Federal Tax Policy: It’s Not All About Comprehensive Reform

Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joseph R. Biden Jr.

Though there’s a lot of room for improvement, I’d guess that any large-scale changes to federal tax policy are off the near-term table. Yes, congressional partisans agreed on a little budget deal late last year, but “comprehensive tax reform” or a “grand bargain” seem awfully far out of reach. Republicans will not countenance tax increases and most Democrats, to their credit, will not agree to cuts in entitlements that compromise the security of economically vulnerable households.

But the absence of “big deals” from the scene could be more of a feature than a bug. In fact, I’d argue that one reason the budget deal came to fruition was that grand bargains were kept out of the room. Could there possibly be enough oxygen left in that room for deals involving parts of the tax code?

In fact, President Obama suggested a number of ideas in his State of the Union speech last week, some of which are meant to have bipartisan appeal, and others … well, they’ll probably have to wait for a broader reform effort. Historically, meaningful changes in the tax code face a long runway, so even if none of these ideas come to pass in the near term, we should still taxi them out of their hangars.

Expanding the Earned-Income Tax Credit for Childless Workers: A positive outcome of the fact that we’re now debating inequality and opportunity (instead of deficit reduction) is that members of both parties have been compelled to offer some ideas to help less-advantaged workers other than just reducing the deficit. One idea that has surfaced with bipartisan support is to expand the earned-income tax credit, a highly effective, pro-work wage subsidy for low-income workers.

But workers without children are currently all but left out of the earned-income tax credit â€" their average benefit is under $300 per year compared with around $2,800 per year for families with children â€" and partly as a result, they are the only group of workers that the federal tax code taxes into â€" or deeper into â€" poverty.

Corporate Tax Reform, With a Side of Infrastructure Investment: Many in both parties argue that our corporate tax rates are too high and render American companies uncompetitive. It’s an odd argument to make these days, given that corporate profits are through the roof. It’s also an argument based on the statutory tax rate. In reality, because of tax advantages to offshore income and debt financing, and other tax breaks and loopholes in the corporate code, what many corporations actually pay in taxes has little to do with the statutory rate.

At least in theory, both sides recognize the need to clean out many of those wasteful and inefficient corporate loopholes and tax breaks, though when it comes down to cases you hear a lot of people defending their “job creating incentives” against your loophole.

Because the tax code currently encourages corporations to squirrel earnings offshore to avoid United States tax, American multinationals now have roughly $2 trillion of foreign earnings stashed abroad. Any transition to a new system that ends the incentive for corporations to shift and keep profits offshore must levy a one-time tax on this hoard. And since it’s a one-timer, you do not want to build expectations regarding future revenue flows from this part of the change into your baseline. So, given the still weak economy and the deep need to invest in our stock of public goods, the smart move is to apply the one-time revenues to some much needed repairs. The permanent revenues would then be used to cut the corporate tax rate.

Those last two ideas, especially the expansion of the earned-income tax credit, could have legs, even in this Congress (though I’d give them less than a 50 percent chance of seeing the legislative light of day). These next two, not so much. But they still belong on the docket.

Turning Upside-Down Tax Savings Incentives Right Side Up: The figure below shows another tax problem in need of a fix: when it comes to incentives for retirement savings, the code channels the bulk of tax breaks to high-income households, but little to low- and moderate-income households. The figure portrays an upside-down system where most savings subsidies go to households that would surely save anyway, while almost nothing goes to the households that need help to save. It is why tax incentives for retirement savings plans, such as 401(k)s and individual retirement accounts, appear to do little relative to their high cost to encourage new saving.

Center on Budget and Policy Priorities Source: Congressional Budget Office

Fixing this could involve changes such as closing loopholes that make it easy for wealthy individuals to exceed contribution limits to tax-preferred accounts (as was found to be the case with Mitt Romney), reducing contribution limits for high-income filers, or simply limiting the value of tax breaks for the wealthiest filers (e.g., allowing them to deduct such contributions at 28 percent instead of 39.6 percent).

That last change alone would yield many, many times the revenue needed to pay for the expansion of the earned-income tax credit.

Funding Early Childhood Education: Economists of all political stripes agree that quality preschool for children in low-income households returns positive net benefits over the life of the child. The president has proposed to pay for such a program by increasing the federal excise tax on tobacco products.

Researchers have found large demand “elasticities” â€" responses to price changes â€" when it comes to tobacco products, especially among teenagers and low-income adults, providing a health offset to a regressive tax. And of course, lower-income children and families would be the main beneficiaries of the expanded availability of early childhood education that these tax revenues would finance.

Though big-ticket tax reform is not on the horizon, a concerted, bipartisan effort could lead to an expanded earned-income tax credit in the near term, and perhaps even corporate reform that initially supports infrastructure investment (though that is less likely). Flipping inefficient retirement incentives that subsidize savings that would be made anyway and taxing tobacco to fund early childhood education will most likely have to wait for the pendulum to swing a lot further back toward compromise. Maybe then, sensible changes like these with bipartisan support could have a chance of being legislated.