-sponsored tax expenditures distort these forces, undermining their inherent efficiency, simplicity and fairness, and their removal will promote these values.

Source: Alan D. Viard and Alex M. Brill, "The Benefits and Limitations of Income Tax Reform," American Enterprise Institute, September 2011.

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