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Tax Reform Trepidation
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During a recent speech in North Dakota, President Trump referred to the tax code as a “giant self-inflicted economic wound,” and urged Congress to take up the mantle of tax reform. And rightly so. The president, after losing a bruising fight on Obamacare repeal, is looking for a win for his activist base. With Republicans in control of the White House, the Senate, and the House of Representatives, it is the ideal time to push for fundamental tax reform. Yet, even with the stars favorably aligned, without aggressive leadership, Republicans may fall short yet again. Washington is full of tax lawyers and lobbyists whose careers are defined by the existing tax code. Letting go won’t be easy.

There’s no question that the American tax code is broken. It’s inefficient, unfair, and burdensome. The tax code is over 70,000 pages long, making it virtually impossible for individual taxpayers and small businesses to comprehend. Even the IRS has problems understanding the tax code. The office of the National Taxpayer Advocate, “an independent voice for the taxpayer within the IRS,” concludes: “a Code consisting of four million words and requiring six billion hours of taxpayer time when meeting their filing requirements is simply too complex to administer well. Add to that the fact that the federal government ‘spends’ more money through the tax code each year than it spends to fund the entire federal government through the appropriations process.” It’s no wonder the tax code is incomprehensible.

Adam Smith, the father of modern economics, had a strong influence on our Founding Fathers. In the Wealth of Nations, published in 1776, he explained, “Every tax ought to be so contrived as both to take out and keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury.” The U.S. tax code fares poorly in this regard due to a mix of social engineering, crony capitalism, and bureaucratic bloat. Rather than efficiently collecting revenues, the tax code has become a tool to shape incentives and behavior. From the home mortgage deduction to the tax exemption for employer-based health insurance, the tax code is used in ways that often leads to unfair outcomes, with two individuals making the same income paying wildly different tax rates.

That the tax code is over 70,000 pages long is not an accident. Every page was put there for a reason, typically at the insistence of a highly paid tax lawyer. Importantly, at this granular level, the interest is not fundamental reform; rather, it is protecting or expanding the preferred tax treatment that special interests have carved out for themselves. For many, there is no interest in fundamental tax reform because of specific benefits that have been written into the current code.

Consider the mortgage deduction, for example. While many economists have pointed out the distortions it has created in the housing market, removing it is almost impossible, because the benefits of the mortgage deduction are capitalized into the current prices of housing. Removing the deduction could substantially increase housing costs for many potential buyers, leaving homeowners with a lower demand for their homes and a much thinner market.

The tax code is riddled with these price distortions that create what economist Gordon Tullock called transitional gains traps, where the benefits of the tax code or regulations have been capitalized into the price of assets. So even if a section of the code is outdated and does not really provide any benefits, change is difficult because it would impose significant costs on entrenched interests. Which is why most debates over tax reform ultimately settle on a narrow set of targeted rate cuts rather than broad attempts to create a sensible tax code. While rate cuts may be helpful, they do nothing to address the underlying problems of a fundamentally flawed tax code.

These problems are exacerbated by calls to keep any tax reform revenue neutral, meaning that the new tax law generates as much revenue as the old tax code. But this is a call for failure that dooms any attempts at real reform. In essence, the call for neutrality sets up a circular firing squad, as every special interest goes to war to defend its carve out. Rather than press for revenue neutrality, Congress should remember that there are two columns in the budget: revenue and spending. Efforts to restore fiscal prudence, therefore, should not be afraid to examine both sides of the ledger, reforming not only taxes, but federal spending as well.

So while Republicans in Washington are desperate for a win, fundamental tax reform, a key Republican issue, will be an uphill struggle. If the old playbooks hold true, fundamental tax reform could be whittled down to a simple set of rate cuts that does little to solve the complexity and confusion of the current tax code. Real reform will require a concerted effort by the president and Congress to push for a simpler, fairer, and more efficient tax code. Is that too much to hope for?

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