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The Public Choice of Sustainable Tax Reform

by Christopher Koopman on July 3, 2013

in Public Choice, Study of American Capitalism, Tax and Budget

Comprehensive tax reform has gotten a jump-start from Senators Max Baucus (D-MT) and Orrin Hatch (R-UT), the chairman and ranking Republican on the Senate Finance Committee.  The Senate’s two top tax writers announced a new “blank slate” approach to tax reform in a “Dear Colleague” letter issued last week.

The Senators describe their new, blank slate approach as follows:

In order to make sure that we end up with a simpler, more efficient and fairer tax code, we believe it is important to start with a “blank slate”—that is, a tax code without all of the special provisions in the form of exclusions, deductions and credits and other preferences…

However, under their framework, every current tax privilege has a chance to survive.  The Senators explain:

We plan to operate from an assumption that all special provisions are out unless there is clear evidence that they: (1) help grow the economy, (2) make the tax code fairer, or (3) effectively promote other important policy objectives.

This plan has drawn both praise and criticism, and rightly so.  Yes, this is a step in the right direction; however, this is unlikely to lead to any sustainable reforms for two reasons.

First, forcing Congress to defend tax privileges won’t be hard.  To become law, each privilege had a sponsor, and each sponsor had a rationale to defend it.  Each tax privilege was passed by Congress, and each was then signed into law.  It is difficult to see how privileges that have already survived this process won’t once again find a congressman willing to defend them.  So long as Congress has the power to create and protect tax privileges, it will be nearly impossible to simply wipe such privileges away.

Second, even if a blank slate were achieved, it is unlikely that a privilege-free tax code would last long under the current institutional framework.  This is best demonstrated by what happened in the aftermath of the Tax Reform Act of 1986 (TRA86).

James Buchanan, writing after the passage of TRA86, predicted that very little its reforms would remain intact.  Buchanan noted that “[t]o the extent that [political] agents do possess discretionary authority, the tax structure established in 1986 will not be left substantially in place for decades or even years.”

Buchanan was spot on.  From 1986 through 2005, the tax reform of 1986 suffered a death of 15,000 tweaks.  As reported by the President’s Advisory Panel on Federal Tax Reform in 2005, in the two decades after the 1986 tax reform bill was passed, nearly 15,000 changes were made to the tax code – equal to more than two changes per day for 19 years straight.

What insight did Buchanan have that allowed him to so aptly predict the demise of the Tax Reform Act of 1986?  Buchanan understood that institutions matter.  That is, he understood that no matter how many times the tax code was reformed, so long as the same institutions remain unchanged, political actors will continue to respond in predictable ways, and the result would be tax privileges creeping their way back into the code.  Buchanan explained:

The 1986 broadening of the tax base by closing several established loopholes and shelters offers potential rents to those agents who can promise to renegotiate the package, piecemeal, in subsequent rounds of the tax game. The special interest lobbyists, whose clients suffered capital value losses in the 1986 exercise, may find their personal opportunities widened after 1986, as legislators seek out personal and private rents by offering to narrow the tax base again. In one fell swoop, the political agents may have created for themselves the potential for substantially increased rents. This rent-seeking hypothesis will clearly be tested by the fiscal politics of the post-1986 years.

Going forward, if any sort of reforms are achieved in the tax code, this rent-seeking hypothesis will be tested again.

Senators Baucus and Hatch admit that a blank state “is not, of course, the end product, nor the end of the discussion.”  If Buchanan’s predictions remain true today, as they most certainly are, then the Senators are quite right in admitting that a blank slate is not, and will never be, an end product.  That is, of course, unless any reform in the tax code is paired with institutional reforms to ensure that special tax privileges do not creep back into the code.

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