 his
is the time of year when many Americans reluctantly turn their attention
to filling out tax returns. They quickly encounter complicated forms,
confusing instructions, contradictory definitions and widely varying
tax treatment of different forms of income. No wonder that filing
one's taxes ranks among the most stressful human activities, according
to psychologists.
It is too easy
to blame the Internal Revenue Service for this state of affairs.
In truth, the IRS suffers as much from it as taxpayers do. The problem
is that the tax law itself is a total mess. Congress is always trying
to accomplish conflicting goals with the Tax Code and those goals
change frequently. The result is a federal tax system that is desperately
in need of fundamental reform.
An excellent
road map to tax reform has recently been produced by the Organization
for Economic Cooperation and Development in Paris. Because the OECD
has an international focus, unencumbered by domestic politics, it
offers as close to an objective perspective on U.S. tax policy as
one is likely to find anywhere.
The OECD report
starts with a simple point: tax cuts increase economic growth. Commenting
on those enacted last year, it says, "the average tax burden
does influence the growth rate of the economy and so these cuts
should boost the medium-term growth rate of the economy by a small
yet worthwhile amount."
It shouldn't
even be necessary to mention this point. It's equivalent to declaring
that the sky is blue. Nevertheless, in Washington today it is controversial.
Senators Ted Kennedy and Tom Daschle have both blamed last year's
tax cut for slowing growth, and the latter is almost single-handedly
stalling a stimulus bill because he so adamantly opposes tax cuts.
The OECD goes
on to explain that it is not just the amount of money that the state
takes from our pockets that affects growth, but how it does so.
In comparison to other major countries, the United States has relatively
low taxes. On average, other OECD countries have total tax burdens
about one- third higher than ours. However, the U.S. tax system
is unusually complex and has disincentive effects out of proportion
to the revenue raised.
A key source
of complexity is the Alternative Minimum Tax, which appears to be
unique among industrialized countries. It is supposed to ensure
that all rich people pay some taxes. Yet the OECD notes that the
number of such people has actually risen. Moreover, the burden of
the tax now falls most heavily on those with middle incomes. Thus
the AMT adds greatly to tax complexity without even achieving its
stated purpose.
Another source
of complexity is Congress's inability to resist adding more and
more special provisions to the tax law. At least 50 so-called tax
expenditures have been added to the Tax Code since 1986, lowering
federal revenue by about 1.5% of the gross domestic product. Basically,
Congress has incrementally repealed almost all of the Tax Reform
Act of 1986.
The great achievement
of the 1986 legislation was to get the top income-tax rate down
to just 28%. At this level, most tax loopholes are not worth bothering
with. As a result, rich people were encouraged to spend their time
starting businesses and making profitable investments, rather than
wasting their time on tax shelters designed to generate losses instead
of profits. Now, with a top rate of 39.6%, rich people spend considerably
more time on the latter activities and less on the former.
The OECD notes
that this misdirection of economic activity by the wealthy —
and increasingly among the middle class — reduces federal revenue
at the same time it stifles growth. Consequently, tax-rate reductions
can partially pay for themselves by reducing the use of tax shelters.
Says the OECD, "the fall in tax yields from rate cuts would
be significantly offset by changed behavior and perhaps most markedly
at high income levels."
The principal
barrier to cutting tax rates on the wealthy is that they are thought
to be needed to equalize incomes. But the OECD notes that progressive
tax rates have a very small impact on income distribution. Most
redistribution in the U.S. takes place on the spending side of the
budget, rather than the tax side.
Lastly, the
OECD is highly critical of the way the U.S. taxes business and capital
income. Only 3 major countries tax new equity investments more heavily
than we do. The result is excessive reliance on debt finance, which
leads to problems such as those with Enron.
The OECD report
makes many useful suggestions for reforming the U.S. tax system.
They echo those often put forward by American economists. However,
because they come from a neutral international organization, perhaps
they will command more respect.
Reference:
Richard Herd and Chiara Bronchi, "Increasing Efficiency
and Reducing Complexity in the Tax System in the United States,"
Economics Department Working Paper No. 313 (December 17, 2001).
Available at www.oecd.org.
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