Schumer’s spot on: 1986 is the wrong model for tax reform

Sen. Chuck Schumer (D-NY) recently made headlines in declaring that marginal income tax rate reductions are a terrible starting point for tax reform—they shouldn’t be a priority, period—and that the dual objectives of the Tax Reform Act of 1986 are completely inappropriate today. The 1986 reform, the last comprehensive “cleaning” of the tax code, is often touted as the model for tax reform, which Schumer attributes more to coalescing political bipartisanship than policy specifics. The ’86 framework of base-broadening, rate reductions, and distributional neutrality was recently adopted by two prominent tax proposals Schumer is now urging Democrats to reject—reforms proposed by Fiscal Commission Co-Chairs Alan Simpson and Erskine Bowles, as well as the Gang of Six (although both of these proposals would raise revenue, unlike the ’86 reforms). And Schumer is absolutely right about both the premise and conclusion of his argument. Here’s his take in a recent interview with Ezra Klein:

Klein: “The core of your argument is that tax reform in 2012 is proceeding atop a mistaken analogy to tax reform in 1986. So why isn’t 2012 like 1986?”

Schumer: “It’s not like 1986 for two reasons. First, in 1986, we didn’t have a deficit [we were trying to reduce]. The two greatest problems we face are declining middle-class incomes and huge deficits. Neither existed in 1986. The old model of tax reform doesn’t deal with either of those problems. It was revenue-neutral, so no new revenues, and, while it was slightly progressive, that was not its intent. So if your goal is to reduce the deficit, you can’t really use the old model.”

Spot on. As I argued in International Economy Magazine earlier this year, the dual challenges of stabilizing the long-term fiscal outlook and rebuilding the middle class necessitate that tax reform raise more revenue and distribute the tax burden more fairly. These realities render the Tax Reform Act—which, as Schumer notes, was designed to be both revenue– and distributionally-neutral—a wholly inappropriate benchmark. Given valid concerns about widening income inequality and unsustainable long-term budget projections, it makes zero sense to lock in the tax code’s revenue levels or distribution.

In fact, further flattening the rate structure will likely further exacerbate income inequality. The Congressional Research Service (CRS) found that recent tax changes have been the second largest driver behind widening income inequality over 1996–2006, following the rising share of capital income—heavily concentrated at the top of the income distribution—at the expense of labor income. Even the rising share of capital income was almost certainly influenced by tax cuts too, as the largest relative and absolute changes in tax rates over this period were decreases in the long-term capital gains rate (from 28 percent to 15 percent) and the qualified dividends rate (from 39.6 percent to 15 percent). This incentivized shifting income away from wages and salaries toward capital income—for the privileged few that can reclassify compensation to minimize tax liability. CRS subsequently found a statistically significant relationship of the labor share of income increasing with higher top capital gains and ordinary income rates, concluding “the top tax rate deductions appear to be associated with increasing concentration of income at the top of the distribution.”

And as Larry Summers has argued, simplifying the tax code is often falsely equated with reducing the number and range of marginal tax rates; but tax rates don’t add to complexity, particularly in the age of tax return computer software—the complicating factor remains calculating taxable income, which “base-broadening” would actually address. So flattening the rate structure will hardly simplify the tax code but will almost certainly undermine progressivity, shifting the tax distribution away from upper-income households and toward the middle class. The emphasis on marginal rate cuts so dominant in the tax plans of Mitt Romney or Rep. Paul Ryan (R-Wis.) unduly risks tax reform morphing into a massive, unaffordable, regressive tax cut.

In other words, using the 1986 tax reform as a model for tax reform today risks exacerbating inequality and blowing up the deficit. In fact, there’s no reason that marginal rate reductions are merited: As economists Peter Diamond and Emmanuel Saez convincingly argue, top federal income tax rates are already well below their optimal levels and cleaning the tax base—thereby reducing opportunities for avoidance and income shifting—would imply an even higher optimal tax rate. As Schumer advocates, it would be more prudent to eliminate tax expenditures for deficit reduction than for rate reduction.