The showdown between the Democrats and GOP over the debt ceiling, spending, and taxation has a lot of people talking about the rich paying their “fair share” of taxes – Warren Buffet’s op-ed is a notable example. Liberals are upset that Obama wouldn’t stick to his guns when it came to increasing marginal tax rates on really high income earners. I always thought this was a silly idea because of tax base limits. High income earners already account for the overwhelming majority of revenues and the reality is that there’s just too few of them to seriously close the budget gap. Liberal critics will be quick to point out that, empirically, European countries have higher marginal tax rates on high earners and collect more revenue. This is true. Conservatives will be quick to retort with what some have dubbed “Hausner’s law” and point to this chart showing that while marginal tax rates have varied widely, federal revenue as a proportion of GDP has hovered around 19% over a long period of time. So what gives? Who is right here?
Both and neither. The first explanation, as I’ve mentioned several times before on this blog, Europe collects more revenue because they levy highly regressive value-added taxes on everyone. The second reason is that the US tax code is filled with tax breaks/loopholes/expenditures which widen the gap between marginal tax rates and effective tax rates. Ignoring for a minute the idea that this is a spending rather than revenue problem, what kind of tax reforms would help the situation? More importantly, what are the obstacles to implementing each. The most straightforward solution would be to cut income tax rates and implement some sort of national sales or value-added tax. I have no doubt that such a move would close any structural deficits lickity split. The main obstacle to this move would be trying to get one of the major parties to implement a new regressive sales tax in the midst of a recession. Canada’s Progressive Conservative party did this over two decades ago and were swiftly booted out of office for close to two decades. In other words, its political suicide.
The other solution would be to close the laundry list of tax breaks that make up our current tax code. The problem with this lies with what Gordon Tullock called a transitional gains trap. Tullock starts with a paradox. If the rents that arise from monopoly-granting regulations are only transitional in that super-profits are short-lived and eventually capitalized into the costs of that activity, why do the regulations survive long after profits return to normal? His answer is that while the original gains are gone, a move to eliminate the regulations would lead to losses for those currently being regulated. Thus, we are caught in a trap. In the paper, Tullock focuses on regulations that ensure monopolistic profits for actors – taxi medallions, blue laws, and labor laws – but I think the argument can be extended to tax preferences as a form of regulation as well. Tax preferences lower the price of a particular activity relative to its substitutes, acting as a subsidy. We can use the home mortgage interest deduction as a well-known example. When it first became law, home buyers received “super profits” from the reduction and the increase in home buying made realtors happy. Eventually, this advantage was capitalized into the price of houses so now nobody gets an advantage from it. Economists realize this and most advocate for its elimination, yet it remains on the books. Why? Because the National Association of Realtors and current home owners would be hurt by the short-run slowdown in home sales that would result.
The problem is exacerbated by the particular structure of congress – individual legislators can insert their own tax breaks tailored to their constituencies in a manner similar to pork barrel spending. There are more incentives to increase the number of tax breaks than to collectively eliminate them. Acemoglu and Robinson suggest that political rents are the major impediment to deregulation (or in this case, tax code simplification). Given the collective action problem stemming from the concentrated benefits and diffuse cost of tax breaks as a whole, I have trouble seeing what sort of super-coalition could form to push for simplification.
The best hope we have is the so called Super Congress created by the recent debt deal. If they come away with recommendations similar to the ones which came out of the Bowles-Simpson committee then we could see the elimination of a significant number of tax breaks. Unlike the Bowles-Simpson recommendations which were ignored as soon as they were released, the debt deal contains a mechanism by which sharp cuts would begin to take place in defense (favored by Republicans) and social spending (favored by Democrats) if a compromises cannot be worked out by the committee and approved by an up-or-down vote in Congress.
