Two Governors Propose Radical Tax Reform

The interminable fiscal cliff negotiations in Washington produced almost no substantial reform of taxes despite a general agreement that both our income and corporate tax codes are dense, confusing and layered with perverse incentives that favor some economic activities over others at the expense of overall growth.

"The existing tax code makes compliance difficult," IRS Taxpayer Advocate Nina Olson recently wrote, "leaving many [taxpayers] unaware how their taxes are computed and even what rate of tax they pay. It enables sophisticated taxpayers to reduce their tax liabilities and...it undermines trust in the system."

Just weeks into the new year, however, two governors have decided to raise the stakes in the debate about tax reform in America by proposing to dramatically reshape their state tax systems. Within days of each other Louisiana's Bobby Jindal and Nebraska's Dave Heineman recommended eliminating their states' personal and corporate income taxes, major sources of revenues in both states, and replacing the lost proceeds with additional sales tax revenues (Jindal also wants to dispose of his state's franchise tax). Both proposals are designed to be revenue-neutral, that is, to generate enough new revenue to replace what the cuts with forego.

Why bother? Because the weight of academic evidence tells us that income taxes are among the most counterproductive of levies which can dampen economic activity far more than other kinds of taxes. What Jindal and Heineman are daring to argue, in other words, is that not all taxes are created equal and that government can be smarter about the way it raises revenues.

Much of the recent work on the subject comes from economists working for the Organization of Economic Cooperation and Development, consisting of many of the world's industrialized countries. One 2008 study by economist Jens Arnold concluded that the corporate income tax was the most harmful to economic growth, followed by the personal income tax, while taxes on consumption and property had the least impact on an economy.

Later work by Arnold and four other economists using OECD data estimated that every one percent shift in tax revenues away from income taxes towards other levies produced an additional one-quarter to one percentage point gain in economic growth. As the Tax Foundation in Washington explains: "Corporate and shareholder taxes reduce the incentive to invest and to build capital," while, "taxes on income and wages reduce the incentive to work." Taxes on consumption have much less of an impact on incentives to earn and produce.

Still, many states, like the federal government, have constructed a web of different taxes in part because it is politically easier to "spread the pain," so to speak, by deriving revenues from a host of different activities and sources, even when that involves taxing the same people over and over in different ways. Politicians have also come to love personal and corporate income taxes because officials can use the structure of these taxes as social policy, crafting exemptions and loopholes to encourage activities that policymakers have decided they want to subsidize, or simply granting exemptions to favored groups.

The notion that our tax policy should chiefly be used to pursue social goals is one reason why critics quickly objected to the Jindal and Heineman proposals. Income taxes, after all, can be progressive in nature, with those who earn more paying a greater share of their income in taxes. Sales taxes are considered regressive because everyone pays the same rate and the impact on lower income families is often greater relative to their earnings.

A Louisiana commission has even recommended doing exactly the opposite of what Jindal wants to do, proposing instead to raise the state's income taxes and lower its sales taxes to make its tax system ‘fairer.' That all the evidence suggests such a move would reduce the state's economic performance illustrates how our tax codes are now often viewed primarily as a vehicle for social policy.

The task of both governors will be to persuade legislators that it is possible to replace revenues lost from income taxes without producing a disproportionate impact on low-income families. Gov. Heineman, for instance, points out that Nebraska collects $1.5 billion in sales tax revenue right now but has so many special exemptions on its levy that it forgoes another $5 billion in revenues. About $2.4 billion of that money represents special breaks that Heineman is looking to eliminate on businesses in 84 different industries that are not subject to a sales tax. Among the products and services whose sales that Nebraska does not tax are airplane fuel, newspapers and bull semen (yes, you read that right).

States can also offset any perceived additional burden on lower-income families from consumption taxes with larger subsidies. Most states, for instance, provide some form of earned income tax credits to the working poor, a program which takes the form of additional payments from government to supplement workers' earned income. It's entirely possible for Louisiana or Nebraska to eliminate its income tax but keep in place and even expand its EITC.

Nearly 50 years ago Harvard Professor Stanley Surrey, who served as JFK's assistant treasury secretary for tax policy, coined the term "tax expenditure" to describe government spending through the tax code. His aim was to expose the raft of exemptions and special treatments growing in the federal income tax. His own research also suggested that spending through the tax code on social goals was less effective than direct government expenditures.

But despite Surrey's efforts, tax expenditures grew even more popular in Washington (and in state capitals). Today, many defenders of our increasingly complex tax code have even tried to redefine a tax expenditure as a loophole or earmark inserted into tax legislation, to distinguish it from so-called "worthwhile" spending through the tax code.

But just as there are plenty of ways to raise government revenues, there are plenty of ways to address social policy without fouling the tax code. Jindal and Heineman are proposing that a tax system should reflect the most sensible way to raise the revenues that government requires. That their proposals sound revolutionary just tells you how tough a task they will have in restoring some sense of sanity to taxation.