The case for tax and spending reform is strong. Simply put, the current tax system is complex, costly to administer, a compliance nightmare, riddled with tax expenditures and imposed at relatively high tax rates. Under the current system, total revenues are projected to increase from 17.6 to 19.4 percent of gross domestic product (GDP) by 2039, with all of that increase coming from built-in increases in the taxation of individual income. This is 2 percentage points higher than average revenues as a share of GDP (17.4 percent) from 1974 to 2013. To make matters worse, the current fiscal path is unsustainable, with the federal debt projected to increase from 74 to 106 percent of GDP by 2039 (in a best-case scenario), and even more thereafter if spending and taxes are left unchanged.


Fiscal reform is clearly needed, but what is the way forward? The approach of the National Commission on Fiscal Responsibility and Reform seems to have been foiled at least partially by the attempt to adopt targets for revenue (21 percent) and spending (22 percent initially and 21 percent in the long run) as a share of GDP. But an open discussion of how much national output should be devoted to government-provided goods and services is crucial. However, that discussion, or lack thereof, should not permanently postpone tax reform. Thus, it may be more reasonable to separate the process into a two-stage approach to reform — a revenue-neutral fundamental tax reform, followed by fiscal reform that reduces future budget deficits while reaching a compromise on distributional issues and the politically acceptable size of the government. Indeed, this is a difficult task.

In any case, whether revenue as a share of GDP remains at the projected (and growing) level or is increased as part of a fiscal reform, it is imperative that the U.S. reform its tax system to reduce economic distortions. Otherwise, the combination of rising taxes as a share of GDP and a relatively distortionary tax system could significantly hamper economic growth.

Proponents of corporate tax reform argue that high tax rates discourage investment and capital accumulation and thus reduce productivity and economic growth. In addition, the combination of a high statutory tax rate coupled with a wide variety of tax preferences distorts the allocation of investment across asset types and industries and reduces the productivity of the nation's assets while exacerbating the many inefficiencies of the corporate income tax. A 2008 study by the Organisation for Economic Cooperation and Development (OECD) argued that corporate taxes are most harmful to economic growth, followed by individual income taxes. Clearly, the time for corporate tax reform is at hand as there is widespread agreement that reform is needed to help U.S. businesses compete at home and abroad.

As proposed by economist Alan Auerbach, the corporate tax could be reformed by allowing an immediate deduction for all new investment as a replacement for the current depreciation system and moving to a system that only taxes transactions that occur in the United States (that is, a destination-based cash-flow tax). This would move the U.S. from having the highest corporate tax rate in the industrialized world to one of the lowest, as the cash-flow tax would exempt the normal rate of return to capital from taxation, while taxing above-normal returns. In addition, under this reform, loans would be included and repayment of loans would be deductible on a cash-flow basis. This would eliminate the current preference for debt-financed rather than equity-financed investment at the corporate level.

There is also widespread discontent with the individual income-tax system. High individual tax rates, coupled with widespread tax preferences, distort decisions regarding labor supply, saving and consumption; they also significantly complicate tax administration and compliance and encourage tax avoidance and evasion. Moreover, many tax preferences are poorly designed in any case. The home-mortgage interest deduction is an excellent example. Although its primary purpose is to encourage home ownership over renting, it is poorly designed to achieve this goal as it offers little or nothing to low- and middle-income individuals. Instead, the vast majority of the benefits of the home-mortgage interest deduction accrue to high-income taxpayers, encouraging overconsumption of housing at the expense of less investment in the rest of the economy.

Serious consideration should be given to adopting a consumption-based, rather than an income-based, tax. In general, consumption-based reforms will increase economic growth more than reforms of the current income-tax system. We should avoid base-narrowing, rate-increasing tax-reform plans, such as those proposed by the Obama administration, that increase tax rates on capital income (mainly on capital gains and dividend income) and increase tax expenditures (such as a new $500 second-earner tax credit, an increase in the child credit to $3,000 per child under 5 years old and expanded credits for others). Note that these policies also increase marginal individual income-tax rates, as the expanded credits are phased out, and thus discourage labor supply and saving.

Diamond is the Kelly Fellow in Public Finance at Rice University's Baker Institute.