(Bloomberg View) — America’s convoluted tax code has needed comprehensive reform for years. The case for change would be open and shut even if families on low and middle incomes hadn’t come under increasing strain of late — but they have. The middle-class squeeze underscores the need for a far-reaching overhaul.
The opportunity here is enormous, precisely because the tax system is so badly designed. If it weren’t, making it better would involve difficult trade-offs: The price of a bit more efficiency might be a little less fairness, or vice versa. Happily, no such compromise is required. The system can be made fairer and more efficient at the same time.
The crucial thing is simplicity. The last big tax reform, in 1986, broadened the tax base by removing or limiting exemptions for various kinds of income and spending, then used the proceeds to cut tax rates. This approach spurs efficiency in two ways. First, lower rates encourage people to work and invest; second, simplicity lets market forces, rather than the unintended interaction of complex preferences, guide choices. It’s also more fair, because the tax breaks that Congress has added back since the last cleansing favor the most prosperous taxpayers.
Taken together, so-called tax expenditures — including the deductions for mortgage interest and employer-provided health insurance — cost taxpayers more than what the government spends on Medicare and Medicaid, or on Social Security or defense. It would be best to eliminate such deductions altogether. If that is politically impossible, their cost can at least be capped or reduced.
The same idea applies to taxes on capital. The system taxes income from capital at two stages — first as corporate profits, then in the form of interest, dividends or capital gains received by individuals. The complexity of the code causes huge distortions. Exemptions at the corporate and individual levels combine, so that some capital income is taxed too heavily, and some too lightly or not at all. Also, earnings from work can sometimes be recast as capital income; that way, much less tax is due. The notorious carried-interest loophole, which partners in private-equity firms have made their specialty, is only one example.
Greater simplicity is the essential starting point for a better tax code, but by itself it isn’t enough. To help Americans of limited means do better, reform has to go further than closing loopholes. The tax code needs to lean in favor of the less prosperous — especially those who want to work hard and advance.
The earned income tax credit, which encourages people on low and lower-middle incomes to work, is rightly seen as one of the best features of the code. It should be made more generous and expanded to cover more workers. Refundable child-care credits with an income cap would push the same way — increasing employment while, again, focusing the benefit on parents of modest means. Another idea: Increase the tax deduction for a household’s second earner. At the moment, the effective tax rate on second earners in a lower-income household can easily exceed 50 percent.
In each of these cases, the idea is the same: Use tax reform to raise the pay of people struggling to join, or remain part of, the middle class.
Can any of this happen? It hasn’t lately. Blueprints for reform typically get nowhere. The code is riddled with preferences for a reason: The beneficiaries like them, and they won’t give in easily. Supporters of reform would make more headway if they stopped arguing with each other over the fine points of their respective proposals and made common cause behind the basic principles of fairness and efficiency.
What matters is to simplify the code and, for those on low and moderate incomes, make work pay. The rest is details.