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TDS Co-Editor William Galston: A Tax Reform Proposal That Could Win Over Everybody

This item by TDS Co-Editor William Galston is cross-posted from The New Republic.

If I were forced to choose after the election between extending the Bush tax cuts in total and letting them all lapse, I would join Tim Noah in opting for the latter. But I'm reluctant to assume that's the best we can do. Indeed, as frustrating as the gridlock in Washington is, we should use it as an opportunity to strip down the tax debate to its basics, and reflect on where we want to go. Then we can determine the path that gets us closest to our goal.

In my judgment, the tax code we should aim for should have four key features. It should promote growth, or at least not obstruct growth by diverting resources from productive uses. It should be fair: It should treat taxpayers at similar income levels similarly, and it should tax individuals and families in accordance with their ability to pay. It should minimize complexity, to reduce both compliance costs and opportunities for manipulation. And it should raise enough revenue to pay for the government the American people want. Tax experts tell us that these features are in tension with one another, which means that policy makers must try to strike a reasonable balance among them.

Simply allowing the Bush tax cuts to expire on December 31 would fall afoul of at least three of these principles, and probably all four. It would pour a lot of new wine into the same old bottle--a tax code not notable for simplicity, fairness, or its propensity to promote growth. And while phasing in a tax increase would raise significant revenues, a large all-at-once hit to a still-fragile economy could end up reducing a growth rate that was already far from robust, cutting revenues down the road.

Instead, we need to focus on broadening the base of our tax system, in two ways. First, we need to reduce tax expenditures--the many deductions that currently riddle the tax code, most of which violate all four of my principles. I agree with those who argue that proceeding line by line isn't likely to succeed, as each deduction has backers who would jealously guard it. Instead, we should adopt what might be termed a Comprehensive Flat Tax Deduction. Taxpayers would simply add up all their current deductions, multiply them by a rate that would be the same for all taxpayers (but lower than the top marginal rate), and deduct the result from their taxable income. This simple change would reduce the extent to which deductions now narrow the base of our revenue system. (CBO estimates that setting the rate at 15 percent would raise $1.2 trillion over the next decade; a 28 percent rate would raise less than half that amount.) It would also reduce the massively regressive impact of current tax expenditures, by making deductions less valuable for those at the top and more valuable for those at or near the bottom.

The second strategy for broadening the base of our code should be to look beyond income. No other advanced democracy focuses on income--individual or corporate--to the extent that we do. We should follow other countries' lead in taxing consumption as well. My preference would be a carbon tax, which would both raise money and reduce greenhouse gas emissions. But a Value Added Tax on goods would also be acceptable. We could consider doing some of each. Introducing such alternatives could allow us to further lower marginal rates on income, consistent with our overall revenue requirements. There's something in this strategy for everyone, including environmentalists, businesses that export, and conservative supply-siders.

But all of this will remain abstract and formulaic until we can agree on the size of the government we want our revenue system to finance. Along with most Democrats, I reject the proposition that historical averages offer a sound guide to the future. Demographic changes over the next three decades mean that even with significant reforms to the major entitlement programs, the federal government will consume a somewhat larger share of GDP than it did during most of the post-war period. It is difficult to believe that we'll be able to make do with a revenue system that raises less than 20 to 21 percent of GDP on a sustained basis.

Most Republicans would choose a substantially lower number, and there's no hope of resolving this dispute until the public weighs in. That's why both sides should be willing to wage the 2012 election on the most fundamental domestic questions we confront: How much government do we want, and how will we pay for it? Paul Ryan's budget, which Mitt Romney has endorsed, clarifies the consequences of holding revenues to post-war averages over the next generation. Discretionary spending would be slashed to levels not seen in generations, while rising health care costs would be shifted to Medicare beneficiaries and state governments. President Obama should hammer these choices home--relentlessly, day by day, speech by speech, between now and the election. If he prevails, he will have created a political predicate on which to build his second term.

That doesn't mean that we'll be able to agree on comprehensive tax reform during the post-election lame duck session in which the fate of the Bush tax cuts--and perhaps a larger tax deal--will be determined. The President may be forced to allow the Bush tax cuts to expire without any alternative in sight. But Democrats shouldn't mistake that eventuality for some sort of grand political victory. We would be better off hoping that the threat of a tax hike that no one really wants will finally force Republicans to agree to a fairer, simpler, pro-growth code, one that yields the revenue that the country needs.