Overhauling the tax code: The devil is in the transition

Tax reform continues to move forward like a freight train, slowly picking up speed on a long journey to the president’s desk. Senate Finance Committee Chairman Max Baucus (D-Mont.) and Ways and Means Committee Chairman Dave Camp (R-Mich.) have forged an admirable working relationship, and they have publicly committed to doing something incredibly difficult in Washington: create winners and losers in tax policy. Ultimately, successful tax reform means that some taxpayers will pay more — a necessary condition of “leveling the playing field” and removing the favoritism and crony capitalism that litters the tax code. Others will pay less if the additional revenue is used to offset the cost of reducing marginal tax rates.

The current tax code is fraught with complexity, unfairness and distortions that lead to misallocations of capital, disincentives to invest and tricks by which a savvy taxpayer can achieve a break that another similar taxpayer does not. In many cases, then, the “losers” in tax reform will deserve the higher taxes they pay. In other cases, the burden of a broader tax base will fall on ordinary individuals who simply have been availing themselves of the opportunities that the tax code offers them — a tax credit for replacing their old windows, for example.

The path to a utopian tax code where rates are low and the base is broad is treacherous not only in a political sense, but also in practical, economic terms. The actual transition from the tax code we have to the tax code we want promises to be complex.

For example, if Congress were to recognize that the current tax policy geared toward encouraging home ownership is inefficient and regressive, and chose to replace the current mortgage interest deduction with a fairer, simpler tax credit, transition rules would need to be carefully crafted. Perhaps current homeowners should continue under the rules that were in place when they bought their home. Perhaps the new credit should be more generous in the early years than in the long run to mitigate the potential impact in certain high-priced housing markets.

On another front, Congress might recognize that permitting taxpayers to deduct from their federal taxes the amount they paid in state and local taxes is neither fair to the residents of low-tax states nor effective in encouraging states to engage in pro-growth tax policies themselves. If Congress were to curtail or repeal these subsidies, a transitory path would be essential so that states have time to alter their own tax structures and prevent their residents from being hit with an overnight tax hike that could be untenable.

Of course, not every move broadening the tax base needs a transition rule. Some policies can simply be repealed or, if they are not permanent elements of the code, not be renewed. And of course, some tax policies that appear on the long list of “tax expenditures” are worthwhile and appropriate policies, either because they effectively and efficiently encourage work or investment or because they achieve a social policy objective more valuable than the forgone revenue.

Unfortunately, there are also real costs to providing “too much” transition relief in tax reform. Delaying the imposition of new policies that will permit capital to flow more naturally to its highest and best use means delaying the economic gains that tax reform can offer. In fact, it is quite possible that a generous set of transition rules could wipe out a significant amount of the economic benefit that tax reform could offer. In other words, transition rules in base broadening would raise less revenue in the short run to “pay” for lower statutory tax rates, whether a cut in the corporate tax rate or the rates for individuals and small-business owners. 

But herein lies a political silver lining to the complexities of transition rules. Lawmakers appear committed to “revenue-neutral” tax reform, which will be defined by the aggregate change in taxes over the 10-year budget window. Transition relief is, by its nature, temporary. Thus, tax reform with fair transition rules that yields revenue-neutrality over the first 10 years could result in additional revenue in the long run as transition rules expire. This would allow Republicans to claim that they are not raising taxes according to the official scorekeepers, while Democrats can support this effort knowing there will be additional revenue in the long run. 

Brill is a research fellow at the American Enterprise Institute. He was formerly the chief economist and policy director to the House Ways and Means Committee.