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We need a broader tax base. But how?

James Poterba

TEXT OF COMMENTARY

Kai Ryssdal: John McCain gave a big speech outlining his economic platform today. It wasn't so long ago the presumptive Republican presidential nominee was proudly saying how little he knows about economics.

Today he called for major tax reforms. He wants Americans to choose between the status quo or, as he says, "a vastly less complicated system with two tax rates and a generous standard deduction."

Commentator and economist James Poterba says trying to change the tax code will be tricky, no matter who's in the White House.


James Poterba: Several major tax provisions are set to expire in 2010, including reductions in tax rates on capital gains and dividends, as well as across-the-board reductions in marginal tax rates.

This means that the next Congress and the next administration will have to confront the question "extend or reform?" Moreover, there's ongoing pressure to reform or eliminate the Alternative Minimum Tax -- the AMT. But the cost of AMT repeal has been estimated at an astonishing $1.1 trillion over a 10-year period.

How would we replace this revenue? There are only two ways: raise tax rates or broaden the tax base.

The design of tax rates reflects a value judgment about the fair allocation of tax burdens across income groups, but one important lesson of tax economics is that redistribution comes at the cost of economic efficiency. Higher tax rates distort work, saving and investment. A hike in tax rates almost never generates as much revenue as a simple scaling-up of current revenues would suggest. That's because taxpayers change their behavior when tax rates rise.

When gasoline taxes rise, drivers reduce their consumption of gasoline. When income tax rates rise, taxpayers take steps to reduce their taxable income. They might claim more income in non-taxable forms or seek more deductions or, in some cases, choose to earn less. When Britain instituted the Stamp Tax in 1765, the American colonists drastically reduced their consumption of taxed items. The unexpected shortfall of revenue led Parliament to enact a host of subsequent taxes, further inciting colonial resistance.

Broadening the tax base should be a key component of tax reform, but it presents tough political challenges. Provisions like exemptions for employer-provided health insurance and interest on municipal bonds have very supportive constituencies. So do deductions for mortgage interest, state and local income taxes, and property taxes.

Almost everyone agrees we need a fair tax system that meets our revenue needs, but that doesn't impose unnecessary economic costs. The problem is no one wants to give up his favorite tax deduction.


Ryssdal: James Poterba is a professor of economics at MIT. He's also president-elect of the National Bureau of Economic Research. Not that this has anything to do with tax reform, but they're the ones who officially get to decide whether or not we're in a recession.

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