A how-to guide to raising Americans’ taxes

One of the first acts of the new Democratic-controlled Congress was a return to a budget control rule known as pay-as-you-go (pay-go). The essence of this rule with regard to tax policy says that tax bills cannot make the deficit worse. Therefore, any proposal to reduce taxes will generally be joined with an offsetting tax increase.

The Democrats’ tenet that, above all else, the current projected level of taxation should be a floor dramatically increases the focus in Washington on revenue raisers. Assuming that tax increases will garner attention also assumes there will be interest in tax cuts, but an examination of the outlook for the alternative minimum tax (AMT) makes clear the political imperativeness for near-term tax relief. If nothing is done in 2007, the AMT will affect 23 million households, up from 4 million in 2006. By the pay-go rules, preventing that will require finding about $45 billion in offsetting tax increases for just a temporary fix for this year. Outright repeal of the AMT would require nearly $700 billion in offsetting increases!

Congress faces more than three dozen expiring tax provisions next year, including the research-and-development tax credit and the state and local sales tax deduction. The total price tag of keeping these policies and holding down the AMT for 2008 could approach $100 billion. To prevent those taxes from increasing, Congress will need to find others to increase instead.
While the notion implicit in the pay-go principle — that tax policy should focus first on rearranging the deck chairs without questioning how many chairs on deck to have — is in many ways misguided, the legislative reality is that tax increases are coming. The following are five suggested principles for Congress to consider when searching for revenue increasing proposals:

• Look to the tax base, not the tax rates. Focus on policies that reduce the existing distortions caused by taxes, and thereby help grow the economy. Raising existing tax rates higher will exacerbate economic distortions and can retard economic growth. But, there are a plethora of tax credits, deductions and exclusions that do little economic good and perhaps some harm that could be eliminated. Such changes would also simplify the tax code dramatically.

• Be honest and avoid budget gimmicks. If the new majority truly believes in the pay-go concept, they shouldn’t cheat when applying the rules. Republicans certainly borrowed from a bag of tricks to make the apparent size and exact shape of a tax bill fit their budget structure, and Democrats have already been tempted by the ease in which tax lawyers can move federal tax dollars from one year to another to hit a budget target. But, if Democrats want to elevate the degree of budget discipline in Congress, they must cast aside these tricks and enforce their own new rules honestly and consistently.

• Don’t mix corporate and individual tax changes. It will be tempting for Democrats to provide additional tax credits for the average voter, the middle-class family, and jack up taxes on “the rich,” or the “evil industries” that make “too much” profit or that unpatriotically earn or keep income in the wrong part of the world. Yes, the corporate tax code is in desperate need of reform and there are tax increases in the corporate tax code that are acceptable — even desirable — in the quest for a level playing field among businesses and industries. But there is needed tax relief in the corporate area as well, given the increasing pressures from global competition and the fact that the U.S. corporate tax rate is the second only to Japan. Revenue raised by eliminating corporate tax subsidies should be dedicated to lowering the corporate rate and ensuring that the U.S. corporate tax code can compete with those of our trading partners.

• If changing the distribution of the tax code, think horizontally before vertically. Should the new leadership in Congress seek to rebalance the burden of the tax code “more fairly,” keep in mind that much of the inequity in the tax code is a result of two similarly situated taxpayers paying much different tax bills. Before seeking to create more fairness by raising taxes on the rich, recognize that among taxpayers with adjusted gross incomes of $40,000 to $50,000 a year, income tax liabilities average $3,600 in 2004 but 10 percent of tax filers with that income pay zero dollars in income taxes! By limiting or eliminating narrow tax deductions and credits in the tax code, revenue can be raised and this inequality can be addressed.

• Carefully evaluate the economics of both the tax-cut and tax-increase portion of any legislative package to evaluate if it is really worth pursing. An inefficient tax cut by itself will increase the deficit and may create undesirable economic distortions, but an inefficient tax cut plus an inefficient tax increase could be much worse. For example, running two parallel tax structures — as we do with the ordinary income tax and the AMT — is total tax policy foolishness, but doing nothing to address the AMT will have relatively little economic consequence and may do much to promote serious and fundamental tax reform. If Congress enacts a change to prevent an explosion in moderately wealthy AMT payers, offset by raising the tax rate on the truly wealthy, the net economic effect would most likely be negative.

These suggestions are easier said than done. But if this Congress is committed to addressing the short-term deficit pressures while promoting a fair, economic-growth agenda, they shouldn’t be ignored.

Brill is a research fellow at the American Enterprise Institute. He was chief economist and senior adviser on the House Ways and Means Committee, where he worked from 2002 to 2007.