A Cynic's View of Tax Reform

06/10/2015 04:36 pm ET | Updated Jun 09, 2016

The more complicated a tax provision is, the more likely it is hiding an unjustifiable tax subsidy, and we all know our tax code is way too complicated.

Unfortunately, politicians have discovered that it is much easier to give a subsidy to their friends and contributors through the tax code than through an appropriation, which is more likely to be open to public scrutiny every time it is appropriated. As Anthony Downs pointed out in his classic book, An Economic Theory of Democracy, rational politicians will do whatever is needed to maximize their votes. If voters are focused on an issue, politicians will do whatever they think will appeal to the most voters. If voters are not aware of the issue -- and most aren't -- politicians will do whatever will raise the biggest amount of money so that they can reach as many voters as possible with whatever arguments their experts think will maximize votes.

The result is that winners and losers are picked not by the market, but by those who can afford the best-connected lobbyists. And the system feeds on itself. Any rational businessperson who can afford it is going to try to get a subsidy because it is likely that the benefit of the subsidy will far exceed the cost of acquiring it and will exceed whatever rate of return one could earn in the market. Subsidies also create a lot of inequities because only the powerful benefit from them. Small businesses don't have the same resources and consequently are at a disadvantage when competing with the powerful interests that set the agenda in Washington and increasingly in the states.

The amount of subsidies the powerful interests have acquired is awe-inspiring. In our business tax code, we hand out more in subsidies than we receive in revenue. And if the multinational corporations get Congress to adopt a territorial tax system, that will get far worse. The multinationals will not have to pay taxes on profits they claim they earn offshore, which would put domestic competitors at a great disadvantage and would provide even more encouragement to export jobs and profits.

Another problem with these special tax subsidies is that to take advantage of them, too many taxpayers must set up uneconomic entities. This creates a lot of economic waste and even more damage when these entities are unwound. We saw how many taxpayer dollars were required to save the big banks that hid their risks in special purpose entities.

Even if the public does discover an unjustifiable tax subsidy, it is usually futile to attack it. Those who benefit from the subsidy will expend as much political capital as necessary to save it, while the general public usually isn't outraged enough to expend the political capital needed to eliminate it. The only ones who take seriously the public outrage at these special subsidies are lobbyists trolling for clients.

Two things need to happen before we get real tax reform: One, we need an economic crisis that will force Congress and the president to agree to push for reform or face outraged and energized voters. Two, we need to agree on how to efficiently and fairly raise the money needed to run our government. Economists almost unanimously agree that the best taxes are those that create the least distortions in the market, that are progressive, and that can be administered easily. Unfortunately, given the current political situation, in which theology seems more important than facts and in which people want to cut taxes without asking about the consequences or about the kind of government we want, it will require a real crisis to spur tax reform. That may be happening in Kansas, Ohio, and Wisconsin, where the governors have cut taxes so much that schools are closing early, roads are not being repaired, pension debts are increasing, and the economies are falling behind those of neighboring states. Even in Congress, it is beginning to dawn on the tax cutters that their policy is hurting the programs they have traditionally supported, like the military, which according to those closest to the scene, is facing dire consequences since it doesn't have the resources to defend us against the most likely attacks.

Consideration should be given to the idea of eliminating all business tax subsidies and thereby forcing those who want to reinstitute them to prove publicly that the subsidies are economically justified -- that is, prove why the free market should not be allowed to work. This recognizes the reality that once a subsidy is removed, there will be pressure to reinstate it and opportunities for fundraisers. But requiring a public disclosure of the cost of the subsidy and the justification for it -- as Oklahoma does -- might at least limit some of the more egregious attempts for subsidies, like the territorial tax system being pushed by the multinationals. Adopting a worldwide unitary combined reporting system and eliminating the capital gains and dividend subsidies would also make our tax code much fairer and help eliminate the increasing income disparity.

Consideration should also be given to the idea of leveling the playing field between corporations and so-called passthrough entities, like master limited partnerships, limited liability companies, etc. One way to do this might be to treat investors like employees. The business entity would pay a tax on its profits and then give investors a credit for the taxes paid on their behalf. This would be easy to administer and could raise significant revenue depending on the rate. Of course, requiring corporations to pay a tax based on the income they reported to shareholders would eliminate thousands of jobs for the accountants and lawyers who try to devise various ways to use tax accounting to minimize taxes, which is why this is unlikely to pass.