Monday, August 08, 2005

Tax Reform

Mark Thoma tells us to be worried about tax reform. Judging by the "chatter" that he links to, he's mostly scared of the Fair Tax, but Bruce Bartlett doesn't think that will happen:
We still don't know what the commission will recommend. The assumption has been it would endorse one or more comprehensive reform options, such as the flat tax or national retail sales tax. But there are indications the commission report may be more targeted and less comprehensive. ... The other week, the tax commission's co-chairmen, former Sens. Connie Mack, Florida Republican, and John Breaux, Louisiana Democrat, said abolishing the Alternative Minimum Tax would definitely be one of the recommendations to the Treasury Department. ... The AMT unquestionably is a very bad part of the tax system and should be abolished. But making this isolated recommendation suggests the commission's report will be less comprehensive than previously thought. After all, if the commission were to recommend, say, a flat tax system, there would be no need to make abolishing the AMT a separate recommendation. It would be ended automatically. ... Therefore, I think we be more likely to get a laundry list of specific recommendations for improving the tax system than a master plan for complete overhaul.
Given that the reform plan has to be revenue-neutral, the only cause for concern seems to be that reform could make the tax system less progressive. But given the revenue-neutrality constraint, any attempt to make the system less progressive means actually increasing the amount of taxes that lower- and middle-income families have to pay. I'm not sure that's politically viable. (Yes, Bush's tax cuts also somewhat deprogressivized income taxes, but that was accompanied by *everyone* paying less absolute tax. It's another matter to out and out raise taxes on poor people and lower them on wealthy people at the same time.)

At the same time, there's a lot of opportunity for good changes. This graph shows the marginal tax rates on income for a typical family taking advantage of tax-deferred savings plans, child care tax credits, educational tax credits and so forth. The different limits and thresholds for those programs are what make the curve so choppy and distorted. Though I don't think it's as important* as some other things, fixing this might be a good idea. In particular, why have absolute limits on these things? Why not have a graded, downward-sloping ability to contribute? For that matter, why do we still have tax brackets? Having a smooth marginal tax rate would not be hard. At least it would be easier to model real-world situations.

If we want a smooth, gradually increasing marginal tax rate, we could combine it with an earned income tax credit to get something of the form t(Y) = b(Y - a), where t is the marginal tax rate, Y is income, a is the income level at which you pay a marginal tax rate of 0 and b is the increase in the marginal tax rate per dollar of income. So, if you want to have the earned income tax credit below $10,000 and for someone making $100,000 to pay 25% in taxes, you would set a = 10000 and b = 1/360000. Needs some tweaking, certainly, but it's in the correct vein. (Even better, have a curve which approaches some maximum tax rate asymptotically.)

In addition, many of the universal minimum income plans we've mentioned before could be implemented. Of course these things probably won't happen.

*Not as important because people don't usually get to pick exactly how many hours to work. Most people make the leisure-labor decision over a set of discrete leisure/consumption combinations, not a continuous constraint. Thus, messed up marginal rates don't affect things as much as they could.


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