09/15/2011 10:58 am ET Updated Nov 15, 2011

Memo to Members of the Budget Super Committee: You Have a Once-in-a-Lifetime Opportunity

The recently appointed congressional Super Committee has a unique opportunity to accomplish something that normal legislative processes would almost certainly preclude. Legislation normally goes through a labyrinth process weaving through obscure committees where it can be amended almost invisibly at the request of lobbyists acting largely out of public view. The rules of the game set in the recent debt limit legislation, however, enable this Super Committee to produce legislation that must be voted up-or-down without amendment by each house of Congress. And there is a hammer: an alternative set of budget-cutting provisions will take effect if they are voted down, and (differing) aspects of this alternative are anathema to each side.

Comprehensive reforms almost inevitably contain components that are unattractive to particular groups. Since there will be an up-or-down vote on the entire package, the rules of the game present a unique opportunity to present a comprehensive set of proposals that cannot be picked to death by amendment. The right package could produce significant progress towards a balanced budget. More importantly, however, if done right, it could help create an environment of citizen willingness to share necessary sacrifices in hard times. For that to happen, however, we need something to dramatically increase our sense that the tax system is fundamentally fair.

To get there, however, we need to explode two tenaciously held but entirely unsupported myths. Each party has one. Without such creative destruction, the necessary compromises are unlikely.

The Republican Myth: Tax Expenditures are Not Expenditures

Republicans love lower tax rates, and many would even prefer to see a completely flat tax. Democrats see a flat tax as unfair and generally prefer steeply progressive tax rates. Our tax code is nominally progressive, but is so riddled with deductions, exceptions, and special treatment of income that, in practice, it favors only those who game the system. Some wealthy taxpayers and corporations pay nothing (which Democrats tout), while others pay quite a lot (which Republicans observe). And nearly everyone agrees it is obscenely unfair.

If the Congress passed a law saying Mike O'Neil is a fine fellow, let's just give him $10,000, Republicans would say this is an unacceptable increase in government spending and Democrats would say it is unfair, since no one else would get the money. And both would be right. But what if the law instead said that because Mike O'Neil is such a fine fellow, he should get a $10,000 reduction in his federal income taxes? Current Republican orthodoxy would dictate that if the current law already had such a provision, taking it away would amount to a completely unacceptable "tax increase" since it would permit me to keep what is, after all, "my money." Any Republican who voted to remove such an unfair provision of the tax code would be accused of "raising taxes" (and incur the wrath of Grover Norquist). While this is an obvious absurdity, the current tax code is riddled with many preferences and provisions that are functionally the equivalent of this blatant giveaway. A tax break not given to everyone is a tax expenditure. And a tax expenditure is a government expenditure just like any other.

The Democratic Myth: Social Security Benefits were Fully Paid for by Current Recipients

But Republicans are not alone in holding to unsupported beliefs. Cut Social Security benefits by a penny and you are taking away what recipients believe they fully paid for with their employment (FICA) taxes. And the indignation is real. The only problem is that an honest actuarial analysis of the system reveals that the vast majority of current Social Security recipients get benefits far in excess of what they "paid for." Furthermore, there is no "lock box" or piggy bank that contains even what recipients did actually pay in to the system. Rather that piggy bank contains nothing but a stack of government IOUs -- IOUs that will have to be paid for with general tax revenues. Over the last decades, Social Security trust funds were used to fund several wars and unfunded tax cuts (and, yes, it was also used to fund the much-maligned stimuli of 2008 and 2009, although this component is comparatively smaller than the wars and tax cuts).

While there is not a penny of actual cash in the system, there is a legitimate moral claim on the assets of the Social Security trust fund, even if those assets are just government IOUs. Those who paid into the system are entitled to receive a fair return on what they paid in. But in most cases, current benefit levels exceed these amounts. And every politician in Washington knows this but is afraid to say it publicly.

The Grand Compromise

So what grand compromise could come from this Super Committee? It has two parts. Both are a necessary component of any deal, because each appeals to a different constituency.

1. Reform Income Taxes.

The current tax system is justifiably seen as totally unfair. Rectifying this requires:

  1. Elimination of all tax expenditures, meaning any deduction that applies only to some people.
  2. Taxing all income on the same basis. That means no sacred cows. No special treatment for dividends, capital gains, or any other class of income. Income is income. Period.
  3. All tax deductions distort behavior. And all are discriminatory, even if some are popular, like the home mortgage deduction. Remove all of them. Try to save a single one and we open the floodgates. There is no chance of keeping just a few favored deductions. It's all or nothing.
  4. If we do the first three things, we could dramatically reduce income tax rates without decreasing government revenues. But, given the committee's mandate to reduce the deficit, cut rates a bit less and contribute to debt reduction while still lowering tax rates.
Democrats could cheer the elimination of all deductions and special treatment of some forms of income, both of which disproportionately favor the well-off. And Republicans could embrace the lower rates for everyone. And both would know that the result meets simple notions of fairness -- a test which the current tax code fails miserably.

A proposal that did this would still leave intact one residual question. Democrats want steeply progressive rates while Republicans like flat rates. Fortunately, quantitative matters lend themselves to relatively easy compromise. This compromise is obvious: split the difference. Make marginal rates lower for everyone to make Republicans happy, but maintain some progressivity to please Democrats. And, most importantly, everyone pays taxes on all of their income. This, and only this, will return the sense that our tax system is fundamentally fair.

2. Adjust Social Security.

While the tax reforms have aspects which Republicans could embrace, it is clear that they will never agree to a proposal that is tax-only. But meaningful expenditure reductions can only come from large (and hence popular) programs. Only defense, Medicare/Medicaid, and Social Security meet this test. Everything else is practically rounding error in the federal budget. That means that returning Social Security to an actuarially sustainable basis will have to be part of any bipartisan deal. (These other big items should be looked at as well, but are beyond the scope of this piece. Other government programs can't be exempt, but most are so tiny in comparison to entitlements and defense that they contribute far less to any deficit than most people realize). Some eventual combination of retirement age and/or cost-of-living adjustment modification in Social Security is an inescapable necessity. This is not a matter of politics, but of arithmetic: the current numbers simply don't add up.

Immediate cuts could, however, hurt an economic recovery and would not permit recipients to adjust. Fortunately, the impactful Social Security issues are the long-term ones. So structure these reforms to take effect several years down the road. This would provide people an opportunity to plan and also cushion the impact in hard economic times. In all probability, these savings can be accomplished without actual cuts, only long-term adjustments in nominal rates of increase. (Most agree that the current formula has overestimated real cost increases for seniors anyway). If sustained over the long run, the impact of such incremental changes on budget deficits can be both dramatic and gradual enough that no one gets hurt. A little belt-tightening, to be sure. But that is something we all have to get used to in troubled times.

Shared Sacrifice.

These two proposals are linked. Each involves some sacrifice. But you can't ask retirees to take a hit on Social Security payments while they observe multimillion dollar a year hedge fund managers given a special 15% tax rate when ordinary wage earning professionals pay 35% or 39%. Indeed, the moral claim of asking any taxpayer to pay more taxes -- or to receive less from government -- is undermined when there are so many examples of huge profitable companies and rich individuals who obviously do not contribute fairly to the system.

The current system is so riddled with loopholes and preferences that everyone feels cheated and no one feels it is legitimate to ask them to sacrifice -- ever. It is a return to this sense of collective fairness above all else that would be the primary positive result of a massively simpler and more equitable system. A return to an ethos of shared sacrifice requires no less than this.

In normal times, such a grand compromise would never happen, since Christmas tree amendments would be written into legislation in obscure congressional subcommittees and in amendments proposed on the floor by one of 535 members of Congress. These would eviscerate any attempt to produce a tax code that is both simple and fair. But the provisions of the debt ceiling legislation mean that the Congress must vote up or down on the entire package offered by the Super Committee. And the mandated alternative contains provisions that many in Congress will not like. As a result, this Super Committee has what may be a once in a lifetime opportunity to fix a corrupt and cumbersome system that distorts economic incentives and leaves almost everyone feeling cheated.