The budget debate in Washington goes on, highly partisan and seemingly with little prospect for compromise, much less progress. Even after the November elections, it’s likely neither party will gain enough power to move fiscal matters in a concerted direction. Still, for all the prospect of an impasse, tax reform remains possible. It would be an overstatement to say that substantive reform is probable, but the prospect is much greater than most investors and business people seem to believe.
For all Washington’s intense partisanship these days, similar tax reform proposals have surfaced with remarkable frequency on both sides of the aisle. All, in one way or another, would reduce statutory tax rates and broaden the base by eliminating tax write-offs and other breaks. Though prospects for such reforms seem far-fetched, their reoccurrence speaks to a broad underlying appeal.
This latest round began in 2010 with the Bowles-Simpson proposals for overall deficit reduction. They would have cut the top personal tax rate from 35% to 29% and more than made up the lost revenue by eliminating deductions, tax expenditures and tax credits throughout the personal and corporate code. Though the commission that made these proposals had a bipartisan composition, both Democrats and Republicans rejected the plan, although not because of the nature of the reforms. Republicans were opposed because Bowles-Simpson would have raised taxes overall and Democrats objected because the accompanying spending restraints would have hit social programs hard.
Despite the defeat, President Obama resurrected a small part of the Bowles-Simpson proposals in his State of the Union address. He narrowed his focus to corporate tax reform, but otherwise his plan looked the same: reducing statutory rates and broadening the base by eliminating tax breaks and favors. Though the president was vague, many in Congress nonetheless talked up the principles of his reform proposal, narrow as they were. A later Republican-backed budget proposed by Rep. Paul Ryan (R-Wis.) differed radically in many respects from Bowles-Simpson, but still shared the notion of a broader tax base and reduced statutory rates. Both the House and the Senate have seen efforts to revive Bowles-Simpson as the only bipartisan path to deficit reduction, though this latest effort failed again, largely for the same reasons as the first. Most recently, House Speaker Boehner proposed reforms along similar lines.
For all its failure to date, Congress faces sufficient fiscal pressure to prompt another reconsideration before year-end. The main issue is the “fiscal cliff,” to use the phrase coined by Federal Reserve Board Chairman Ben Bernanke, that the country faces. Unless Congress acts, a raft of spending cuts and tax hikes will be imposed in January on an already weak economy. On the spending side, the sequestration required by 2011’s Budget Control Act threatens to impose across-the-board cuts on much of the budget. On the tax side, certain levies associated with Obamacare will go into effect, but the burden will emerge mostly because the Bush tax cuts for all taxpayers will expire.
Congress could easily postpone the spending pain with continuing resolutions. Tax matters, however, are more complex. Democrats want to continue tax relief for lower-income people—individuals making less than $200,000 a year and couples making less than $250,000. Republicans want to continue tax relief for all. Since all tax relief would otherwise disappear automatically, Republicans will threaten, as they did in 2010, to vote down anything but complete renewal. If the parties reach an impasse, tax hikes on all would occur automatically.
In such a difficult political situation, tax reform may again appeal to both parties. It would get Republicans out of the bind of possibly being the cause of across-the-board tax increases. It would also fit with the kind of growth-oriented tax efficiencies that the party has embraced previously, most recently in the Ryan plan. Republicans would, of course, fight a net tax increase, such as that recommended by Bowles-Simpson, but even if they had to compromise on this front, they could still offer their constituents the comfort, or perhaps the word is distraction, of a drop in the statutory rate. Tax reforms would allow Democrats to sidestep accusations of class warfare and avoid the label of tax increasers as well as the risk that an impasse would force tax hikes on their constituencies at the lower end of the income distribution. Democrats also would embrace the broadening since, rhetoric aside, they know that tax hikes on the wealthy alone cannot close the budget gap.
By making the tax code simpler and more equitable, such reforms would have a generally positive effect on the economy and markets. At the very least, the elimination of the current code’s complex of tax breaks and benefits would allow market signals to direct business and investment decisions instead of arbitrary favors to politically connected players. Obviously some firms and industries would lose their formerly generous tax advantages, but the lack of distortion in such a reformed code would more than offset the impact on the overall economy and capital markets generally. Such favorable effects would likely be powerful enough to offset even the ill effects of a net tax increase. In this desperately partisan Congress, likelihoods still point away from such positive actions, but there remains a stronger chance of progress than is widely believed.