Tax fairness: Good luck with that

Making taxes fairer is a worthy aim but often a matter of 'Says who?' And President Obama's attempts may create some unintended consequences.

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By Jeanne Sahadi, CNNMoney.com senior writer

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NEW YORK (CNNMoney.com) -- Make the tax code fairer? That's one of the things President Obama wants to do in the 2010 budget, which Congress resumes work on this week.

"We start from the simple premise that we should reduce the tax burden on working people, while helping Americans go to college, own a home, raise a family, start a business and save for retirement. Those goals are the foundation of the American Dream, and they are the focus of my tax policy," Obama said in a speech last week.

His biggest proposal: let many of the Bush cuts expire for high-income families (those making more than $250,000) in 2011, while extending them for everyone else and even expanding tax breaks for lower-and middle income households.

Of course, when it comes to taxes, fairness is in the eye of the beholder, and reasonable people can disagree on how to achieve greater equity.

Moreover, the quest for fairness can't be pursued in isolation. For tax policy to be effective, it must not only be fair, but it must raise sufficient revenue to fund government efforts; promote economic efficiency; and be simple enough to maximize compliance.

In this context, the president's proposal doesn't get high marks from some tax experts on several counts, starting with simplicity.

"It's an unprincipled and inconsistent jumble of ideas. It doesn't make the system simpler," said William Gale, vice president of economic studies at the Brookings Institution.

Gale and others would prefer a loophole-free tax system that has lower overall income tax rates that apply to a broader base of people. "The more we get away from that the more the system feels arbitrary," Gale said.

Figuring out one's taxable income under the current system is made difficult thanks to the long list of complex deductions, credits and exemptions.

"It's almost like a game show," Gale said. "It couldn't possibly increase compliance. There are more rules to break."

And more reasons to feel the system is rigged in favor of some more than others.

How to split the tax burden

The rationale often cited for making high-income taxpayers pay more than they do now is three-fold: the country needs more revenue; the rich have enjoyed disproportionate growth in their income over the past 30 years; and upper income taxpayers have gotten the biggest benefits from the tax cuts of the past decade.

"Any fairness argument should address the distribution of overall tax burden ... . I would interpret Obama's proposals as redressing an inappropriate sharing of tax burden, circa 2001-2008," said Joel Slemrod, director of the Office of Tax Policy Research at the University of Michigan Business School.

But Gale considers the idea of restoring Clinton-era tax rates for high-income households while leaving the tax cuts in place for everyone else "a bit of a bait and switch." People who didn't support extending the tax cuts now want to keep them in place for 95% of Americans, he said.

"If it's not a big deal to raise taxes on high-income taxpayers, why is it a bad idea to do it for everyone else?" Gale said.

Of course, it's a fundamental principle of the country's progressive tax system that the wealthiest households should pay more than others. But there's no agreement on how much more is appropriate, or conversely, how much less is appropriate for people lower down the income scale. That's a political decision as much as anything else.

Currently, tax burdens on most taxpayers are near their historic lows - as are tax receipts - at a time when deficits are at record highs. And the number of lower income households that end up paying little or no income tax has grown in recent years because of an expansion of tax breaks available to them. The Bush tax cuts increased the ranks of those with zero or negative liability, and Obama's proposals are likely to do the same.

Given the country's deficit, there may be an argument for raising taxes on higher income families, wrote Howard Gleckman, editor of the Tax Policy Center's blog, TaxVox.

"But by proposing to raise rates rather than broadening the base, Obama is practically begging the wealthy to seek out new sheltering opportunities," Gleckman said.

If that turns out to be the case, the perception of fairness in the tax system will take another hit.

Mind the revenue gap

Even those who support Obama's proposals don't believe the president's ideas would raise sufficient revenue to significantly address the country's fiscal hole - growing deeper because of the recession and government efforts to address it.

And many tax experts believe that eventually broad-based tax increases and spending cuts may be in the offing for everyone.

"The recent budget has not confronted the long-term fiscal imbalance faced by the federal government. Part of the solution to this may eventually involve tax increases and, if these tax increases are significant, may require tax increases on a broad swath of the population," Slemrod said.

Gale noted that even if everything went well economically and politically, the country's annual deficit - currently estimated to be 12% of GDP this year - would still be at 6% in 2019 after the economy recovers and the unemployment rate drops to nearly half what it is today, according to estimates from the Congressional Budget Office.

"Let's stipulate we should do all the things the administration wants to do [in terms of health care, education and energy]. It's still the case that we'd need to do more to bring about fiscal balance," Gale said.

Obama inherited record deficits and has said repeatedly the country needs to take steps to restore fiscal balance. But by promising not to raise the tax burden on the majority of Americans, he will have to answer the question of whether it's fair to potentially further burden future generations.

Once the country is out of recession, Gale said, the choice will be "you can fix it now or you can fix it later. We're piling up the debt very quickly under the Administration package." To top of page

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