Tax Reform Has a ‘Base Line’ Problem

How much does the federal government actually spend? About $830 billion more than you think.

That’s the conclusion of a recent Tax Policy Center study by Donald Marron and Eric Toder. They analyzed tax expenditures — the deductions, breaks and loopholes that clog the tax code — and sorted them into two groups: “spending substitutes” and “tax policy design.”

The tax policy expenditures “represent broad choices in tax policy design but are not associated with any clear spending objective.” Marron and Toder cite the treatment of qualified retirement saving plans, which, for good or ill, nudges the tax code toward taxing consumption rather than savings.

Other expenditures, however, are simply government spending programs by another name. The mortgage-interest deduction, for example, is a spending substitute: it seeks to “subsidize identifiable activities” — homeownership in this case — and could easily be designed as a spending program in which the government sends homeowners an annual check.

Bloomberg View columnists Justin Wolfers and Betsey Stevenson have proposed that we “replace all tax expenditures with explicit subsidies — that is, with actual federal payments — so we can really see the costs and debate all spending programs on an equal footing.” For spending-like expenditures, at least, that’s a pretty good plan.

Marron and Toder counted about $600 billion of such expenditures in the 2010 tax code. Add in $230 billion in “user fees” that are counted as “negative spending” but are more like tax revenue, and you reach the $830 billion total — “almost 30 percent more than officially reported.”

Some in Washington see this number and their eyes light up: It’s tax reform time! Democrats can get more revenue. Republicans can cut effective federal spending. Taxpayers can get a simpler code. And the economy can get a boost from a tax regime that does less to distort the workings of the free market.

They’ve even got a model: That’s how the 1986 tax reform worked. We cleared out much of the code’s underbrush and used the savings to lower rates. Now, the undergrowth of expenditure is larger even than it was in 1986. In addition, there are the Bush tax cuts, which are set to expire at the end of this year. There has never been a better time, they argue, for tax reform.

Ah, but there’s the rub: Although the looming expiration of the Bush tax cuts adds urgency to reform, they also stand in its way.

Because the ultimate purpose of the tax system is to fund the government, reform proposals generally target a certain revenue level. Usually, it’s the same level as the current code, or even a bit less. Veterans of past efforts generally advise against using tax reform as a vehicle for deficit reduction. Most say that for reform to succeed, it must be “revenue neutral.”

But the Bush tax cuts have created a “base line” problem. The two parties can’t agree on a plan because they can’t agree on a common equation for how much revenue counts as “revenue neutral.”

Republicans work from a base line that includes a full extension of the Bush tax cuts. The Democrats’ base line assumes the expiration of the tax cuts for families earning more than $250,000. The Congressional Budget Office uses yet another base line, one that assumes that all of the Bush tax cuts will expire, because that’s what current law says will happen at the end of 2012. The difference in revenue between the Republican and the current-law scenario exceeds $4 trillion over 10 years.

So before we can even discuss what a new tax code should look like, we somehow need to resolve the most polarizing question in American politics: Should taxes be higher or lower?

It’s extremely unlikely that the two parties will come to an agreement on their own. Luckily, they don’t have to. If they simply continue to disagree, at the end of this year the Bush tax cuts will expire, and two of the competing base lines will fade away, leaving only the CBO’s standing.

Some Republican staff members say, though they oppose this outcome, it would actually make tax reform easier by enabling both parties to sell reform as a huge tax cut that reverses the expiration of most of the Bush tax cuts.

Here’s why: Using the Republican base line that assumes all of the Bush tax cuts are extended, President Barack Obama’s plan amounts to a $1.5 trillion tax increase. But using a base line in which all of the Bush tax cuts have expired, a tax reform plan that hits the same revenue target as Obama’s amounts to a $2.5 trillion tax cut. Neat, huh?

That’s not just a PR point: Tax reform would, in that scenario, actually be a huge tax cut because, after expiration, taxes really would have reverted to a much higher level.

Reality is always more compelling than base lines. The two parties would still have to settle on a final revenue number, but at least they could agree on one that would cut taxes on almost all Americans.

Which highlights another reason that letting the Bush tax cuts expire might lead to tax reform: Their sudden withdrawal would be so calamitous to the economy, and so embarrassing to Washington, that the crisis could force the two parties to fast track a reform plan, saving most taxpayers from feeling the bite of Washington’s failure.

It’s sad to think that the only way to save the tax code might be to let it collapse at the end of the year. But that doesn’t mean it isn’t true.