The Economic Costs of Tax Policy Uncertainty: Implications for Fundamental Tax Reform

December 14, 2012

There are multiple discussions currently about altering tax policy. There are several proposals that have been set forth, which creates a lot of uncertainty over the future of tax policy and the overall economy, say Seth H. Glertz, an assistant professor of economics at the University of Nebraska, and Jacob Feldman, a research analyst at George Mason University.

But policymakers need to be careful because economic literature increasingly finds that policy uncertainty itself has negative implications for the economy, reducing investment, consumption, employment and growth, and possibly prolonging a weak recovery.

Specifically, uncertainty has led to an increase in rent-seeking.

  • It encourages parties to spend more money on lobbying efforts to get preferential tax treatment.
  • However, this diverts resources from economically productive activities.
  • This creates a cycle where uncertainty in tax policy increases rent-seeking and then rent-seeking drives changes to the tax code creating more uncertainty.

There are several reasons for the uncertainty of tax policy. First, the budget process encourages lawmakers to game the system by creating phase-ins, phase-outs and expiration dates. Since the actual impacts of these are unknown, there is uncertainty, which is reflected by the "fiscal cliff."

Second, many lobbyists and interest groups do not care to make a predictable tax code that is efficient. Despite the potential for economic efficiency to produce large, dispersed benefits, interest groups would rather focus on what measures bring them the most benefits, meaning that the tax code keeps changing to reflect these one-sided interests.

The Tax Reform Act of 1986 provides an example of how successful fundamental tax reform can reduce inefficiencies and promote economic growth. However, over the years, there have been about 15,000 amendments to the tax code.

When discussing fundamental tax reform, it is important to create a code that is simple, efficient and predictable. First, this would require budget process reform. Second, there needs to be restrictions on deductions by closing loopholes to make the tax code simpler. This could take the form of a constitutional amendment that enforces a flat tax with limited exclusions, possibly requiring supermajorities to pass laws dealing with tax expenditures.

Source: Seth H. Glertz and Jacob Feldman, "The Economic Costs of Tax Policy Uncertainty: Implications for Fundamental Tax Reform," Mercatus Center, November 27, 2012.

 

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