A Plausible First Step Toward Tax Reform

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Tax reform perpetually tops policymakers' lists for ways to grow the economy, but a generation has passed since the last successful effort, the Tax Reform Act of 1986. This is because of a simple political reality-it's hard. But not, I believe, impossible. In the 26 years since the last reform, both our economy and the global economy have changed so significantly that the case for reform has never been stronger. In addition, the level of political interest in tax reform is the highest it has been since the mid-1990s, with Presidential candidates, Members of Congress, and the President are all talking about the issue.

Considering these motivating factors but also recognizing the political challenges, I devised a six-point proposal for revenue-neutral tax reform that addresses some of the most harmful elements of the current tax system but purposefully stops short of an outright overhaul. Here, I outline the key elements of this pro-growth, progressive, and practical proposal that, while not perfecting our current convoluted tax system, constitutes a significant leap forward.

When examining the case for tax reform, two characteristics of the current tax code stand out: 1) the corporate tax rate is too high to permit them to compete in the current competitive global economy, and 2) there exists an excess of tax preferences - government subsidies - that distort taxpayers' natural decisions and lead to a misallocation of resources. Fortuitously, these two faults are complementary from a budget perspective - revenue raised by curtailing or repealing distortionary tax subsidies can be used to fund the reduction of the most harmful tax rate in the current tax code. With this in mind, my plan consists of three business tax changes and three individual tax changes:

1. Phase down the corporate tax rate to 25%.

2. Make permanent the 50% bonus depreciation that encourages business investment in equipment and machines in the United States.

3. Limit the deductability of interest expenses for C corporations to 90%.

4. Replace the current mortgage interest deduction with a flat 12% tax credit available to itemizers and non-itemizers alike.

5. Phase out the state and local tax deduction.

6. Repeal the alternative minimum tax.

The net effect of this proposal would be to reduce the tax code's interference in our economy while still raising the same amount of tax dollars. Dramatically reducing the corporate tax rate by 10 points would bring the U.S. in line with the average corporate tax rate among other industrialized nations, thus removing an important impediment to U.S.-based firms' operating globally. The rate on new corporate investment would be cut 7 points overall, while the subsidy for debt-financed corporate investment would be reduced and the tax on equity-financed investment cut even more. Taken together, these changes would lead to more investment over time, a higher capital stock, and a more productive economy.

The subsidy that encourages higher state and local tax rates would be eliminated over time. The home mortgage interest deduction, a federal subsidy that leads to excessive investment in residential property, would be replaced with a flat 12 percent tax credit for all homeowners with a mortgage. In addition to these changes, the cumbersome and complex alternative minimum tax, which ensnares millions of taxpayers annually, would be repealed.

These tax changes would have the effect of increasing the progressivity of the tax code. Because the state and local tax deduction primarily accrues to higher-income taxpayers, its repeal would generally raise taxes only on those households. Similarly, converting the home mortgage interest deduction to a credit would limit the benefit for higher-income earners while increasing it both for those in the 10 percent tax bracket, and for non-itemizers who currently cannot claim a mortgage break. Democrats committed to furthering the progressivity of the tax system will hopefully find this aspect of the plan appealing, while Republicans can take solace that this shift occurs without any increase in statutory tax rates.

More important than the shift in the progressivity is the shift toward a pro-growth tax system. By reducing the most harmful tax rate and eliminating the most distortionary tax subsidies, this plan, without raising or lowering taxes overall, encourages more investment in productive activities and removes government-imposed distortions that hurt our economy.

These proposals are not the be all and end all for tax reform, but rather just a plausible first step. Other important tax reforms will be necessary, including eliminating the political tax favoritism with which the tax code is littered and modernizing the tax treatment of foreign-sourced income to come in line with our trading partners. However, the key objective of my tax reform plan is to remove some of the primary impediments to economic growth. Once we win that battle, we can tackle the next challenge.

Alex Brill is a research fellow at the American Enterprise Institute, served as an adviser on tax policy to the President's Fiscal Commission, and is a former senior adviser and chief economist to the House Ways and Means Committee.

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